18/2/2013: Short-selling and Markets Volatility

A large number of analysts and policy makers tend to believe that highly leveraged trading activity, especially that linked to HFT, is a significant, even if only partial, driver of markets volatility. The channel through this logic usually works is that in the presence of leverage, speed of positions unwinding in response to unforeseen events increases, thus amplifying volatility.

An interesting study by Harrison Hong, Jeffrey D. Kubik and Tal Fishman, titled "Do arbitrageurs amplify economic shocks?" (Journal of Financial Economics, vol 103 number 3, March 2012, pages 454-470) examined the impact of arbitrageurs' activity on stock performance. Based on quarterly data from 1994 through 2007 for NYSE, Amex, and Nasdaq, share prices were examined over two distinct sub-periods: one day before earnings announcement and one day after the announcement. Medium-term performance was analysed for two days before earnings announcement and 126 days after earnings announcement.

The authors find that:

1. Stock price reaction to earnings news is more severe in heavily shorted stocks than in stock with fewer short positions;
2. Changes in the short ratio and earnings surprises counter-move;
3. Share turnover as a result of large earnings surprises is higher for heavily shorted stocks as consistent with (1) above;
4. Positive earnings surprises push up the valu of heavily shorted shares (as consistent with (1) and (2) above)
5. Following positive earnings announcement, returns are higher (in general) for stocks with heavy shorting positions prior to the announcement since price appreciation post-announcement forces covering of short positions and triggers more demand for shares;
6. Consistent with (5) above, post-positive earnings announcement, previously heavily shorted stocks become better targets for further shorting;

Overall, the study finds that:

• Any earnings surprise in any direction (either positive or negative) leads to a corrective action by (either long or short) investors;
• The above increases price sensitivity to newsflow and thus volatility;
• Trading volume and stock price increase abnormally for heavily shorted stocks;
• The abnormal volatility and volume & price effects are temporary and in the medium terms, prices revert to the mean.

18/2/2013: G20 & Currency Wars

Amidst continued rapid devaluation of the Yen, predictably, and per usual, the G20 summit in Moscow has ended with a useless and unenforceable statement. This time around, as was signalled in the days ahead of the meeting, the 'focus' of transnational vacuousness was on the topic de jour: the Currency Wars.

But the background to it was much less economic than political. G20's sole obsession is to drive forward the idea that to survive, the world needs more coordination of top-level policies. This invariably requires (a) finding a convenient newsflow-worthy boggy, (b) making a statement to the effect that greater coordination is needed and that cooperation can cure all ills, and © proceeding to do absolutely nothing about it post-statement. The latests communique went on to conclude that “ambitious reforms and coordinated policies” were the key to achieving strong sustainable growth. Just like that: coordinate and magic shall happen.

Thus, the meeting of G20 has issued a statement rallying against competitive currency devaluations - or in more common parlance, a “currency war”.

In reality, G20 has no power to abate, let alone reverse, the process of currencies debasement. Quantitative easing - in its now fully evolved multitude of forms will go on, with central banks and governments across the OECD continuing to print their ways out of the slump. If G20 communique were to achieve anything, it will be just to push the whole affair under the proverbial rug, with devaluations not explicitly targeted in public pronouncements.

The communique states that G20 states "will refrain from competitive devaluation. [and] will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open.” The devil, of course, is in the slight turn of phrase. The G20 committed to not drive down their currencies values for 'competitive purposes'. But as long as money printing is 'necessary' to sustain domestic financial stability or deliver a monetary stimulus or both - then all is ok.

Just how feeble the whole statement is was illustrated immediately, with the worst offender - the Japanese Yen, down 7% in value already in 2013 - posting a slide against major currencies. In many ways, the communique makes it even more likely that sustained devaluation of the yen will be even more damaging now. Prior to G20 statement, the Japanese Government could have simply continued pushing down yen values by focusing on aggressive statements about the need for monetary stimulus and forex rate targeting. Now, it will have to print hard cash silently.

And the Fed is still sitting on a massive bonds purchasing programme that so far has been running at ca USD80bn per month. At G20 meeting this programme has been squarely defended by Bernanke.

Senior Bank of England, Martin Weale went on, during the G20 summit, to praise Sterling debasement, saying that a 25% devaluation of the pound over 2007-2008 period was not enough to boost exports and that more devaluation should be targeted.

In short, the entire G20 summit was a joke. It neither signaled any real policy shift, nor mapped a single tangible policy response to the crises still impacting advanced economies. If anything, via reducing potential rhetorical impact of monetary policy stance, it pushed the G7 countries into a more aggressive real monetary policies responses space. This promises to accelerate the currencies wars, while reducing overall ability of the monetary authorities to quickly unwind the decisions taken in years to come.

17/1/2013: 'Brown' Republicans v 'Green' Democrats?

Farzin, Y. Hossein and Bond, C. A., in their paper "Are Democrats Greener than Republicans? The Case of California Air Quality" (January 16, 2013. FEEM Working Paper No. 97.2012. http://ssrn.com/abstract=2201595 or http://dx.doi.org/10.2139/ssrn.2201595) ask an interesting question: "When it comes to environmental quality preferences, it is popularly believed that Democrats (and more generally, liberals) are “green” while Republicans (conservatives) are “brown”. Does empirical evidence support this popular belief?"

The paper tests the hypothesis that "regional political identification leads to differences in concentration outcomes for several measures of California air pollution indicators, including CO, NO2, SO2, O3, PM10, and PM2.5 concentrations." The authors control for "political party preferences of the local populace, as well as …the political party affiliations at the state-level legislative and executive branches".

And the findings are very much against the grain with the common 'wisdom':  "In general, we do not find a consistent and statistically significant relationship between pollution outcomes and political variables for California. The popular belief is empirically supported only for NO2 and O3, but not for any of the other pollutants, and even in these two cases the relationship only holds at the local regulatory level and not at the state policymaking level. At the state level, for most of the pollutants no significant effect of party affiliation is identified, and in the rare cases where such an effect exists, it is either too weak to be conclusive or is even counter to popular belief."

17/2/2013: Why do economists use models with false assumptions?

An interesting new paper from the PIER on the currently quite acute divergence between academic economics and the general understanding of economic inquiry outside the field of academic economics, namely the divergence in the value attached to theoretical models in analysis. Especially models, that are based on patently false assumptions.

Gilboa, Itzhak, Postlewaite, Andrew, Samuelson, Larry and Schmeidler, David, paper "Economic Models as Analogies, Third Version" (January 27, 2013, PIER Working Paper No. 13-007. http://ssrn.com/abstract=2209153 or http://dx.doi.org/10.2139/ssrn.2209153) argues that although "people often wonder why economists analyze models whose assumptions are known to be false", "economists feel that they learn a great deal from such exercises. We suggest that part of the knowledge generated by academic economists is case-based rather than rule-based. That is, instead of offering general rules or theories that should be contrasted with data, economists often analyze models that are "theoretical cases", which help understand economic problems by drawing analogies between the model and the problem. According to this view, economic models, empirical data, experimental results and other sources of knowledge are all on equal footing, that is, they all provide cases to which a given problem can be compared. We offer complexity arguments that explain why case-based reasoning may sometimes be the method of choice and why economists prefer simple cases."

16/2/2013: Minister Noonan Talks International Finance, briefly

This week, Calgary Herald reported some fascinating remarks made by Irish Minister for Finance, Michael Noonan at the EU Finance Ministers meeting. Quoting from the paper (full link here), with mine emphasis added:

"Arriving Tuesday for a meeting of the 27 EU finance ministers, Irish Finance Minister Michael Noonan said: "I think all this debate about the relative value of currencies is going to be an issue at the G-20 but we're coming through a period where the concern was the volatility of the euro". "It's a bit soon to argue that it's too strong." Noonan said he wouldn't support any proposals that the ECB should intervene in the markets to get the value of the euro down."

This statement bound to raise eyebrows of anyone even remotely familiar with economics and / or international finance.

Minister Noonan - in charge of the Finance portfolio in a Euro area country - seemingly has trouble formulating exactly what the Euro crisis is / was about. Volatility of the euro he cites was never a problem during the crisis. In fact, in major exchange pairs, Euro has not been the driver of the volatility, but the subject to periodically, short-term elevated volatility induced by the changes in policies and fundamentals in non-Euro area countries. And volatility of the EUR relative to any other major currency was actually lower than for exchange rates ex-EUR.

The confusion in his mind seems to arise from the lack of basic grasp of the currency markets.

1. Minister Noonan seems to have no idea that "volatility of the Euro" as a phrase is fundamentally imprecise. Euro (and any other currency) can be volatile only in terms of a bilateral (or in more complicated setting - triangular) exchange rate. He mentions no such pairs. We can talk about EUR/USD exchange rate volatility, or EUR/JPY volatility, etc, but not about 'Euro volatility' in pure terms, unless we want to say that EUR is the driver of volatility in the bilateral exchange rates vis-a-vis all major currencies.
2. Minister Noonan seems to be confusing 'volatility' (definable by a number of statistically objective metrics) and 'uncertainty' (definable only imperfectly by a risk transform approximation). This is more than an innocent failure to understand philosophical differences between risk and uncertainty. By confusing 'volatility' for 'uncertainty', Minister Noonan anchors his analysis of potential and preferred solutions to the crisis solely to policies that can reduce volatility of the exchange rate. By this metric, the crisis was not even worth a footnote in a newspaper.

But then comes a logical step that defies any comprehension. Having stated that the crisis was 'volatility of the Euro', Minister Noonan goes on to say that he opposes ECB intervention to alter the value of the euro. Surely, intervention would be consistent with policy management to reduce the exchange rate volatility that Minister Noonan is so concerned about?

Let's set aside the apparent lack of logic in the statements above. And let's focus on Minister Noonan's longer-term position vis-a-vis the Euro. 

Minister Noonan and his Government have actively pursued policies of extending Irish Government debt maturity. The latest instalment of this strategy was the 'deal' on the IBRC Promissory Notes. In other words, Irish Government entire economic policy (with exception of 'exports-led recovery') can be summed up as a hope for future inflation wiping out real value of Irish Government debt. Forget the fact that such an outcome will destroy the other side of our economy where debt overhang is also present: the households (higher inflation = higher interest rates = higher burden of debt). But what on earth is Minister Noonan doing talking against his own Government policy?

This bizarre combination of 'swinging' focus in policy goes deeper. Irish Government second (and last) pillar for economic policy - other than inflation - is 'exports-led recovery'. 2010-2012 data on Irish exports shows rapidly contracting rate of growth in exports. Monthly and quarterly data show even more reasons for concern. Foreign demand weaknesses and structural issues in the Irish exporting sectors are clearly major drivers. But higher valuation of the Euro are not helping. Yet, Minister Noonan is concerned with preventing devaluation!

Should Enda, perhaps have a chat with Minister Noonan, rather than send troops out after his party backbenchers whenever they are slightly critical about the Government position? Afterall, in the above few words, Minister Noonan has managed to mis-state the source of the Euro problem, derive an implicit but deeply flawed policy conclusion out of this mis-statement, and contradict his Government's two cornerstone policies. 

15/2/2013: Euro Area Banks: Staff & Admin Costs 2008-2011

Brilliant data set on Staff and Admin costs in domestic banking sectors across the Euro Area (H/T to Lorcan Roche Kelly aka @LorcanRK via twitter), via ECB (link) :

So run through these. Over 2008-2001, Admin & Staff costs in banks:

• Declined by 7.84% across the entire Euro Area;
• Went up in Cyprus by a massive 21.9% (banks are now bust), in Spain by 12.16% (banks are largely bust), in Portugal by +4.26% (many banks are zombified)
• Fell marginally by  -0.05% in Italy (some larger banks in pretty dire shape), -3.2% in Greece (banks are bust).
• Fell significantly in Ireland by -26.4% (banks are bust), Luxembourg by 36.5% (brassplates operations), and by 31.3% in shaken Estonia (banks are operating in high risk, low growth environment). Fell consistently in line with overall state of the crisis across the banks-related sectors of the economy in the Netherlands (-10.81%) and overshooting economy's woes in Belgium (-23.2%).
• Fell massively in Germany, where overall banking sector was not as badly mangled (-59.6%).

Go figure...

15/2/2013: Irish CDS mid-day

Mid-day CMA update on CDS markets: Ireland slipping slightly after good rally and so are other peripherals:

Not a game-changer, but then again, Sovereign CDS are hardly a 'game' anymore, given thin trading and other constraints. Still, pleasant to see 167.01 5-year spread.

15/2/2013: Loose Lips of Brendan Howlin & Jens Weidmann's Bother

Strong words today on the Irish Promo Notes deal from ECB's Jens Weidmann via Bloomberg (link to full interview here):

"It’s important that we draw a clear line between monetary and fiscal issues. The transaction in Ireland demonstrates how difficult it is for monetary policy to free itself from the embrace of fiscal policy once you’re engaged. The Irish government in its very own statements underscored the fiscal elements in this transaction.

"I’m rather strict when it comes to the definition of monetary financing. It’s important to draw a clear dividing line and accept the limitations of Article 123 for our actions. It’s not difficult from that to guess what my position is. [I would guess he is 'troubled' by the deal]

"The Irish government liquidated the IBRC. That has repercussions on net financial assets and has to be assessed against the background of Article 123. Of course the Eurosystem has to make sure that its actions are in conformity with its rules and statutes. [Widemann here clearly links NPV from the deal (small but positive by my estimates at EUR4.3-6.5bn, with some other analysts getting their estimates out to EUR8bn or roughly 25% of the original Promo Notes issuance or 30% of the remaining outstanding amounts) to the issue of whether the deal is legitimate.]

"I’m not passing a legal judgment on a particular transaction, but I think it is clear from what I said that I’m very concerned about monetary policy being too closely intertwined with fiscal policy and crossing the line to monetary financing. That’s why I was very skeptical about some of the decisions in the past, and you can be sure that I apply the same benchmark to this transaction.

"Once you cross a certain line, setting a precedent, it’s very difficult to come back and argue against the next similar transaction. That’s why it is important to define our mandate narrowly, so we’re not drawn into fiscal policy matters. There is a reputational issue, there’s a credibility issue. It might make it more difficult to focus on our main objective credibly. If governments had wanted to provide additional funding to Ireland, they could have tapped the ESM.

"We took note of this issue in the Governing Council. Our deliberations aren’t public. Apart from that, the transaction is out there, it’s known, it’s very transparent. Everybody has his own judgment on this -- I have mine.

"The transaction as such is technically a bit complex but it has a fiscal nature as stated by the Irish government. That’s clear enough." [Oh, here we come: Irish Government and senior Ministers have gone out talking about the 'social' dividend on the deal 'savings' etc. This might just bite the Government back. Rhetoric about Government spending (in any way) at least a share of the deal short-term cash flow savings will clearly signal that the Irish Government has pulled ECB into monetary financing and thus opens up the whole affair of the deal to legal challenge in Germany. As they used to say in WWII: 'Loose Lips Sink Ships'... care to listen, Minister Howlin?]

14/2/2013: New Compensation Model for Rating Agencies

I wrote yesterday about two studies on the effectiveness of the rating agencies (link here). Another interesting study on the agencies and their performance was published in Spring 2012 issue of the Journal of Structured Finance (vol 81 number 1, pages 71-75). Authored by Malesh Kotecha, Sharon Ryan, Roy Weinberger and Michael DiGiacomo and titled Proposed Reform of the Rating Agency Compensation Model, the study looks at the current model of rating agencies compensation - the so-called issuer-pay model whereby issuer of securities being rated paying for the rating delivery - in light of the apparent conflicts of interest implicit in the model. The authors propose an alternative model based on fee levied on new issues and secondary markets trade. Fees would be deposited in a dedicated fund which will pay these out to the rating agencies. The agencies will be rotated on a performance basis, taking into account accuracy of their ratings over time.

The criticism of such an approach to compensation model - as noted by the authors - stems from 

-- the disincentive to rating agencies under the proposed changed model to innovate in ratings models development (higher potential errors etc)

-- the fact that the US bonds market is global in coverage and thus requires competitive pricing systems, 

-- difficulty of devising a merit-based rotating system and setting appropriate levels of fees; and

-- the new model introducing a transactions tax.

Overall, the weakest point of this proposal is undoubtedly its failure to consider the US markets role as global issuance platform with any transaction tax eroding cost competitiveness and the failure in recognising that global scope of rating agencies and the US markets also implies severe limits on new compensation model ability to capture the activities of these agencies.

13/2/2013: Rating Agencies Role & Effectiveness: 2 recent studies

In light of all the cases being filed against the rating agencies and in light of the general controversy surrounding them, here are two recent papers dealing with the topic of rating agencies performance and the links between their ratings and investors' decisions.

One interesting paper was published in the Journal of Banking & Finance )vol 36, number 5, May 2012, pages 1478-1491) by Thomas Mahlmann titled "Did Investors Outsource Their Risk Analysis to Rating Agencies? Evidence from ABS-CDOs".

The paper looks at the floating-rate tranches from collateralised debt obligations (CDO) backed by asset-backed securities to test whether yield spreads at the point of issuance (origination) act as good predictors of future performance. The paper found that, once we control for rating at issuance and other deal-specific data, yield spreads do indeed indicate future performance. However, this result is primarily due to tranches that were initially rated below AAA.

The study concludes that at the issuance / origination, investors did not rely only on ratings, when pricing the CDOs studied. The study econometric evidence also indicates that ratings were inadequate for CDOs because these instruments are much riskier than corporate bonds.

Another paper, published in the International Journal of Finance and Economics (March 2012) by Eduardo Cavallo, Andrew Powell and Roberto Rigobon, titled "Do Credit Rating Agencies Add Value? Evidence from the Sovereign Rating Business" look at the credit downgrades made during and after the financial crises asking whether rating agencies opinions provide any incremental information to the market.

The answer to the question is yes. Rating agencies opinions on sovereign risks do explain a portion of variation in three macroeconomic variables, relevant to the market: exchange rates, stock market indices and future sovereign bond spreads, once the authors control for observed bond spreads.

The study also found that rating agencies upgrades (downgrades) are correlated with:

1. decreases (increases) in the spreads one day forward;
2. increases (decreases) in the stock market;
3. nominal exchange rate appreciation (depreciation) relative to the USD.

Top level conclusion: the ratings do contain information about specific credit and the rating's informational content is in addition to other publicly available market data, such as credit spreads.

13/2/2013: BlackRock panel economic outlook for H1 2013

Not surprisingly - and in line with the likes of CESIfo Index measuring global economic conditions (see link here) - BlackRock Institute report on global economic outlook also signaled that analysts' expectations are turning positive.

Here are two key charts for North American and Western Europe:

I like the cautious, but overall improving outlook for Ireland: still significant proportion of experts expecting continued recession, but crucially, Ireland is (at least in expectations) well-decoupled from the peripheral euro area countries.

Do note Spain's position as the worst expectations performer in the group - must I remind you, Mario Draghi recently praised Spain as the country that serves as an example of how to 'stabilise' crisis-hit banking sector... right...

13/2/2013: CESIfo Index shows improvements in Global Economy

CESIfo institute has issued its analysis of the global economy and... some good news: per CESIfo index tracking global growth, world economic climate indicator finally is up after two consecutive declines.


The increase in the index "was mainly driven by significantly more positive assessments of the 6-month [forward] economic outlook." At the same time, "assessments of the current economic situation improved only slightly. After 6 months of stagnation, the prospects for the world economy seem to be brightening."

• Asia led the global index rise, with region index "now higher than its long-term average once again. Both assessments of the current economic situation, and especially expectations, have brightened considerably." 
• In the case of North America "the rise in the economic climate indicator was mainly due to improved assessments of the current economic situation. Despite the improvement, the current economic situation is not completely satisfactory in this region." 
• Per CESIfo release: "The current economic situation is also unfavourable in Western Europe. Assessments of the 6-month [forward] economic outlook, on the other hand, were significantly more positive, which led to a moderate overall improvement in the economic climate." 

CESIfo Index panel "on average expect short-term interest rates to remain largely unchanged over the next six months. However, they believe that long-term interest rates are set to increase slightly. On worldwide average, economic experts expect moderate growth in the value of the US dollar over the next six months."