Perspective on Risk - July 13, 2022
The Value of Reliable Information; Predicting Recession; R* stuff; “The Most Game-changing Challenge We Face”; Intermediary Balance Sheets and the Treasury Yield Curve; Lots more
So I was successfully phished yesterday. Had a number of online credit cards for TV-related sites that needed updating (Hulu etc.) There was an email supposedly from Netflix. Thought it was just another site that needed updating. Filled out and clicked before I realized it was a phish. Happens to all of us. Be careful.
I know I inundate you with this stuff; believe it or not this is only a curated fraction of what I’ve written; lots gets left on the cutting room floor.
The Value of Reliable Information
Bond investors are demanding a premium to hold Australia’s sovereign debt after being burned by the central bank’s failure to provide reliable guidance on inflation and interest rates.
Significant losses from market participants and lack of credibility in guidance have led investors to make a conscious decision to move to the sidelines.
The lack of trust from investors is reflected in Australia’s 10-year bonds, which last month saw yields spike to 92 basis points above similar-dated Treasuries last month, the widest gap since January 2015.
Predicting Recession
I’ve long thought the Estrella/Mishkin 3M/10Y slope was the best predictor of recessionary risk. In Monetary Policy, Inflation Outlook, and Recession Probabilities, the authors state that Engstrom and Sharpe’s nominal near-term forward spread is a better predictor. As with Estrella/Mishkin, it focuses more on the short end of the YC than the 2/10s spread the market seems to prefer. It builds on the r* framework which is all the rage. This note explains WHY Engstrom/Sharpe is a good predictor:
… the current policy gap and the slope of the expected inflation path are the NTFS components that play the main role in predicting recessions. The decomposition helps us to explain why the NTFS does not currently forecast a recession, as shown by Engstrom and Sharpe (2022).
In our baseline case, we forecast increasing real rates, a narrowing policy gap, and a 35% recession probability by the end of 2023. Moreover, we illustrate a second, tighter-policy scenario in which policymakers tighten the stance of monetary policy more rapidly than expected by the model, pushing the real rate above neutral in the first quarter of 2023. In this alternative scenario, inflation declines more rapidly than in the baseline case, at the cost of a higher downside risk for economic activity, as the one-year ahead recession probability approaches 60% by the end of 2023.
You may want to read Engstrom and Sharpe (2022) (Don't Fear) The Yield Curve, Reprise.
So, related to Harald Malmgren’s tweet above, it seems likely Powell is hearing dissonance between market participants and Board economists.
Speaking of r*
Andrew Bailey of the BofE gave a speech titled The economic landscape: structural change, global R * and the missing-investment puzzle. In it he attempts to “step back from the current situation and consider some of the longer-term forces affecting our economy, and shaping the economic landscape in which monetary policy is conducted.”
As a result [of considerable estimation uncertainty], the equilibrium real interest rate is typically used to look back on past policy and its stance, or to provide an indication of the general outlook for interest rates over the coming years, rather than as a direct guide to policy.
Recent research by staff at the Bank has developed a model of the world economy that brings together several key structural factors that could account for the decline in Global R*. These are productivity growth, population growth, longevity, the relative price of capital, and government debt.
With respect to the main drivers of this decline, two factors – population ageing and a slowdown in productivity growth – play the largest roles in explaining the dynamics of Global R*. … The substantial contribution of population ageing to the decline in Global R* in the past stems from the steady increase in longevity, and this mechanism leads to permanently lower Global R*.
Standard neoclassical theory, such as that underlying the structural model considered earlier, implies a strong co-movement between the safe real rate and rate of return on capital. This suggests that we would expect a fall in Global R* to be associated with a fall in the return on capital. But while risk-free rates have been falling globally in recent decades, measures of the rate of return on productive capital across high-income economies have not. As the return on capital has remained stable, as shown in Chart 4, while the safe rate and cost of funding has declined, a wedge has opened up between the return on firms’ investment and the cost of financing it
Accordingly, we might expect to have seen an increase in investment activity alongside the recent increases in the wedge. But, while the wedge has increased, across the same group of countries, … investment has steadily declined, or, at best, remained stable.
The key question, then, is what structural factors can account for this puzzle?
In contrast with the existing literature studying the United States, the results find little role for changes in competition. For the United Kingdom, intangible investment plays the most important role. Indeed, there has been a strong trend in the composition of investment by firms, moving away from physical capital, such as buildings and machinery, towards what is called intangible capital, such as research and development, software, databases and branding.
Where Is r*
Jurrian Timmer, director of global macro at Fidelity, has tweeted out this chart.
He notes:
“The Most Game-changing Challenge We Face”
FBI Director Christopher Wray and MI5 Director General Ken McCallum warned business leaders about Beijing's widespread theft of Western technology. … It is the first time the two heads of the domestic investigations agencies delivered a public speech together.1
In the US, the FBI director said the Chinese government had directly interfered in a congressional election in New York this spring because they did not want a candidate who was a critic and former protester at Tiananmen Square to be elected.2
I encourage you to read both speeches/remarks.
MI5 Director General Ken McCallum speech
FBI Director Christopher Wray remarks
[T]he point I want to leave you with today is that the Chinese government poses an even more serious threat to Western businesses than even many sophisticated businesspeople realize. … The Chinese government is set on stealing your technology … I’m talking about companies everywhere from big cities to small towns—from Fortune 100s to start-ups, folks that focus on everything from aviation, to AI, to pharma.
We’ve even caught people affiliated with Chinese companies out in the U.S. heartland, sneaking into fields to dig up proprietary, genetically modified seeds, which would have cost them nearly a decade and billions in research to develop themselves. … And those efforts pale in comparison to their lavishly resourced hacking program that’s bigger than that of every other major country
Last spring, for instance, Microsoft disclosed some previously unknown vulnerabilities targeting Microsoft Exchange Server software. Chinese hackers had leveraged these vulnerabilities to install more than 10,000 webshells, or backdoors, on U.S. networks, giving them persistent access to data on those systems. That’s just one example
Richmond Fed with a Primer on Incident Notification
Computer-Security Incident Notification Rule — How Does it Affect Your Bank?
[I]nteragency guidance was recently issued jointly with the Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation that outlines a new Computer-Security Incident Notification Rule.
The new notification process went into effect in April with compliance required by May 1, 2022. Key points of focus within this new guidance include:
Each bank is required to notify its primary federal regulator as soon as possible, and no later than 36 hours, once management determines a computer-security incident has occurred.
Bank service providers are required to notify their customers of computer-security incidents as well as outage/operational downtime when they are more than four hours.
Good job Richmond.
Intermediary Balance Sheets and the Treasury Yield Curve
Interesting paper. we’ve talked for years about how dealers are intermediating less since the GFC. This paper gives some insight into the changed incentives of the dealers. As we hypothesized, leverage constraints are the primary driver.
We have documented a regime change in the U.S. Treasury bond market. Prior to the 2008-2009 financial crisis, dealers were net short-sellers of Treasury bonds, swap spreads were positive, and CIP violations were small. Following the GFC, dealers became net buyers of Treasury bonds, swap spreads turned negative, and covered interest parity violations emerged.
We view the large increase in Treasury supply and the tightening of leverage constraints on dealers as the primary drivers of this regime change. Using a stylized static model, we have argued that this regime shift has amplified the effects of quantitative easing and of the yield curve slope on borrowing spreads. In the post-GFC dealer-long regime our model predicts tighter dealer balance constraints in response to Fed quantitative tightening and a flat or inverted Treasury yield curve, and more elevated financial intermediation spreads. Our analysis suggests that other polices, including the use of swap lines and of exemptions to SLR calculations, can help offset these effects.3
Does CB ETF Purchasing Affect The Equity Risk Premium
The BIS has published Bank of Japan's ETF purchase program and equity risk premium: a CAPM interpretation4.
[U]tilizing the cross-sectional and time-series variations in purchases associated with the BOJ's policy changes, the empirical analysis reveals that: (i) the BOJ's ETF purchases instantaneously support stock prices on the days of purchases, and (ii) the instantaneous positive effects on stock prices, combined with the countercyclical nature of the BOJ's purchases, have decreased the market beta and coskewness of Japanese stocks, thus leading to an economically significant decline in risk premia.
… the marginal effect of the BOJ’s purchases on the market beta is ϕ = −0.041
… the estimated impact of the market beta on excess returns is 0.085
… during period (iii) in which the BOJ substantially increased their total amount of ETF purchases, the BOJ’s ETF purchase program decreased the risk premia of TOPIX and Nikkei 225 by -0.58 and -1.15 percentage points and consequently increased TOPIX and Nikkei 225 index by 12.3 and 30.4 percentage points, respectively
Crypto (Again)
3 Arrows Capital
We’re at the Steve Miller band stage - take the money and run
Three Arrows Capital has moved millions worth of crypto assets to KuCoin. The troubled firm moved the stablecoins after filing for Chapter 15 bankruptcy protection.5
A federal judge in a New York bankruptcy court has frozen the remaining assets of crypto hedge fund Three Arrows Capital following the firm’s rapid fall from prominence. … A main reason for the aggressive action is that the physical whereabouts of Zhu and Davies are “currently unknown,” according to lawyers representing the creditors. The creditors also allege that liquidators in Singapore found that 3AC’s offices were vacant, save for a few inactive computer screens.
Celsius
Celsius is "deeply insolvent"6
Vermont's Department of Financial Regulation (DFR) on Tuesday said it believes cryptocurrency lender Celsius Network is "deeply insolvent" and does not have the assets and liquidity to honor its obligations to customers and other creditors.
Tether Sh!tshow
Tether Discloses Celsius' Loan Liquidation Process
Tether has never and will never put the integrity of its reserves at risk. This has been proven time and time again not only by its ability to never refuse a redemption but also in the absolute transparency of its reserves.
While Tether’s portfolio does include an investment in Celsius, representing a minimal part of its shareholder’s equity, there is no correlation between this investment and Tether’s own reserves or stability.
WHAT!!!!!
An equity investment that is to back reserves (and is to a company you have dealings with and been supporting) is uncorrelated to the reserves? Classic wrong-way risk.
Regulatory Standards for Stablecoins
Given the novelty and complexity of stablecoin arrangements, the guidance elaborates aspects related to: (i) governance; (ii) framework for the comprehensive management of risks; (iii) settlement finality and (iv) money settlements. The guidance also provides considerations to assist authorities in determining whether a stablecoin arrangement is systemically important. In the light of comments received in the consultation, the final guidance provides further clarifications with respect to, among other things, the applicability of the PFMI to stablecoin arrangements, determination of systemic importance of a stablecoin arrangement, and settlement finality.
What is the Probability of Being Hit By Rocket Debris?
Unnecessary risks created by uncontrolled rocket reentries (nature astronomy)
Using publicly available reports of rocket launches and data on abandoned rocket bodies in orbit, we calculate approximate casualty expectations due to rocket body reentries as a function of latitude. The distribution of rocket body launches and reentries leads to the casualty expectation (that is, risk to human life) being disproportionately borne by populations in the Global South, with major launching states exporting risk to the rest of the world.7
On Bullshit in Investing
Ben Eifert guest-authored On bullshit in investing on Noahpinion. Worth reading the whole article.
Bullshit in investing, be it wild over-optimism, deception or fraud, is as old as time, precisely because it is hard to resist the promise of easy returns and to tell the difference between innovation and make-believe.
The first step in avoiding being taken for a ride is to recognize that you are a mark for people trying to get rich off your money.
Burn the principle into your brain that financial markets are large and competitive and have a lot of smart people in them.
Easy money-making opportunities are almost never real; professional mercenaries would have found and exploited them first.
High returns with low risk explained away by complicated and nontransparent strategies deserve great scrutiny.
On the institutional side, keep in mind that the world is a relatively small place and tremendous value can be gleaned by asking the views of people close to a particular market or strategy.
Ask questions; be skeptical; do not assume that just because brand-name firms or authority figures are involved that all is well.
How to Talk to Credit Analysts
Another fun read on Stories.Finance. Don Noe, who worked for Moodys, wrote How to Talk to Credit Analysts. It really doesn’t tell you what to say to them; instead it gives a few anecdotes of CEOs and CFOs that seem to like to shoot themselves in the foot/head.
Podcasts
Dr. Rick Bookstaber - The Psychology of Risk (Standard Deviations; 48:37)
Variola Birmingham (Causality - The Engineered Network; 41:00)
In 1978 on the cusp of the eradication of SmallPox a Medical Photographer became infected and would ultimately die from the Variola virus. We look at how admiration, promotion and delegation led to a wholly avoidable outcome.
Corera, China: MI5 and FBI heads warn of ‘immense’ threat, BBC
Du, Hébert, Li, Intermediary Balance Sheets and the Treasury Yield Curve, NY Fed
Katagiri, Takahashi and Shino, Bank of Japan's ETF purchase program and equity risk premium: a CAPM interpretation, BIS
Pessarlay and Price, Three Arrows Capital’s Crypto Assets Are in Transit – Here’s How the Millions Are Moving, Beincrypto.com
Tanna, Gibbs, U.S. state regulator says it believes crypto lender Celsius is "deeply insolvent", Reuters
Boley, Byers, Byers, and Wright, Unnecessary risks created by uncontrolled rocket reentries, nature astronomy