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Recent news and market analysis has featured a spate of warnings about diminished liquidity in the U.S. Treasury market and reminders of how quickly markets can seize. It’s a topic we’ve addressed on our blog with an investigation of the bond market sell-off of 2013.
The rise in oil prices from near $30 per barrel in 2000 to around $110 per barrel in mid-2014 was a dramatic reallocation of global income to oil producers. So what did oil producers do with this bounty? Trade data show that they spent about half of the increase in total export revenues on imports and the other half to buy foreign assets. The drop in oil prices will unwind this process. Oil-importing countries will gain from lower oil bills, but they will also see a decline in their exports to oil-producing countries and in purchases of their assets by investors in these countries. Indeed, one can make the case that the drop in oil prices, by itself, is putting upward pressure on interest rates as income shifts away from countries that have had a relatively high propensity to save.
Oil prices have declined substantially since the summer of 2014. If these price declines reflect demand shocks, then this would suggest a slowdown in global economic activity. Alternatively, if the declines are driven by supply shocks, then the drop in prices might indicate a forthcoming boost in spending as firms and households benefit from lower energy costs. In this post, we use correlations of oil price changes with a broad array of financial variables to confirm that this recent fall in oil prices has been mostly the result of increased global oil supply. We then use a model to assess how this supply shock will affect U.S. economic conditions in 2015.
Valentin Haddad, Erik Loualiche, and Matthew Plosser
Buyout activity by financial investors fluctuates substantially over time. In the United States, peak years result in close to one hundred public-to-private buyout transactions and trough years in as few as ten. The typical buyout is primarily funded by debt, hence the term “leveraged buyout” (or LBO). As a result, analysis of buyout fluctuations has focused on the availability and cost of debt financing. However, in a recent staff report, we find that the overall cost of capital, rather than debt alone, is the primary driver of buyout activity. We argue that it is the common changes in both the cost of debt and the cost of equity—the aggregate risk premium—that are the source of booms and busts in buyout activity.
In February, the Federal Reserve Bank of New York’s trading desk announced it will publish a new overnight bank funding rate early next year. The new rate will be based on both federal funds and Eurodollar transactions reported in a new data collection—the FR 2420 Report of Selected Money Market Rates. In a previous post, we explained how FR 2420 fed funds transaction data will replace brokered data as the base for the fed funds effective rate. This post provides insights on the Eurodollar market in advance of the publication of the overnight bank funding rate.
Marco Del Negro, Marc Giannoni, Matthew Cocci, Sara Shahanaghi, and Micah Smith
Second post in the series
In a recent series of blog posts, the former Chairman of the Federal Reserve System, Ben Bernanke, has asked the question: “Why are interest rates so low?” (See part 1, part 2, and part 3.) He refers, of course, to the fact that the U.S. government is able to borrow at an annualized rate of around 2 percent for ten years, or around 3 percent for thirty years. If you expect that inflation is going to be on average 2 percent over the next ten or thirty years, this implies that the U.S. government can borrow at real rates of interest between 0 and 1 percent at the ten- and thirty-year maturities. This phenomenon is by no means limited to the United States. Governments in Japan and Germany are able to borrow for ten years at nominal rates below 1 percent, and the ten-year yield on Swiss government debt is slightly negative. Why is that?
In our earlier post, we described how the tri-party repo arrangement was a clever way to reduce the costs and risks that individual firms faced when settling bilateral repos. In this post, we explain how the efficiencies created by this new arrangement facilitated the growth of the repo market by expanding the class of securities to be used as collateral. This expansion had benefits as well as costs. On the positive side, it led to lower interest costs for a wide variety of borrowers in the real economy. But on the negative side, tri-party repos backed by riskier assets increase the risk of fire sales, which can have negative spillovers on the broader financial system.
The conventional wisdom about financial innovation is that it is typically undertaken as a way to increase profits. However, financial innovation can also occur as a response to the need to reduce risk. Tri-party repo is an example of such innovation. While tri-party repo ultimately evolved in ways that created and amplified systemic risk (as we describe in the second post in this series), its origin was as a solution to inefficiencies and risks associated with the repo settlement arrangements prevailing at the time.
Mounting evidence says that “low-risk” investing delivers superior returns, comparable to strategies based on value, size, and momentum. Such tactics include the “risk parity” (RP) asset allocation approach, which received considerable attention during the 2013 taper tantrum when many RP funds reportedly deleveraged. This strategy requires long or overweight positions in low-risk asset classes, such as government bonds, and offsetting short or underweight positions in risky asset classes, including shares. The low-risk umbrella also covers “betting against beta” (BAB) within, rather than across, asset classes. For example, investing in shorter- as opposed to longer-duration bonds beats the bond market, or owning low-beta at the expense of high-beta shares outpaces the S&P 500. Whether RP or BAB, what matters is return per unit of risk, the bang for the buck. Put more formally, RP and BAB profitability rests on an inverse relation between Sharpe ratios (SRs) and beta, the covariance of asset returns with the market portfolio. Such findings contradict the intuition that higher returns compensate for risk. Instead, investors profit handsomely by levering up relatively safe assets and shorting comparatively risky securities. However, as my New York Fed staff report argues, alternative reasoning and samples, as well as the types and number of “risks,” raise questions about not only BAB with government bonds (BABgov) but perhaps also RP. The investment implications are obvious, but the arguments and underlying data patterns also hint at key policy issues.
On April 1, 2014, the Federal Reserve began collecting transaction-level data on federal funds, Eurodollars, and certificates of deposits from a large set of domestic banks and agencies of foreign banks operating in the United States. Previously, the Fed had only received fed funds and Eurodollar data from major brokers, and not directly from the banks borrowing in these markets. These new data, collected on form FR 2420, have helped the Fed better understand activity in the fed funds and Eurodollar markets. In this post, we focus on the new data on fed funds, in light of the Federal Reserve Bank of New York’s Trading Desk announcement that it plans to use these data to calculate and publish the fed funds effective rate. We plan to publish other posts on the fed funds and Eurodollar markets over the next several months.
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