Hedges, Credit Default Swaps and the Euro Area - would you credit it?

About this time very year, as the clocks go back, I ask my students: How do I hedge risk?  Eventually we stumble on the answer which involves buying an asset whose prices changes, or returns in financial language, are negatively correlated with those of my current portfolio.  Thus I give up a little of the returns from my current portfolio and add an asset whose returns will be high (low) when those of my current portfolio will be low (high).  And so I ensure, through the purchase (giving up of some of returns) of a hedge, that my returns or income stream is better stabilised.   The hedge will not make you rich and “will not make you look five pounds thinner” but will be preferred by anyone who wishes to stabilise returns from their portfolio over a larger range of possible events.  The price that people are willing to pay for hedges can give us very useful information on the market’s perception of risk.

Let us, for example, consider credit default swaps on sovereign debt.  These instruments are simply instrument designed to make a risky government bond into a risk-free government bond (you can buy them on corporates but let's concentrate on govvies).  The holder of a risky bond buys a hedge from someone who wishes to sell insurance.  The seller of the credit default swap (CDS) collects the premia from the owner of the risky bond and insures against default by promising to pay the par value of the bond in the event of a default, or “credit event” by the original debt issuer.  In the event of no default, the seller of the CDS simply collects premia and the owner of the bond has reduces his stream of payoffs by the amount of the insurance paid.  The returns from the risky bonds are thus shared between the owner and the seller of the CDS and in principle the combination of holding a risky bond plus a CDS “insurance” contract recovers a risk-free bond for the bond holder.  The seller of the CDS is just collecting insurance premia, having calculated that the expected value of these premia are no less than the cost of par value of the bonds insured times the probability of default. 

The buyer of the CDS pays a percentage of their notional principal and this is called the CDS spread and given reasonably ordered markets are indicative of the riskiness of a given sovereign’s (or corporate's) debt.  There are a number of caveats attached to reading the spreads as indicating risk directly: (i) liquidity in CDS markets, there are over the counter may not always be high, which means spreads may reflect time-varying liquidity premia; (ii) insurance premia may include fixed cost, which drives the spread up; (iii) they reflect risk aversion rather that credit risk, per se, and, relatedly (iv) may reflect a more general contagion rather than an individual country or sovereign risk.  And so we have to be very careful in interpreting the level of spreads and their changes.  

But for the sake of telling a story, let us now look at this CDS spreads for 10 year protection for a group of advanced economies in and outside the Euro Area.  The actual spreads suggest that Spain and Italy lie outside the norm, with spreads at around 300bp.  But if we simply re-index the series for January 2010, which is rather arbitrary admittedly, but we might use a start date of sorts for the Euro-crisis – it is the date that the EU cast doubts on theGreek deficit numbers – we can observe a bifurcation of sorts between the change in the spread between 2010 and today for the EMU countries and non-EMU countries.  The latter have been relatively flat, implying the financial market price have not priced in especially higher rates of Soveriegn risk, even though sustained economic growth has not returned. But for the four Euro Area economies Italy, France, Germany and Spain, CDS spreads seemed to have, at least, tripled.  Whether this is contagion or liquidity or a true measure of heightened Euro Area risk, I leave for another time.  But the price of a hedge does seem to say something clear cut about the continuing problems of the Euro Area and that much work remains to be done.

Did policymakers learn to blow bubbles in 1987?

We have not yet, as a profession, teased out the contribution to the business cycle from monetary policy actions.  This is, in part, because there is not only considerable dispute on how to measure monetary actions but also we know that any results will be heavily dependent on the particular model that is chosen.  There is another reason.  We tend to think of policy as acting to stabilise the economy from shocks, so that agents will plan over the longer run in a manner consistent with the policymakers key objectives.  But what if policy gets it wrong from time to time?  Then it has the ability to increase as well as reduce the volatility of the economic cycle.  And so working out the contribution to an event from something that both may have caused it and responded to it, turns out to be quite hard.

On Friday, at both my lectures, I reminded my students of the events of 19^th October 1987, so-called Black Monday.  Or rather given their youth, offered the historical account.  Although this was a global event, I concentrated on the FT100.   The index of leading companies, see Figure, was based to 1000 in January 1984.  So we can see that by New Year’s Day on 1987, there had been a 68% increase in three years, implying an annual return of just under 19% and the index stood at 1679.  By 16^th July, the index had gained another 764 points to reach 2443, giving a further 46% return in just over half a year.  The correction to this boom was rapid.  There was an 11% fall in the index on Monday, followed by further falls on Tuesday, Thursday and Friday.  So by the end of that week, the index was at 1684 and nearly 27% down on the previous Friday close.  There are a number of contemporary accounts of the proximate causes of this large correction: margin calls, automated stop-loss trades, trading desks-cum-ghost towns as a storm prevented people manning the desks but all seem to suggest to me simply that any downward correction may have been somewhat amplified (See Carlson, 2007, for a nice summary of the the US view).

 

The question facing policymakers was whether this fall in equity prices was a bubble bursting or a market re-valuation of firms’ profitability.  The former implies some form of correction back to fundamentals but the latter change in the underlying profitability of the large firms and by association the economy.  Either way, of course, the possibility of panic remained so perhaps something had to be seen to be done.  Indeed there was a considerable attempt to co-ordinate the responses across central banks throughout the world.  And so Bank Rate was cut from 9 7/8 by 150Bp in three steps, starting on Friday 23^rd, to fall to 8 3/8 by early December.  Equity prices reached their lowest point after this crash on 9^th November at 1565 and some sort of recovery in prices commenced.  Certainly there was no Great Depression as some doomsters (I should look up who they were) were arguing and the business cycle expansion continued until the last quarter of 1990.  With the benefit of considerable hindsight, it would appear that Black Monday was simply a correction and the policy response initially helped adjustment to the new path for equity prices.  In practice, subsequently, house prices were stoked up to a great extent, households became rather indebted and the economy subsequently could not bear the real rates required from continued membership of the ERM but I can tell that story another time.

And so when we turn to list the reasons for the financial crash of 2007/8, we do, I think, tend to overlook the role of excessively accommodative monetary policy in stoking the imbalances that the crisis finally revealed.  Equity market turbulence in the early years of this century led to super-accommodative monetary policy, alongside levels of transparency in policymaking that were designed to reduce uncertainty about the level and path of policy rates.  Casually, at least these policy choices seemed to have played a role in prolonging the business cycle and also supporting asset prices rather like the situation in the late 1980s.  A representative policy maker in their late forties or early fifties in 2003, would have been in his or her mid-to-late 30s in 1987 and I wonder to what extent the experience of 1987 was instructive.  I doubt we shall be able to point the finger for the causes of this crisis at policymakers who had learnt formative lessons as to how to respond to a crises with the Big One in 1987 but I wonder if they did grow up to become bubble blowers?

An OMT swap versus a QE injection - how should central banks buy bonds?

The ECB is planning to undertake a form of bond yield stabilisation for peripheral countries with a new tool, Outright Monetary Transactions, to deal with the on-going Sovereign Debt Crisis in the Euro Area.  Many people are treating this as another example of non-conventional monetary policies that will use central bank money to affect asset prices and at first glance it seems so as well.  But after some reflection, OMTs seem me to be a little more, and I hesitate to use the word, insidious and takes us right back to classic debates about whether monetary policy should prick bubbles and/or identify them.  The answer used to be no.  What mattered was the shock or structure that might have led to any mispricing and to try and deal with that by market reform or some examination of the implications of the shock for macroeconomic stability: central banks, so the argument ran, do not generally think they have more information than the market and so ought to concentrate on the cause of mispricing rather than attempt a direct correction - cause rather than symptom was the proper concern.

Under OMTs, in principle, there will be unlimited purchases of (one to three year maturity) distressed sovereign debt, providing the country whose debt is being purchased is on track under its IMF programme.  The purchases will be sterilised, presumably by sales of more stable sovereign debt, and so simply represent a re-shuffling of the bonds held by the private sector from distressed to more stable.  In effect the ECB is buying risky debt, financing it by selling less-risky debt and putting on a convergence trade so that it will make money if the risky debt goes up in price relative to the stable country’s debt.  In effect the ECB is doubling up, if its overall policy strategy works, it will lead both to a convergence in spreads and also a healthy rate of return, with perhaps a bonus for staff (!).

But rather like selling foreign exchange reserves to buy domestic currency, this kind of sterilised intervention is a kind of strategic game with the financial markets who though may collectively have deeper pockets than the central bank may not wish to challenge central bank policy institution-by-institution.   The idea is that the excessive risk spread does not represent a fair reflection of the credit risk of an individual sovereign but somehow results from contagion or bubble-like forces.  This opens up a number of issues: (i) should the ECB behave like a hedge fund, or specifically as the counterpart to the break-up trade put on by a typical highly leveraged financial institution?; (ii) how do we estimate robustly the fundamental and non-fundamental component of any asset price and esnure that our purchases bring the price to fundamental value?; (iii) how do we contain any moral hazard issues arising, whereby debt issuers may feel they can “misbehave” in the presence of ECB insurance?; (iv) to what extent are ECB purchases of sovereign debt an attempt to offset structural weaknesses in its own policy design – given the financial markets pricing of exit or redomination reflects ECB policy - and so can further ECB policy be used to assuage risks in its own policy? (v) can open market operations of this sort, deal with the structural payments problems and debt overhang faced by Euro Area countries?  My answers to all of the above makes me rather worried about the ultimate efficacy of OMTs.

So you may ask why is QE any better?  I am not completely sure.  But QE is about swapping interest bearing reserves for government bonds held by the non-bank financial sector.  And this swap is specifically designed to replicate the impact of a notional cut in Bank rate, so that 10 year government yields fall to the point that they would have done if we could have had negative Bank rate or equivalently a longer duration of Bank rate at the zero lower bound (ZLB).  The swap is designed to be reversed so that any reserves issued will go out of circulation – with no permanent impact on the price level.  So QE adds us to a temporary injection of reserves that leaves the private sector long (liquid) reserves and short (less liquid) bonds for an uncertain but extended time.   Given the hedge fund analogy, the Bank of England and HMT in this case is actually betting against itself because when (or if) the economy stabilises it will take a large loss on the bonds it has bought.  In some sense, because “it is betting on the opposition" and so providing a commitment technology of the sort that says believe us when we say that we will keep interest rates low for as long as is required because when they are raised it will cost us a heck of a lot of money.

OMTs, on the other hand, are not designed as an instrument to compensate for the ZLB but result from some view that the market-determined rate for distressed sovereign spreads incorporates something other than credit risk, that is not well pinned down by fundamental factors such as the current and prospective stance of fiscal policy alone. Remember if they were on track during an IMF programme, the spreads ought to come back in. And so that is why, OMT sounds more like the defence of an exchange rate peg rather than a QE-type policy.  The advantage here, compared to an exchange rate peg, is that this interest rate peg is being defended by domestic central bank money.  But because  operations are to be sterilised, there is no overall change in the relative quantities of bonds and money simply the risk composition of debt held by the private sector.  The literature on sterilised interventions in forex markets does not suggest any great hopes for OMTs.  I therefore wonder whether OMTs should be unsterilised so that at least the exchange rate can jump downwards.  

Overall there clearly is a missing instrument (or two or seventeen) in the Euro Area, which might be a form of country specific non-conventional policy, it is just that I am not sure that OMTs as they currently stand are the answer.  What we probably need is more debt issued by stable sovereign states, i.e. Germany, which might give the central bank more ammunition.  It is this debt that could then be bought by a QE-style operation that would increase central bank money and might well help lead to a large depreciation in the Euro.  And then for some kind of swap between risky and less risky debt in specific lots. I will return to this question.  Meanwhile OMT looks at least one or two letters short of being the required instrument.

What is an Old Lady to Do? Nominal Income or Inflation Targeting

    There are growing calls to consider moving from inflation targets to nominal income targets as the prime objective of monetary policy. There is much merit in such a move. No central bank model yet can accurately forecast the split between real and nominal GDP particularly well as this requires us to understand whether shocks currently driving the economy are primarily demand or supply and also what the slope of short run aggregate supply curve is, which is itself likely to vary with an unknowable level of spare capacity. So the argument runs, let's limit ambition and simply target real GDP growth and, broadly speaking, inflation jointly rather than the latter explicitly and the former implicitly (because inflation is generally thought to be consequence of lagged, current and expected output gaps). Maybe.

    And so this morning, I ran a little simulation of a small macro model with either one of a nominal income targeter and an inflation targeter at the helm. This model is standard with consumption, output, fiscal expenditure, overseas demand, cost-push and a Phillips curve and both a fiscal and monetary policy maker. The Figure below shows us that inflation will rise more and consumption fall less when there is a nominal income targeter in office rather than an inflation targeter in the presence of cost-push shock i.e. ones that depress output and raise inflation. In this simple simulation, the response of agents embeds the policy reaction function and so leads to a higher inflation response because of higher expected output growth when the policy maker is told to care equally about inflation and output compared to being given an inflation target alone. So if you want to see higher nominal growth following cost-push shocks then nominal income targetry may be for you.  On the other hand when we allow the model to be buffeted by a panoply of shocks, such as, autonomous spending, changes in the velocity of money and also fiscal expenditure, the results look quite different: although the variability of household consumption is broadly similar when simulated over the long run, both of nominal interest rates and inflation are significantly more volatile under an nominal income targets. There main reason here, I think, is because fiscal policy is already assigned to the control of output, in these kinds of models, by then also asking monetary policy to consider output, we end up with the two policy arms wrestling somewhat with each other (see Chadha and Nolan, 2003, pp55-57).

Response of consumption, policy rates and inflation to a cost-push shock

    With appropriate assignment, and institutional reform, it may not always follow, of course, that more volatility may be injected by a nominal income target but I am not convinced yet about the need for any change. The main impetus for changes in policy have arisen from the real failures identified during this ongoing financial crisis, which involved an incomplete integration of financial factors in an understanding of what determined macroeconomic stability. And a quick glance at the data do not suggest that nominal GDP growth was especially excessive in the run-up to the financial crisis (see Chadha and Holly, 2011, pp 12 and 29 on this point), though it was perhaps a little stronger than some policymakers would have wanted. But what we probably needed more was a story of why excessive growth in monetary balances, debt and house prices did not show up in the aggregate numbers: what has been called a balance sheet expansion and recession. And so I am not sure that a targeting regime that forced the policymaker to concentrate his or her mind on nominal output rather than inflation would have forced a balanced assessment of (im)balance(d) sheets. Furthermore most of the results I have seen about how to escape a balance sheet recession-cum-liquidity trap seem to involve some form of commitment to inflate, so that the real value of debt is eroded. Moving to nominal income target may well make such signals about the likely future path of inflation hard to impart. Either way, I think the answer is not so much about the form of target but the quality of the analysis about the ongoing developments in the economy and how any emergent problems ought to be stabilised.