Toward a global risk map

Now I’m quite involved now with trading and coding so I have little time to write posts. But today in the very morning a read a very interesting BIS paper written by by Stephen Cecchetti, Ingo Fender and Patrick McGuire.(Link here)Authors wants to build a giant global risk monitoring system which would monitor risks not only on macro level but also will monitor feedbacks between funding and asset side of financial institutions. This will be another important step in understanding functioning of global financial system

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Analyzing Interconnectivity among Economies

Complecixty of the global financial system first became so obvious when the Lehman Brothers collapsed in 2008. A complex wave of feedback loops which the collapse has generated was far beyond expectations and far more disastrous than classic economic/risk models were suggested. Since then there is growing number of economic papers focused on how the economic network topology, interconnectivity, etc contributes to economic stability. Here you can find to link to Alfred Wong and Tom Fong paper. This study focuses on CDS spreads of 11 Asia Pacific economies and its interactions. A major finding is that all these economies register a significantly higher sovereign risk once the condition that another economy is in distress is imposed.

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Credit – another dimension of commodity trade

Amid mounting fears of debt crises in Europe (or more generally sovereign debt around the world) commodities are seen as safe haven. This consensus might be misconception as market participants could miss several points.

• First point is (but possibly lest important) the fact that “FEAR” is not an equilibrium concept
• Secondly demand and supply curves may not be independent the demand and supply is not guided my current prices but rather by future prices.
• My last but not least important point is that the futures markets heavily depend on credit market. As I mentioned earlier the supply and demand curves may not be independent (even in case of commodities) as financial intermediaries adjust actively their balance sheets to their VAR models (pro-cyclical). In other words greater demand for the assets tends to put upward pressure on its prices, and then there is a feedback effect in which stronger balance sheets feed greater demand for the asset which in turn raises the asset price and lead to bigger balance sheets ( for more detail analysis of this process please look on the one of the previous post or read Shin and Adrian paper ). This process if unchecked can lead asset prices up to the sky and then down to the hell. At climax of this process utilization of collateral is at full and the price is strongly dependent on further and faster credit inflow which amid rising LIBOR rates may be difficult.
  
  Chart above shows swap positioning for US copper futures (The Spreading: For the futures-only spreading measures the extent to which each non-commercial trader holds equal long and short futures positions. Non- commercial traders are not involved in an underlying cash business; thus, they are referred to as speculators). It clearly shows that copper prices are strongly affected by speculative activity and are heavily dependent on credit market. This I just one example but cross-correlation of metals is high and all commodity markets looks similar. As I wrote previous post I think we just get into unstable phase.

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Note on log-periodic description of 2008 financial crash

Here you may find link to short paper of Katarzyna Bolonek-Lason and Piotr Kosinski. This another example of implementation of LPPL for detecting a critical state of market

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Do bubbles lurk in metals?

Sugar bubble has burst. Analysis posted earlier on this blog was correct but... it was not accurate enough to make money out of it.

Now again I’m turning my attention to commodities but this time to metals as my intuition tells me that the bubble may lurks in there. My intuition is driven by increasing cross correlation of base and precious metals. This time on top of estimating LPPL I also plan to implement Minimum Spanning Tree (MST) to get more insight in to the metal markets topology. This project is partially inspired by Paweł Sieczka and Janusz Hołys research paper (link here).

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Empathy, bubbles and mistake of Polish monetary policy

“Investors are concerned, not what an investment is really worth, but with what the market will value it at…three months or a year hence”…”We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be and there are some, I believe, who practice the fourth, fifth and higher degree”

J.M.Keynes , The General Theory of Employment, Interest and Money (1936 London page 152)

Keynes paid a great attention for market psychology and higher orders expectation. In his “General theory…” he compares asset markets to a beauty contest where participants have to chose the faces that other competitors find the most beautiful. His beauty contest may be also helpful in understanding uncovered interest parity failure.

Speculative capital moves in search of the highest total return. Let’s assume for simplicity that the total return has two elements: the interest rate differential and the return on exchange rate appreciation. In words to make money you should borrow in low yielding currency i.e. USD and put deposit in high yielding currency i.e. PLN (Polish zloty) and pray for exchange rate to depreciate slower than the interest rate differential.
Classical economy claims that uncovered interest parity (UIP) holds and expected future exchange rate is equal to the interest rate difference. Meaning that higher yielding currency should depreciate faster, flattening out the possible profit. But classical economy assumes that the valuation process is passive whereas the capital inflow is motivated primary by expectations about future exchange rates.

If sufficiently large group of investors expect that the market will value the high yielding currency too high next period, they will buy it pushing exchange rate down vs. lower yielding currency. This self validating process will be in place as long as capital will continue to flow in and as long as there will remain investors non confident in appreciation of high yielding currency.

This expecational error has finite time singularity where the crash probability is highest. Nowhere is Keynes beauty analogy more relevant than in the characterization of the crash hazard rate, because the survival of the bubble rests on the overall confidence of investors in the bullish trend.

In that view bubbles are result of positive feedback among investors and imperfect information processing. LPPL model developed by D.Sornette is just a tool which is designed to catch the coordinated swing in market opinion. I will not here describe it again ( you my find it in Sornette papers or in my presentation about sugar bubble)

Here I want to concentrate on macro signs/”fingerprints” of positive feedbacks which leads to bubbles and crashes.

Below charts show some stylized facts of EUR/PLN exchange rate fluctuation. I cut the whole decade (1999-2010) into 5 periods (3 bubble formation periods ( I 1999-2001, II 2004-2008, III 2009-2010,)and 2 – anti-bubble / crash periods).

It’s clear in the charts below that every single period of rapid appreciation of PLN (and failure of Uncovered interest parity ) was triggered either by large FDI flow or expectations of future FDI inflow (or both). The first chart indicates that FDI inflow was the initial seed for the bubble which triggered self-reflective capital inflow expectations.

Self-reflective character of speculative inflows is well visible on the second chart (blue line). In 2004 portfolio inflow was not only constant but was even accelerating along zloty appreciation ( the stronger zloty was the more was demanded). This may suggest supply and demand curves were not independent but self-reflective.

Again same situation we could observe most recently. Large interest rate differential between Polish and US rates and expected large FDI inflow created initial bias in expectations for zloty appreciation. This was followed by portfolio inflow which to keep zloty appreciate has to accelerate. This is well visible in the fourth chart which shows that at the beginning of the year inflows were become stronger as foreign holding of Polish treasury bonds jumped to record high level.

The charts also suggest that most recent rapid appreciation of PLN was feed by foreign buying of Polish treasury bonds. To keep zloty appreciate the inflow had to be not only continued but also accelerate which amid PIIGS crises was unlikely. This finding supported LPPL estimation results which indicated that the exchange rate went into “critical” period. But as I said in the previous post the full inflating of the bubble is rather unlikely as only half of this year expected FDIs has been executed.

One period which especially needs attention is period between mid 2007 and end of 2008. For me this period is so important because the bubble which was created then triggered most rapid deprecation of polish local unit ever. What stands out is that at that time Polish monetary policy remained firm on tightening (interest rates up) course (inflation fears) despite the fact that the US monetary policy stance has been changed and also ECB was became dovish at this time suggesting that interest rate cuts were in the pipeline. Very high interest rate disparity and large FDI inflows generated initial bias for PLN appreciation. Because stance of local monetary policy at that time was still hawkish the speculative capital was not flowing through portfolio window (Treasury bonds priser are falling when the interest rates are increasing) but through short term FX instruments (options, SWAPS, Loans). Cumulative inflow to Monetary and Financial Institution (MFI) in that period of time top around EUR40bn!!! Polish exporters to withstand competition amid falling global demand started to buy EUR PUT PLN CALL FX options and financing the premium by selling EUR CALL PLN PUT FX options. As the chart is showing the stronger zloty the more it was demanded a clear self-reflective relationship. To keep zloty appreciate capital had to flow in even faster but process has singularity. Capital inflow slows down in mid of 2008, bubble has busted and a Polish corporations bankrupted as EUR CALL FX options were executed. It would be unfair to blame NBP MPC for that but its shows that inflation targeting framework has to be extended and financial stability has to be also targeted by central banks.

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worst preforming currency of the month - Polish Zloty (lucky me)

Polish zloty bubble has burst or at least we going through large bifurcation (more likely). A month ago I posted here a short note saying that the bubble is lurking in Polish zloty. At that time I also said that a more detailed analysis will follows however… Since then I was fully concentrated on trading trying building and executing strategy which would utilize findings of my research. Today I have closed EUR/PLN longs and option position. Now It’s time to celebrate but no later than on Monday I will post some short presentation with LPPL estimates for Polish zloty and some stylized facts

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Leaning against the bubble –Polish central bank intervenes to weaken local unit

Today Polish central bank (NBP) intervened to weaken local unit. Amid signs of bubble formation in fx market adopting “lean against” policy seems to be reasonable. Problem how the central banks should deal with potential asset bubbles is not trivial but there is growing consensus that aims of monetary policy should be broaden beyond targeting only consumer prices in efforts to stabilize economic growth. Here you can find NY FED president remarks at The Economic Club of New York on how the central banks should deal with asset bubbles.

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Bubbles lurk in government debt

In today’s FT you can found superb article by former IMF chief economist Kenneth Rogoff. Reading this article was a pleasant surprise for me as it is very rare for main stream economist to refer to reflexive bubbles. In the article Rogoff points out that that the real issue is not whether conventional economic theory can rationalize bubbles but the real issue is to detect bubbles. I reckon that without a good theory this task is impossible and I think that economist toolbox will be soon extended by out of equilibrium tools like LPPL.

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Polish zloty bubble in the making

Speculative capital moves in search of the highest total return. Let’s assume for simplicity that the total return has two elements: the interest rate differential and the return on exchange rate appreciation. In words to make money you should borrow in low yielding currency i.e. USD and put deposit in high yielding currency i.e. PLN (Polish zloty) and pray for exchange rate to depreciate slower than the interest rate differential.
Classical economy claims that uncovered interest parity holds and expected future exchange rate is equal to the interest rate difference. Meaning that higher yielding currency should depreciate faster, flattening out the possible profit. But classical economy assumes that the valuation process is passive whereas the capital inflow is motivated primary by expectations about future exchange rates. To the extent that exchange rates are dominated by speculative capital inflows, they are purely reflexive: expectations relate to expectations. This process is self-fulfilling and self-validate but increasingly unstable as to keep it in place capital hast to flow in faster and faster.
To cut story short It all depends on how market participants co-ordinate their expectations. LPPL formula is handy tool to detect synchronization of market participant’s expectations and to estimate probable end of the bubble. Several months ago I posted here chart with LPPL formula fit into EUR/PLN exchange. In all boom and bust periods the formula fit well to the data and accurately predicted the end of the bubble or ant bubble process.
Before I will fit the LPPL formula to the current data let’s take a closer look on the stylized facts. At present zloty is top performer in the region. Some says that fundamentals are supportive for the local unit. Indeed this is true as it was in 08 when the zloty lost half of its value vs. Euro. I see main reason behind zloty strength in budget deficit and how the budget deficit will be financed. This year Polish treasury through privatization process wants to sell stakes in state own companies worth PLN 26bn or roughly EUR7bn. Most likely a large chunk of this offer will be bought by foreign investors meaning a FDI inflow. Huge expectations about FDI inflow triggered portfolio inflow and that’s how the process started. This process is very similar to the 1999-2001 period when record high privatization inflows (FDI) brought zloty down to 3.4 vs. EUR

Lomb spectral analysis applied to residuals from linear part of LPPL equation confirms a strong log-periodic component in EURPLN time series (18-02-2009 to 07-04-2010). This is a confirmation of growing synchronization among market participants about future course of events (appreciation).

More detailed analysis to follow

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Bubble Fighter

WSJ article suggest that FED is likely to change its passive approach to building bubbles in asset prices. One problem is that economists don't have models that prescribe how much interest rates should go up when asset prices or financial leverage run to excess.

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Organic mechanics – complex networks in finance. FT article

In today’s FT you can find a very interesting article about implementation of complex networks in finance. The article is also an indication that more and more economists became aware that “Efficient Market Hypothesis” does not explain market behavior and that there are better models (i.e George Soros reflexivity or Andrew Lo Adaptive Markets Hypothesis). Full article you can find here

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Risk appetite gets into alarm zone

You don’t need to look at risk appetite indicator (short description of the index you may find here) to know that optimism spreads across markets. But the above attached chart is giving a good visualization of the current market situation. As John Maynard Keynes famously said “Successful investing is anticipating the anticipations of others”. Along this line high risk appetite may be signal that this rally is maturing and soon the optimistic assumptions may be put under test.

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Financialization of Commodity Markets: Nonlinear Consequences from Heterogeneous

Just read quite interesting paper form central bank of Argentina. Authors’ claims that that high discrepancies between spot and fundamental commodities prices tend to be corrected relatively fast, while small misalignments tend to persist over time without any endogenous correcting force taking place. This is quite non-intuitive conclusion. Isn’t it?

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Commodities corner: Sugar futures bubble ready to burst - an update

Over the past few months, sugar has been on accelerating upward spiral, hitting a 28-year high at USD24 cents per pound. On September 1rd In analysis posted on this blog I stated that sugar prices exhibit a “bubble” characteristic. Fitting LPPL model I came to conclusion that bubble get into critical zone. The critical zone describes the maturation of a systemic instability forewarning of an inevitable crash. Since the beginning of September the sugar prices abandoned the „super-exponential” growth pattern and start to widely oscillate which goes along the prediction of the LPPL model

Here you can download a PowerPoint presentation. This presentation is aimed to show a more detailed analysis of the sugar#11 futures contract prediction and the methods used to make and test them. Specifically they are LPPL model, LPPL fitting procedure

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Two interesting papers worth reading

Complex Systems: From Nuclear Physics to Financial Markets

Multifractal analysis and instability index of prior-to-crash market situations

Enjoy!

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Latvia - (small) Lat devaluation on cards

Earlier this week heavily exposed to the Baltic region Swedbank reported its third straight quarterly loss. Swanbank also acknowledged that it was planning for a possible currency devaluation but said it’s seeing signs that credit quality in the Baltic region is beginning to stabilize. Indeed the worst may be over but its cleaver to prepare for devaluation in Latvia as the move would help country to recover faster and possibly would limit credit losses.

Just to give a brief characteristic of the country I should say that Latvia peg its currency just after the country won independence from the Soviet Union in 1991. In the recent past on the Latvia’s acceptance into the EU, the economy experienced a huge boom with the growth rates well above 10% per annum. The boom was driven by very strong credit growth financed by FDI inflow mainly into nontradable sectors ( real estate, retail and financial services). As time passes the imbalances built up. The wages went strongly up, the inflation level exceeds the EU level which further eroded the country competitiveness, current account gap top 25% of GDP in 2007.

There were several seeds of economic instability (bad mix policy – too loose fiscal policy combined with lack of monetary sovereignty) but among them most important was positive feedback mechanism from banking sector to private non-financial sector which fueled the housing bubble.

Simply credit growth was stimulating the home prices which were taken as collateral for loans. The more quickly the credit was flowing in the higher were the house prices. This process continues until the credit was unable to grow fast enough to further stimulate the house prices. At that time the private indebtedness top 125% of nominal GDP. (More detailed analysis of that process you may find in the previous post here or in Adrian and Shin paper ). The bad news is that this process works in reverse too (lower prices of homes lead to liquidation of loans which makes the decline more precipitous). In case of Latvia the credit bust was compressed in short time period which had catastrophic consequences on home prices. The figure below is a chart of home prices in capital of Latvia. Now the household’s holds negative equity as the home prices deflated but the nominal debt remained unchanged which suggest that more credit related loses lays ahead. As the households remains heavily indebt the recovery is likely to be very sluggish (L-type recovery is possible)

To get a better insight in situation I just implemented a simple balance sheet approach to Latvia. This analytical approach is different than ESA95 approach and it’s focused to examine balance sheet of the country and potential misalignments and vulnerabilities (more on that methodology here). In particular case of Latvia I focus on credit and currency misalignments so this is not a comprehensive approach. Figure 2 is a excel balance sheet of Government sector, Commercial banks sector and Private –non bank sector (click to enlarge the figure).

First observe that government indebtedness is low(ish) both in local and in foreign currencies. Second somehow modes net liability position of commercial banks masked the fact that the majority of the commercial bank assets consists around EUR 8.5bn (Lat12bn) in FX loans to the domestic nonbank sector. In words FX-risk of the banking system simply has been transferred in credit risk which was quite “natural“ as majority of the local banking sector assets are in foreign hands.

Without the coordinated IMF/EU/WB programs the country balance sheet gaps would not be sustainable would end up with currency crises. As I read IMF lead program as financing bridge to adopt euro (in 2012?) and extricate Latvia from currency risk. However this strategy is very difficult to implement as the government has to cut spending to meet the Maastricht criteria among dramatic economic downturn. In words this strategy is unlikely to win sustainable political support. But this is the minor problem. The major problem is fixing LAT to euro at too low level (maintaining overvaluation i.e. Portugal peg its currency too low to euro which had negative implication for the GDP growth). Latvia to repay the debt would need to increase the competiveness to be able to generate the current account surplus. Amid the crises the Latvian C/A deficit shrunk rapidly but this was achieved by collapse of domestic demand and import. Unfortunately amid weak external demand export also drop but leaser than import which ends up in small C/A surplus.

The easiest way to increase the country competitiveness would be allow currency to depreciate if not then the competitiveness may be raised by adjustment on the real side of economy (decreasing wages etc. which is rather painful process). In case of Latvia because of large FX misalignment devaluation is not a cost free solution but implemented orderly would increase the quality of the credit portfolio in the medium term as it would it would promote higher employment. The orderly devaluation would not necessarily jeopardize Latvian plan to join euro soon(ish) as in ERM2 mechanism currency can fluctuate -+15%. from the central parity. An orderly and small Lat devaluation seems to be a plausible solution.To make it orderly both banks and government has to be prepared. If the Swedbank is preparing for possible devaluation maybe Latvian government is preparing for devaluation too but this is only my interpretation and I may be wrong.

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This Time is Different: Eight Centuries of Financial Folly

Preview of new book by Reinhart and Rogoff is now available in Google Books (link here). I just read this book and i must say that Reinhard and Rogoff have compiled an impressive database, which covers eight centuries of government debt defaults from around the world. This historical study gives what they call a "panoramic view" of the unending cycle of boom and bust, showing how claims that "this time is different" are invariably proven wrong.

Reinhart and Rogoff shows that financial crash typically follow real-estate bubbles, rising indebtedness and gaping current-account deficits. It also shows that financial meltdowns are followed by state bailouts which led to deterioration in government finances. Must Read!!!

This book is an extended compilation of series of working papers (links to some of them you may find here 1 ,2 ,3 )

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How the Fed Can Avoid the Next Bubble?

Interesting article from WSJ. This time Nouriel “Doom” Roubini and Ian Bremmer calls Fed to Establishing financial stability—in addition to price stability and growth. Its needed but difficult target to aim it also requires changing/updating economics toolbox (look at the previous posts).

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IMF Needs to Spot New Investment Bubbles: Geithner

CNBC just reports that U.S. Treasury Secretary Timothy Geithner called on the International Monetary Fund to provide rigorous surveillance to spot new investment bubbles (link here). IMF pays a central (and successful) role resolving the current crises and politicians keep to brothering the role of the fund. Despite the Fund success in dealing with the crises it failed to send a warning signal before the crises broke out. Still may be questioned whether rare high impact events may be predicted but I think is worth trying to broad the fund surveillance toolbox with complex system tools which may give some better insight into the stability of the system as a whole. Unfortunately so far the Fund keeps working with models which prove to be wrong indicators ahead of the recent crises (i.e. chapter 3 of new WEO). I think that there is urgent and general need to extend the economists toolbox with the out-of-equilibrium models

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