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May 3, 2021
Is There a Global Factor in U.S. Bond Yields?
The answer to this question seems obvious simply from observing the secular comovement of global nominal yields across some advanced economies plotted in chart 1.
This observation raises the possibility that domestic bond yields, including those in the large U.S. Treasury market, may be anchored by global economic developments (see, for example, here and here), provision of global liquidity, and international markets arbitrage. The synchronized dynamics in global yields during the last few months serve as a stark reminder of the powerful role that global bond markets play in the transmission of country-specific shocks as well as of monetary and fiscal impulses.
Yet the standard term structure models (see, for example, here), that policymakers and market participants use to form their expectations about the future path of the policy rate, are typically estimated only with information embedded in domestic yields. Global influences enter only via the term premia—that is, the extra returns that investors demand to hold long-term bonds—and are influenced by the flight to safety and arbitrage across international markets. But because the term premia are obtained as a residual component in the model, any misspecification of the factor structure that drives equilibrium interest rates—by omitting a common global factor, for example—may result in erroneously attributing some fundamental movements to the term premia.
Chart 2 illustrates this point, presenting a less-noticed and even overlooked empirical regularity between the term premia on the spread between the 10-year U.S. bond and the 10-year/2-year German bond, which is the benchmark bond for the Eurozone government bond market. This comovement has proved remarkably strong since 2014.1
Take, for example, the pronounced decline in the term premia and the accompanying slide in the German bond spread between 2014 and 2019. Although technical factors might be behind the downward trend in the German bond spread—for example, large Eurozone bond outflows triggered by the euro-area crisis and the introduction of negative interest rates—the slope of the yield curve could also convey important information about the fundamentals of the economy. If the term premia on the 10-year U.S. bond reflect an exogenous "distortion" in the U.S. yield curve due to a flight to safety or an elevated demand for global safe assets, yields are likely to return to normal levels when the uncertainty shock dissipates. In contrast, if investors interpret the yield curve's decline as an endogenous "risk-off" response—that is, a switch to less risky assets—to a deteriorated global environment that can spill over to the U.S. economy, the term structure model would require a "global" factor whose omission may otherwise contaminate an estimate of the term premia.
So how sensitive is the estimate of the future path of policy rate to model specification? I next illustrate this sensitivity by augmenting the factor space in a standard (five-factor) term structure model with incremental information from an additional global factor, not contained in the other factors. Given the reasonably tight correlation between the term premia for the 10-year U.S. bond and the 10-year/2-year German bond spread, it seems natural to use the latter as an observed proxy for a global factor, although other statistical approaches for extracting one or more common global factors are certainly possible.
To quantify the potential effect of the global factor, I focus on yield curve dynamics seen in 2019, a period characterized by elevated economic, trade, and geopolitical uncertainty that led to a material decline in observed yields. But did a fundamental shift in the expected path of policy rate, or lower term premia, drive this decline? In the left panel of chart 3, I plot the expected policy rate paths for the second quarter (or midpoint) of 2019, obtained from models with and without a global factor. (Recall that in the second quarter of 2019, the target range for the federal funds rate was 2.25 percent to 2.50 percent.)
The difference in the shape of the expected policy rate paths implied by the two models is striking. (The models' estimates use unsmoothed yield data at quarterly frequency, with continuous bond maturities from one to 80 quarters.) Although the expected policy rate path for the standard model is fairly flat, the rate path for the model with a global factor is deeply inverted up to five-year maturities, suggesting that over this horizon one could have expected rate cuts of almost 100 basis points. These expectations occurred against the backdrop of stable growth and inflation outlook in the United States but deteriorating global economic and trade conditions. The right panel of chart 3 displays the evolution of the expected rate path, estimated from the global factor model, for the two quarters before and the two quarters after the second quarter of 2019, as the Federal Reserve started to adjust its policy rate lower. It is worth noting that the strong effect of the German 10-year/2-year spread in the term structure model with global factor is a relatively recent phenomenon. (Additional results suggest that this factor has only a muted impact on the model estimates prior to 2014.)
The policy implications of these findings warrant several remarks. One direct implication is that the common global determinants of the neutral rate of interest, as well as inflationary dynamics, could constrain the potency of domestic monetary policy. A prime example of these constraints was the policy rate normalization phase undertaken by the Fed during the 2016–18 period, which was characterized by global disinflationary pressures, underwhelming economic performance in Europe and Japan, slowing economic growth in China, and escalating trade tensions. These forces were potentially counteracting the Fed's policy efforts and exerting downward pressure on the global neutral rate of interest. The recent economic and financial developments resulting from the COVID-19 pandemic (such as the global nature of the shock, synchronized monetary and fiscal response across countries, and international financial market comovements) and the ongoing recovery appear to only strengthen the case for the importance of incorporating global information in bond-pricing models.
1 [go back] I should note that the correlation between the two series increased from 52.9 percent before 2014 to 76.2 percent after 2014. Interestingly, the beginning of 2014 marks another important shift in financial markets: a sharp and persistent compression in the breakeven inflation forward curve, as a Liberty Street Economics blog post recently discussed. A similar flattening is present in the forward term premia of nominal bonds. This is consistent with the interpretation that such flattening—starting in 2014—is likely the result of a new regime, characterized by the compression of inflation risk across maturities.
May 13, 2014
Today’s news brings another indication that low inflation rates in the euro area have the attention of the European Central Bank. From the Wall Street Journal (Update: via MarketWatch):
Germany's central bank is willing to back an array of stimulus measures from the European Central Bank next month, including a negative rate on bank deposits and purchases of packaged bank loans if needed to keep inflation from staying too low, a person familiar with the matter said...
This marks the clearest signal yet that the Bundesbank, which has for years been defined by its conservative opposition to the ECB's emergency measures to combat the euro zone's debt crisis, is fully engaged in the fight against super-low inflation in the euro zone using monetary policy tools...
Notably, these tools apparently do not include Fed-style quantitative easing:
But the Bundesbank's backing has limits. It remains resistant to large-scale purchases of public and private debt, known as quantitative easing, the person said. The Bundesbank has discussed this option internally but has concluded that with government and corporate bond yields already quite low in Europe, the purchases wouldn't do much good and could instead create financial stability risks.
Should we conclude that there is now a global conclusion about the value and wisdom of large-scale asset purchases, a.k.a. QE? We certainly have quite a bit of experience with large-scale purchases now. But I think it is also fair to say that that experience has yet to yield firm consensus.
You probably don’t need much convincing that QE consensus remains elusive. But just in case, I invite you to consider the panel discussion we titled “Greasing the Skids: Was Quantitative Easing Needed to Unstick Markets? Or Has it Merely Sped Us toward the Next Crisis?” The discussion was organized for last month’s 2014 edition of the annual Atlanta Fed Financial Markets Conference.
Opinions among the panelists were, shall we say, diverse. You can view the entire session via this link. But if you don’t have an hour and 40 minutes to spare, here is the (less than) ten-minute highlight reel, wherein Carnegie Mellon Professor Allan Meltzer opines that Fed QE has become “a foolish program,” Jeffries LLC Chief Market Strategist David Zervos declares himself an unabashed “lover of QE,” and Federal Reserve Governor Jeremy Stein weighs in on some of the financial stability questions associated with very accommodative policy:
You probably detected some differences of opinion there. If that, however, didn’t satisfy your craving for unfiltered debate, click on through to this link to hear Professor Meltzer and Mr. Zervos consider some of Governor Stein’s comments on monitoring debt markets, regulatory approaches to pursuing financial stability objectives, and the efficacy of capital requirements for banks.
By Dave Altig, executive vice president and research director of the Atlanta Fed.
April 22, 2013
Too Big to Fail: Not Easily Resolved
As Fed Chairman Ben Bernanke has indicated, too-big-to-fail (TBTF) remains a major issue that is not solved, but “there’s a lot of work in train.” In particular, he pointed to efforts to institute Basel III capital standards and the orderly liquidation authority in Dodd-Frank. The capital standards seek to lower the probability of insolvency in times of financial stress, while the liquidation authority attempts to create a credible mechanism to wind down large institutions if necessary. The Atlanta Fed’s flagship Financial Markets Conference (FMC) recently addressed various issues related to both of these regulatory efforts.
The Basel capital standards are a series of international agreements on capital requirements reached by the Basel Committee on Banking Supervision. These requirements are referred to as “risk-weighted” because they tie the required amount of bank capital to an estimate of the overall riskiness of each bank’s portfolio. Put simply, riskier banks need to hold more capital under this system.
The first iteration of the Basel requirements, known as Basel I, required only 30 pages of regulation. But over time, banks adjusted their portfolios in response to the relatively simple risk measures in Basel I, and these measures became insufficient to characterize bank risk. The Basel Committee then shifted to a more complex system called Basel II, which allows the most sophisticated banks to estimate their own internal risk models subject to supervisory approval and use these models to calculate their required capital. After the financial crisis, supervisors concluded that Basel II did not require enough capital for certain types of transactions and agreed that a revised version called Basel III should be implemented.
At the FMC, Andrew Haldane from the Bank of England gave a fascinating recap of the Basel capital standards as a part of a broader discussion on the merits of complex regulation. His calculations show that the Basel accords have become vastly more complex, with the number of risk weights applied to bank positions increasing from only five in the Basel I standards to more than 200,000 in the current Basel III standards.
Haldane argued that this increase in complexity and reliance on banks’ internal risk models has unfortunately not resulted in a fair or credible system of capital regulation. He pointed to supervisory studies revealing wide disparities across banks in their estimated capital requirements for a hypothetical common portfolio. Further, Haldane pointed to a survey of investors by Barclays Capital in 2012 showing, not surprisingly, that investors do not put a great deal of trust in the Basel weightings.
So is the problem merely that the Basel accords have taken the wrong technical approach to risk measurement? The conclusion of an FMC panel on risk measurement is: not necessarily. The real problem is that estimating a bank’s losses in unlikely but not implausible circumstances is at least as much an art as it is a science.
Til Schuermann of Oliver Wyman gave several answers to the question “Why is risk management so hard?” including the fact that we (fortunately) don’t observe enough bad events to be able to make good estimates of how big the losses could become. As a result, he said, much of what we think we know from observations in good times is wrong when big problems hit: we estimate the wrong model parameters, use the wrong statistical distributions, and don’t take account of deteriorating relationships and negative feedback loops.
David Rowe of David M. Rowe Risk Advisory gave an example of why crisis times are different. He argued that the large financial firms can absorb some of the volatility in asset prices and trading volumes in normal times, making the financial system appear more stable. However, during crises, the large movements in asset prices can swamp even these large players. Without their shock absorption, all of the volatility passes through to the rest of the financial system.
The problems with risk measurement and management, however, go beyond the technical and statistical problems. The continued existence of TBTF means that the people and institutions that are best placed to measure risk—banks and their investors—have far less incentive to get it right than they should. Indeed, with TBTF, risk-based capital requirements can be little more than costly constraints to be avoided to the maximum extent possible, such as by “optimizing” model estimates and portfolios to reduce measured risk under Basel II and III. However, if a credible resolution mechanism existed and failure was a realistic threat, then following the intent of bank regulations would become more consistent with the banks’ self-interest, less costly, and sometimes even nonbinding.
Progress on creating such a mechanism under Dodd-Frank has been steady, if slow. Arthur Murton of the Federal Deposit Insurance Corporation (FDIC) presented, as a part of a TBTF panel, a comprehensive update on the FDIC’s planning process for making the agency’s new Orderly Liquidation Authority functional. The FDIC’s plans for resolving systemically important nonbank financial firms (including the parent holding company of large banks) is to write off the parent company’s equity holders and then use its senior and subordinated debt to absorb any remaining losses and recapitalize the parent. The solvent operating subsidiaries of the failed firm would continue in normal operation.
Importantly, though, the FDIC may exercise its new power only if both the Treasury and Federal Reserve agree that putting a firm that is in default or in danger of default into judicial bankruptcy would have seriously adverse effects on U.S. financial stability. And this raises a key question: why isn’t bankruptcy a reasonable option for these firms?
Keynote speaker John Taylor and TBTF session panelist Kenneth Scott—both Stanford professors—argued that in fact bankruptcy is a reasonable option, or could be, with some changes. They maintain that creditors could better predict the outcome of judicial bankruptcy than FDIC-administered resolution. And predictability of outcomes is key for any mechanism that seeks to resolve financial firms with as little damage as possible to the broader financial system.
Unfortunately, some of the discussion during the TBTF panel also made it apparent that Chairman Bernanke is right: TBTF has not been solved. The TBTF panel discussed several major unresolved obstacles, including the complications of resolving globally active financial firms with substantial operations outside the United States (and hence outside both the FDIC and the U.S. bankruptcy court’s control) and the problem of dealing with many failing systemically important financial institutions at the same time, as is likely to occur in a crisis period. (A further commentary on these two obstacles is available in an earlier edition of the Atlanta Fed’s Notes from the Vault.)
Thus, the Atlanta Fed’s recent FMC highlighted both the importance of ending TBTF and the difficulty of doing so. The Federal Reserve continues to work with the FDIC to address the remaining problems. But until TBTF is a “solved” problem, what to do about these financial firms should and will remain a front-burner issue in policy circles.
By Paula Tkac, vice president and senior economist, and
Larry Wall, director of the Center for Financial Innovation and Stability, both in the Atlanta Fed’s research department
November 4, 2010
Some in Europe lag behind
Since around June, news of European fiscal deficits, financial markets stresses, potential sovereign debt defaults, or even a breakup of the euro zone has faded. The focal points of global economic policy have shifted to the sluggish recovery in developed countries and potential for further unconventional monetary stimulus.
A cursory look at a few key data reflects an improved European economic outlook from this summer. The simple dollar/euro exchange rate (see chart 1) shows that since June 1 the euro has appreciated nearly 15 percent against the dollar. While many different factors affect exchange rates—and increasing expectation of further monetary stimulus in the United States has helped the euro appreciate against the dollar—some of the appreciation seems to reasonably reflect the relative improvement of market sentiment about the fiscal situation in several European countries. Similarly, looking at the major stock indexes (mostly in Western European nations) shows a steady improvement from the lows of this summer, with the Euro Stoxx 50 index rising nearly 11 percent since June 1 (see chart 2). Thus, looking at most aggregate European data paints a picture of relative improvement, though most forecasters expect sluggish growth going forward. It's when one examines individual countries that it becomes clear some are lagging behind.
While the early stages of the European sovereign debt crisis centered on the fiscal scenario in Greece, market stress eventually spread to all the so-called PIIGS (Portugal, Ireland, Italy, Greece, and Spain) and even appeared to threaten the wider euro zone. Following an assortment of unprecedented interventions—highlighted by the 750 billion euro (approximately $1.05 trillion) rescue package from the European Union (through the European Financial Stability Facility) and support from the International Monetary Fund—market confidence slowly grew, and since this summer, various measures of financial market functioning have stabilized.
But while the threat of wider European contagion appears contained, fragilities remain. As has been documented in a variety of media reports, the recent improvement masks the individual euro zone peripheral countries' struggles with implementing fiscal consolidation, improving labor competiveness, resolving fragile banking systems, and staving off a crisis of confidence in sovereign debt markets.
Both bond spreads of individual European sovereign debt (over German sovereign debt) and credit default swap spreads show some stabilization for a few of the euro zone countries, but spreads in three countries—Greece, Ireland, and Portugal—are distinctly more elevated than the others (see charts 3 and 4).
The reasons for rising financing costs in these countries vary. In Ireland, for example, concerns about the Irish banking system (and the resolution of Anglo Irish Bank, in particular) were initially the driving cause. In Portugal, it was doubt over the implementation of necessary economic reforms that drove investor reluctance to provide financing; the recent adoption of austerity measures into the 2011 budget should alleviate some worry. But now much of the market action in both Irish and Portuguese bonds is focused on tough new bailout rules being implemented by the European Union.
On one hand, the renewed financing pressure brought upon these countries is less worrisome because of the backstop of the European Financial Stabilization Facility (EFSF). In fact, Moody's thinks it is unlikely there will be a euro zone default. Should market financing become too expensive for Greece, Ireland, or Portugal, the special purpose vehicle (SPV) imbedded within the EFSF could help by providing financing up to 440 billion euros ($616 billion).
But on the other hand, as part of the wider crisis prevention following the introduction of the EFSF, most European governments are implementing some level of fiscal austerity measures. From a political perspective, the implementation of these austerity measures varies widely, as demonstrated recently by the strikes in France over legislation trying to raise the retirement age. In addition to the uncertainty of implementing fiscal consolidation, there is pressure from the administrators of the EFSF to enforce burden-sharing on private bondholders in the event of any future bailout. This pressure is the primary impetus causing investors to shun the weaker peripheral countries.
One important player in this saga is the European Central Bank, which began buying European bonds for Greece, Ireland, and Portugal (among others) in conjunction with the EFSF announcement. Yet in recent weeks this bond buying has abated, and with money market pressures remaining in Europe, "something clearly has to give way," as Free Exchange wrote recently.
While aggregate market measures (exchange rates, stock indices, etc.) from Europe appear to be improving, a few specific countries face some hard challenges ahead.
By Andrew Flowers, senior economic research analyst in the Atlanta Fed's research department
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