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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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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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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Irrational Exuberance. LPPL signatures in EUR/PLN

People like to go to excesses. I think that what started out with a tulip, maybe four-hundred years ago, and continued through the South sea bubble and all of those sorts of things ( Tronic bubble in 60’s, new economy bubble in 90’s). I’m not saying here that that all human choices are orthogonal to rational ones but in human nature is to heard. Herding can result from a variety of mechanisms, such as anticipation by rational investors of noise traders strategies, agency costs and monetary incentives given to competing fund managers, sometimes leading to the extreme Ponzi schemes, rational imitation in the presence of uncertainty, and social imitation. Many financial economists recognize that positive feedbacks and in particular herding is a key factor that can push prices upward (downward) faster-than-exponentially which if unchecked can lead to bubbles.

Roughly 10 years ago Johansen and Sornette proposed model that attempts to incorporate those ingredients into a traditional rational expectations model of bubbles proposed by Blanchard.

The Jochansen-Sornette model assumes the financial market is composed of two types of investors: perfectly rational investors who have rational expectations and irrational traders who are prone to exhibit herding behavior. The noise traders drive the crash hazard rate according to their collective herding behavior, leading its critical behavior. Due to the no-arbitrage condition, this is translated into a price dynamics exhibiting super-exponential acceleration, with possible additional so-called “log-periodic” oscillations associated with a hierarchical organization and dynamics of noise traders.

A+B*(t-tc)^C*(1+D*COS(w*LN(t-tc)+O)

This so-called log-periodic power law (LPPL) dynamics given by has been previously proposed in different forms in various papers. The power law A−B(t−tc)_ expresses the super-exponential acceleration of prices due to positive feedback mechanisms. The term proportional to cos(w ln(t-tc)+o) describes a correction to this super-exponential behavior, which has the symmetry of discrete scale invariance. This formulation results from analogies with critical phase transitions (or bifurcations) occurring in complex adaptive systems with many interacting agents. The key insight is that spontaneous patterns of organization between investors emerge from repetitive interactions at the micro-level, possibly catalyzed by top-down feedbacks provided for instance by the media and macro-economic readings, which are translated into observable bubble regimes and crashes.

In previous posts I fit the LPPL formula into several financial time series. This time I fit LPPL into EUR/PLN exchange rate. As it is seen on the chart the formula fits remarkably well into the data. Even more surprisingly the LPPL model explains not only the periods when the positive feedbacks let to the zloty overvaluation but also it fits well to the period when zloty was depreciating (2001-2003). This confirms the universality of the process described by LPPL formula which describes well not only bubbles but also antibubbles.

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