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| Implied Rate Correlations and Policy Expectations Posted: 06 Nov 2013 02:00 AM PST Implied Rate Correlations and Policy Expectations
Certain financial instruments provide information on expectations of future interest rate movements. One relatively new instrument is yield curve options, which allow investors to take financial positions on a range of possible future interest rates. These options can shed light on the views of financial markets regarding future monetary policy at a time when short-term interest rates are near zero. The term structure of interest rates—rates at the full range of maturities—is vitally important to investors, policymakers, and market observers. Financial market focus on the term structure, also known as the yield curve, is particularly intense now since it reflects the trajectory of economic recovery and prospects of a shift in Federal Reserve monetary policy to a less stimulative stance. One place to look for market views on these issues is interest-rate derivatives markets, where traders put money at risk by taking positions in instruments linked to interest-rate movements. This Economic Letter describes implied correlations among interest rates, a set of indicators of market uncertainty about and exposure to the future slope of the yield curve based on interest-rate derivatives. Each rate correlation expresses the collective views of market participants on the future spread between two points on the term structure. As a market-based estimate of uncertainty about the future slope of the yield curve, implied rate correlations can shed light on what policy moves market participants expect the Fed to make. Implied rate correlations are derived from the prices of swaptions and yield curve options. Swaptions lock in the right to pay or receive a stipulated fixed interest rate, known as the strike rate, in a swap when the option expires. Curve options pay off if the spread between two interest rates with different maturities is above or below a stipulated strike level on expiration. Combining the information in the prices of these types of options offers an implied view on whether short- and long-term rates will tend to move together. Implied rate correlations are a relatively new instance of a well-established category of policy indicators: estimates of market expectations of future asset prices based on derivatives. Other examples include using forward interest rates to estimate future interest rates, and estimates of the probability distributions of future interest rates based on interest-rate option prices (see Jackwerth 1999). Curve options and implied rate correlation A curve option is a cap or floor on the spread between two constant maturity swap rates with different terms. Its payoff is determined by the difference between the option strike and the swap rate spread at the curve option's expiration. An example is the 10-year minus 2-year curve option expiring in one year, or "1-year 2s-10s." If such an option is struck at 250 basis points, that is 2.50 percentage points, it pays the owner 0.0001 times the notional underlying amount multiplied by the amount by which the spread between 2- and 10-year swap rates exceeded 250 basis points in one year, provided that number is positive. If the constant maturity swap spread were 275 basis points in one year and the notional amount were $1,000,000, the option writer would pay $2,500. Curve options were first traded in the early 2000s. Participants included retail, corporate, and other investors selling yield curve volatility, and hedgers such as insurance companies. In the years preceding the financial crisis, hedge funds and others expressing views on the yield curve entered the market. Dealers are mainly large banks. They describe liquidity as good, in that prices are consistent across dealers, for options up to one year and for standard curve spreads such as the 10-year minus 2-year. Figure 1
Curve option prices express implied rate correlations, that is, market estimates of uncertainty about the future term spread. For example, the price of the 1-year 2s-10s option expresses the views of market participants on how the 2s-10s swap-rate spread will change over the next year. These implied rate correlations can be thought of as extending to the shape of the yield curve the notion of interest-rate implied volatility, which is the market estimate of the magnitude of rate fluctuations over an option's life. The interest-rate derivatives used to compute implied rate correlations are standard at-the-money swaptions on two points on the yield curve and a curve option on their spread with the same expiration. For example, a 1-year estimate of the implied rate correlation between the 2- and 10-year rates is computed from 1-year swaptions on the 2- and 10-year rates, and a 1-year 2s-10s curve option. As seen in Figure 1, for given swaption prices, a more expensive curve option corresponds to a lower implied rate correlation. The implied rate correlation expresses how market participants expect the term structure to change. A correlation close to one means the market considers it likely that any changes in interest rates will be parallel, that is, the two rates in a term spread will change roughly equally. A low correlation indicates the market expects rates at different points on the term structure to change by different amounts. A decline, say, in the 1-year implied correlation between changes in the 2- and 10-year rates might be driven by greater uncertainty about the path of short-term rates over the next three years, uncertainty about long-term rates, or both. Rate correlation doesn't indicate what form such changes will take. It might be a steepening or flattening of the term structure, and could coincide with either a rise or fall in the general level of interest rates. As with any market-derived indicator, implied rate correlations may contain risk premiums. If some market participants are particularly anxious to protect against a big change in the term structure, curve options may be more expensive and implied correlation lower than they would be based only on participants' beliefs about its future shape (see Driessen, Maenhout, and Vilkov 2009 on equity market correlation risk premiums). Fed policy and implied rate correlation Figure 2
Note: Numbered lines show the following event dates: (1) 3/14/08, Bear Stearns failure; (2) 11/25/08, LSAP I announcement; (3) 5/9/10, European Financial Stability Facility; (4) 8/9/11, Calendar-based forward guidance; (5) 1/25/12, forward guidance extended; (6) 9/13/12, Flowbased LSAP announcement; (7) 12/12/12, Threshold-based forward guidance; (8) 5/22/13, Joint Economic Committee testimony. Figure 3
Note: See Figure 2 for event line descriptions. Figures 2 and 3 show option-based implied rate correlations from 2007 to 2013 for a forecast horizon of one year. Figure 2 shows the correlation between changes in the 2- and 10-year swap rates and Figure 3 between changes in the 5- and 10-year rates. These are interesting correlations and based on relatively liquid curve options. Implied rate correlations gravitate to 1, since the market generally expresses stronger views on changes in the level of the yield curve than its slope, particularly for longer-term segments such as five to ten years. Implied correlations have fallen since the Fed initiated its highly stimulative policy responses to the global financial crisis, and have varied over time in ways that help illuminate the impact of the Fed's communication and asset purchase policies (see Bauer and Rudebusch 2013 and Rosa 2013). The Lehman bankruptcy, the introduction of the federal government's capital injection and debt guarantee programs for financial institutions, and the Fed's announcement of its first large-scale asset purchases preceded a particularly sharp implied correlation decline in late 2008. As the financial crisis subsided in mid-2009, implied rate correlations rose a bit. But the onset of the European sovereign debt crisis in April 2010 and the announcement of the first collective European response on May 9 were followed by a further sharp drop as prospects for economic recovery dimmed and expectations of further monetary easing grew. Forward guidance is the Fed's policy of publicly communicating its likely future monetary stance. In August 2011, the Fed's policy committee adopted forward guidance based on estimates of the date when it would begin raising short-term rates. Following the announcement, implied rate correlations dropped to the lowest levels in the data. By announcing its intention to maintain policy rates near zero until a specified date, the Fed essentially pinned the short end of the yield curve, to the extent market participants regarded the guidance as credible. Longer-term rates remained outside the guidance window. They were influenced by current and anticipated asset purchases, as well as the path of short rates. Evolving economic conditions and the Fed's anticipated changes to its asset purchase program were then seen as likely to affect longer-term rates disproportionately. This fostered expectations of changes in the slope rather than parallel shifts in the yield curve. Contrasts between the 2s-10s and 5s-10s implied correlations offer additional perspectives on how markets interpreted Fed communications. While the introduction of forward guidance spurred an immediate drop in 2s-10s correlation, 5s-10s correlation initially rose. Market participants apparently believed that, since both 5- and 10-year rates were well outside the guidance time frame, both would respond similarly to news. But 5s-10s correlation soon dropped sharply, particularly after the Fed extended forward guidance into 2014 and 2015, pinning much of the yield curve with maturities below five years. Implied rate correlations have increased since the Fed introduced open-ended asset purchases in September 2012 and forward guidance based on macroeconomic conditions in December 2012. These initiatives suggested that monetary policy would remain highly stimulative until the economy improved substantially and that stimulus reduction was not tied to specific dates. With adoption of these policy tools, parallel shifts in the yield curve may have appeared more likely to investors than changes in slope because both policy and longer-term rates would depend on expectations regarding the economy, which would be influenced by new data. Higher implied correlations suggest that market participants found this form of communication credible and perceived that stimulus would be reduced only when economic conditions improved. The 5s-10s correlation rose on introduction of open-ended asset purchases, which lowered the likelihood of longer-term rates rising, and thus the term structure steepening, in the absence of stronger data. The 2s-10s correlation rose and the 5s-10s correlation rose further when threshold-based guidance was introduced, making policy at both the short and long ends of the yield curve dependent on incoming data. The correlation increase adds perspective to other market-based evidence that rates at both ends of the term structure would be held down until recovery, such as the stock market rally since the end of 2012 and an only slight increase in the implied volatilities of swaptions expiring near the Fed's previous estimates of the earliest dates when short-term rates might begin to rise. The trend toward higher implied rate correlations accelerated after Chairman Bernanke indicated in May 2013 that the pace of asset purchases could slow later in 2013, possibly suggesting that a recovery strong enough to lift both short- and long-term rates was more likely. The jump in implied correlations may also indicate that market participants did not fully appreciate that Fed asset purchases and changes in the policy rate are distinct tools, and that policy rates could remain low after asset purchases slowed if the data improved but did not reach the Fed's guidance thresholds. Conclusion Financial markets offer several sources of data on expectations and perceived risk of interest-rate changes. The yield curve is an indicator of the future path of short-term rates. Swaption and bond implied volatility is a measure of uncertainty about future rates. The skew of implied volatility provides information about probable—or feared—interest rate movements. Implied rate correlations represent an additional source of information, showing market views on the uncertainty of the term structure. Allan M. Malz is a senior advisor in the Markets Group of the Federal Reserve Bank of New York and was a visiting scholar at the Federal Reserve Bank of San Francisco.
References Bauer, Michael D., and Glenn D. Rudebusch. 2013. "Monetary Policy Expectations at the Zero Lower Bound." FRB San Francisco Working Paper 2013-18. Driessen, Joost, Pascal J. Maenhout, and Grigory Vilkov. 2009. "The Price of Correlation Risk: Evidence from Equity Options." Journal of Finance 64(3), pp. 1,377–1,406. Jackwerth, Jens C. 1999. "Option-Implied Risk-Neutral Distributions and Implied Binomial Trees: A Literature Review." Journal of Derivatives 7(2), pp. 66–82. Rosa, Carlo. 2013. "The Financial Market Effect of FOMC Minutes." FRB New York Economic Policy Review (forthcoming).
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| Posted: 05 Nov 2013 10:30 PM PST Heading toward a Cliff
The global economy is likely experiencing a bigger bubble than the one that unleashed the 2008 crisis, and should it burst the ensuing recession would be mammoth
The U.S. Federal Reserve is unlikely to taper its quantitative easing in 2013. The recent improvement in the global economy is due to its surprise decision in September to not taper. The resulting return of hot money or increase in leverage for speculation boosted the economy. The market is again increasing the odds for Fed tightening. It may trigger some deleveraging, which would cool the economy again. The Fed would be forced to postpone tapering again. The Fed’s QE policy has caused a gigantic liquidity bubble in the global economy, especially in emerging economies and asset markets. The improvement in the global economy since 2008 is a bubble phenomenon, centering around the demand from bubble goods or wealth effect. Hence, real Fed tightening would prick the bubble and trigger another recession. This is why some talk of the Fed tightening could trigger the global economy to trend down. Only inflation will force the Fed to tighten. Inflation at present is mainly in emerging economies. The United States’ dysfunctional financial system is slowing monetary velocity there. It is delaying inflation. But, it is a matter of time. Inflation in the United States could come through imports and expectations. When its financial system is emboldened to lend like before the 2008 crisis, inflation will surge. As the economy is so sensitive to the Fed’s tightening, its pace will be slow, even when forced by inflation. It means that inflation will stay high and for long. U.S. inflation would trigger the bursting of the bubbles in emerging markets, similar to what occurred in the 1980s. They will face the choice of devaluation or deflation. The global economy has seen high inflation in emerging economies and low inflation in the United States. The roles may reverse in the years ahead. Return of the Dotcom Bubble Wild speculation in Internet stocks brings back the bubbly days of 2000. Facebook is trading above 100 times earnings, Amazon over 1,000. AOL and Yahoo did not go that high in the last dotcom bubble. I am sure that some clever analysts could come up with stories to sort of justify the valuation. And, of course, no one can be absolutely sure about a bubble until it bursts, which was Alan Greenspan’s justification for not acting against bubbles. I suspect that this dotcom bubble will burst in 2014, as soon as the Fed is forced to tighten. The extremes in the new dotcom bubble tell us what the monetary condition is in the world. The real interest rate is practically negative everywhere. This is happening for probably the first time in modern history. Negative real interest rates also trigger bubbly valuation in credit, property and stocks. Bubble Globalization The Fed’s QE policy inflated emerging markets first, while a bad financial system at home slowed the circulation of money and the rise of bubble. Property usually becomes bubbly first in emerging economies in an environment of rising liquidity. Rapidly rising prices and falling rental yields are sure signs of a bubble. From Mumbai to Beijing, the bubble has taken root. An interesting phenomenon this time is how the property bubble in emerging economies, triggered by the Fed policy, spread back to the United States. Buyers from China, Russia and other emerging economies have pushed up property prices in central London and Manhattan. So their rental yields resemble that in hot emerging market cities rather than that in other cities in Britain or the United States. The tight linkage between the Fed and emerging economies is mainly due to a lack of independent monetary policy in the latter. Emerging economies are much more dependent on trade than developed economies. The dollar is the currency for global trade. It is impossible for emerging economies to allow their currencies to reflect entirely financial flows and disregard the impact on trade. This tendency to resist the impact of hot money on the exchange rate is why emerging economies are so tightly linked to the Fed’s policy. Hot money does not just disappear into emerging markets. It flows back into the U.S. financial system either through official foreign exchange reserves or private investment seeking higher returns. When hot money first emerges, the former tends to dominate, which keeps down the U.S. bond yield. As the bubble takes hold and yields on property and real interest rates decline, private investment also flows to the United States for higher returns, which pushes up the prices of risk assets, like property, stock and credit, in the United States. The relationship between the Fed and emerging economies is like a turbocharger for asset prices around the world. The bigger the share of trade in emerging economies, the more power the turbocharger has. With China’s rise in global trade, it has played a powerful role in this dynamic. It is not a coincidence that China’s property bubble inflated so much during the Fed’s QE, despite a weak economy that would have destroyed the confidence for bubble making. Pushing on a String I have written many times before that the linkage between monetary policy and employment is very weak in the era of globalization. The information technology revolution has made most high paying jobs mobile. That force is equalizing compensation for many professions across the world. The equalization process is still ongoing. Hence, monetary easing alone will not increase investment at home, which leads to employment growth. Investment today depends on its global competitiveness, not a small change in the interest rate at home. Employment in any country can be created through cutting wages. This helps explain why reemployed in the United States has lower wages on average. An economy is like a company. It can expand its market share or employment by cutting prices. That explains why competitive devaluation is such a force nowadays. If one economy cannot use its monetary policy effectively, the global economy could be stimulated through collective monetary easing. Hot money sort of plays the role of exporting the United States’ monetary policy around the world. The trouble is that the main force behind hot money is speculation. Hot money earns a profit only if it creates a bubble and leaves a hot potato for others to hold. The Fed’s QE may have stimulated emerging economies, which in turn benefited the U.S. economy. It is mainly a bubble phenomenon. When the bubble bursts, the global economy tanks again, leaving behind collateral damage like bad loans. Despite its terrible record, the Fed continues to believe in the power of its policy in creating employment. It has created one bubble after another. Each bursting leads to a downturn, which justifies another round of monetary stimulus and the making of another bubble. Rising Inequality Rising inequality in income and wealth has become a major social issue around the world. I would argue that it is a major drag on the economy and contributes to bubble formation. The latter further increases inequality and, hence, a vicious cycle forms. Statistics suggest that the top 5 percent account for most wealth and almost as much in income. The concentration generates instability in circulation among income, demand and production. When income is so concentrated, a few must lend to others to finance demand. As people pile up debt, they pay interest and, hence, must borrow more for the same demand. As debt piles up, a crisis is inevitable. The crisis leads to monetary stimulus and more bubbles. A bubble is a zero-sum game at best and, due to a misallocation of resources, a negative-sum game most of the time. While in aggregate, a bubble may be zero sum, significant redistribution occurs in the process. History tells us that wealthy and high-income people are more likely to win than others. Serial bubble-making by central banks only exacerbates inequality. Activist monetary policy is possibly one of the most destructive forces in modern economic history. It creates the illusion of effectiveness during bubble formation, which justifies its relevance despite so many financial disasters. Tapering Talk When the Fed talked about tapering QE, global financial markets reacted furiously. Emerging markets saw money leaving, currencies falling and stocks tumbling. The tightening financial condition led to a string of weak economic data, which was partly used to justify the Fed’s decision not to taper in September, contrary to the market consensus. The decision was followed by hot money returning and some improvement in economic data. The sensitivity between financial speculation and economic strength reflects how bubbly the global economy is. Better economic data is increasing market expectation for the Fed to taper. That expectation would again trigger speculation declining and economic data weakening. Such back and forth is likely to haunt the Fed’s decision to taper or not to taper. In the end, it cannot do so any time soon. But, the fluctuations in the market expectation will cause a great deal of volatility in financial markets. The tapering will come when the Fed is forced to do so, probably by inflation rising above its target. As there is a long lag between monetary policy and inflation, whatever it does then, inflation will keep rising. The Fed, when it does taper, is unlikely to be aggressive. It begins by cutting stimulus. Raising interest rates is many months away. When it does raise interest rates, it may not do so fast enough to catch the rise in inflation, i.e., the real interest rate would still be declining. After the 2008 financial crisis, I expected massive stimulus around the world. But, the stimulus would not bring back a healthy economy. It will eventually take the global economy to stagflation. I still hold this view. Another Global Recession The odds are that the world is experiencing a bigger bubble than the one that unleashed the 2008 Global Financial Crisis. The United States’ household net wealth is much higher than at the peak in the last bubble. China’s property rental yields are similar to what Japan experienced at the peak of its property bubble. The biggest part of today’s bubble is in government bonds valued at about 100 percent of global GDP. Such a vast amount of assets is priced at a negative real yield. Its low yield also benefits other borrowers. My guesstimate is that this bubble subsidizes debtors to the tune of 10 percent of GDP or US$ 7 trillion dollars per annum. The transfer of income from savers to debtors has never happened on such a vast scale, not even close. This is the reason that so many bubbles are forming around the world, because speculation is viewed as an escape route for savers. The property market in emerging economies is the second-largest bubble. It is probably 100 percent overvalued. My guesstimate is that it is US$ 50 trillion overvalued. Stocks, especially in the United States, are significantly overvalued too. The overvaluation could be one-third or about US$ 20 trillion. There are other bubbles too. Credit risk, for example, is underpriced. The art market is bubbly again. These bubbles are not significant compared to the big three above. When the Fed does normalize its policy, i.e., the real interest rate becomes positive again, this vast bubble will burst. Given its size, its bursting will likely bring another global recession worse than the one after the 2008 crisis. The disinflationary force from globalization, especially from East Asian economies driving down the prices of manufacturing goods, is the background for the serial bubbles over the past three decades. As China’s labor surplus is gone and no other country is taking over the disinflationary role, the big background for bubbles seems to be winding down. The disinflationary force for the current bubble is weak demand in developed economies, not rising productivity. This is why inflation will come to end this one. When inflation emerges and persists, interest rates will have to rise. For example, the U.S. 10-year bond yield may double to 5 percent. Bubbles are less likely in an environment of rising interest rates. I suspect that the current bubble is the last one for a long time to come. |
| Posted: 05 Nov 2013 02:00 PM PST My Afternoon train reading:
What are you reading?
Emerging-Stock Rally Raises Concern |
| Posted: 05 Nov 2013 11:30 AM PST click for ginormous graphic |
| Posted: 05 Nov 2013 11:00 AM PST These 50 metrics are must haves for any CMOs, CDOs, CIOs and CFOs. They help to illustrate why marketing is important and how marketing will help your organization.
Vala Afshar, Chief Marketing Officer at Extreme Networks on Oct 31, 2013 |
| Does Too Few Bears = Correction? Posted: 05 Nov 2013 09:32 AM PST What do you get when you cross an overbought market with too few bears? Often, that combination of complacency leads to a correction. So far, all it has produced is a lot of frustrated contrarian traders. As of October 25, Investors Intelligence (II) % Bears extended deeper into contrarian bearish territory below the 20% level with a reading of 16.5%. |
| Posted: 05 Nov 2013 07:08 AM PST Its guilty-plea Tuesday, and that means time for some reads:
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| Meet Uncle Sam, Your Partner in Crime Posted: 05 Nov 2013 04:30 AM PST The news leaked over the weekend: Steve Cohen and SAC were about to pay a monster fine for a decades worth of insider trading and failed supervision of traders. Some prefer the term "expert networks," but – po-TAY-to, po-TAH-to. The rules have changed, and so have the penalties. The lessons of the post-crisis era are clear:
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| Posted: 05 Nov 2013 03:00 AM PST A look at some of the principles of critical thinking. |
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