Benn Steil

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A graphical take on geoeconomic issues, with links to the news and expert commentary.

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Showing posts for "Financial Markets"

More Evidence That LIBOR Is Manipulated, and What It Means

by the Center for Geoeconomic Studies
LIBOR v NYFR

Barclays’ admission that it deliberately understated the interest rates at which it could borrow between September 2007 and May 2009 suggests grievous flaws in the widespread process of using LIBOR (the London Inter-Bank Offered Rate) as a benchmark off which to price commercial loans, mortgages, and other forms of lending.  Our figure above illustrates this by comparing LIBOR with so-called NYFR Read more »

Can Household Risk-Aversion Measures Predict Fed Policy?

by the Center for Geoeconomic Studies
risk aversion

The so-called Taylor Rule in monetary policy suggests how the Federal Reserve should adjust interest rates based on movements in inflation and economic output.  Although the Fed has never explicitly followed such a rule, it described fairly well the path of interest rate policy under much of Alan Greenspan’s tenure as chairman. Read more »

Where Have All the Profits Gone? Karl Marx Could Have Told You

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Labor and Dividend Income

Since 2009, labor’s share of income in the United States has plummeted while personal dividend income as a percentage of disposable income has soared. This is not surprising for the early stage of a recovery in which firms are earning more with less and the stock market has been buoyant. The divergent trends between the two over the last 30 years, however, is notable and important. The small upper-right figure shows that dividend income as a percentage of after-tax corporate profits leapt markedly and permanently in the early 1980s. This corresponds with a general upward trend in corporate profits as a percentage of gross domestic product since that time; a time in which labor’s share of income has fallen almost continuously. Dividend income, not surprisingly, accrues largely to the stock-owning wealthy, as the small bottom-right figure shows. The fuller picture is one of growing inequality; one for which the globalization of business is frequently fingered as a primary culprit. But globalization itself makes the data difficult to parse. When an American firm uses components provided by foreign firms they appear from the data to have no labor content.

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It’s Time to Euthanize Sovereign CDSs

by the Center for Geoeconomic Studies

Imagine life insurance contracts that wouldn’t pay off if officials declared heart attacks to be “voluntary.” Welcome to the world of sovereign credit default swaps, or CDSs.  When the Greek debt deal was announced on October 27, the eurozone leadership insisted that the banks were taking a 50% write-down “voluntarily,” meaning that Greek CDS contracts would not be triggered.  This was done to protect official creditors like the ECB and IMF, to avoid rewarding speculators, and to prevent possible financial contagion.  In response, Greek CDS prices plunged 20 percentage points.  Policymakers didn’t seem to care, but they should.  Those who bought CDSs believing that they were prudently insuring their bond holdings now face unexpected losses.  Sovereign CDSs have lost so much credibility that the troubled investment bank Jefferies felt it necessary to state publicly that it was not using them.  This credibility loss has spread to other sovereign CDSs, as shown in the bottom part of the figure above: the correlation between PIIGS debt spreads and CDS prices has plunged, indicating that CDSs are no longer viewed as reliable sovereign credit risk insurance.  Using CDS prices as a measure of default risk is now like setting your watch to a defective clock.  Yet the market is unlikely to die owing to Basel III bank capital regulations, which still treat CDSs as meaningful offsets against certain types of sovereign credit exposures.  This gives banks a perverse incentive to hold them just to reduce their capital requirements.  Given the permanent political distortion that Europe has introduced into the sovereign CDS market, it would be best now if the market could simply be shuttered.

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Are Stocks Cheap?

by the Center for Geoeconomic Studies

Weak economic data, a Washington debt standoff, a downgrade of U.S. federal debt, and rising European default fears helped send the S&P 500 stock index down 16% between July 22and August 6.  As the figure above shows, equity prices of late imply the worst earnings growth rate expectations in 25 years—such expectations even turned negative last week.  This dour outlook stems partly from renewed risk-aversion, which ironically redirected cash into downgraded U.S. debt, but it also reflects a sharp rise in concerns about where new profits will come from.  Operating margins and profits are near all-time highs, but revenues are still below their 2008 peak and real consumer spending has grown by only 2% over the past year.  Corporations currently have strong balance sheets and the lowest net debt-to-revenue ratio on record, but this is largely the result of cost-cutting which may have run its course.  In short, either stocks are very cheap or growth prospects very dim.

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Is the ECB Draining its own Powers?

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Back in 2000, the European Central Bank’s first president, Wim Duisenberg, explained how he knew the Bank’s operational framework for implementing monetary policy was working well.  It was, he said, successfully “steering short-term market interest rates” where the Bank wanted them to go.  Prior to the financial crisis, that was indeed the case: the ECB’s policy rate was tightly connected to important short-term interest rates, such as the 3-month government borrowing rate.  In a growing swath of the eurozone, however, this is no longer the case.  As the figures above show, the correlation between the ECB’s policy rate and actual government borrowing rates in Spain, Greece, Italy, Ireland, and Portugal has plummeted since the ECB began its debt-buying program.  The market’s view of default risk on eurozone government debt has increasingly come to dominate these rates, which themselves strongly influence borrowing rates in the private sector.  By Duisenberg’s criterion, monetary policy in the eurozone is becoming less and less effective.  The only thing that will reverse this trend is a resolution of Europe’s growing bank and government debt crisis.  Yet by continually insisting that debt restructuring is out of the question, the ECB is only delaying such a resolution – and almost surely making it more costly.

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Greek Debt Crisis – Apocalypse Later

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The difference between Greek and German government bond yields can be used to estimate the market’s view of the likelihood of a Greek default. The chart above shows these probabilities over different time frames on three different dates. On April 30th, no European plan was yet in place to address the ballooning Greek debt, and default was considered a real possibility in the short term. On May 11th, just after the European Stabilization Mechanism (ESM) was announced, markets sharply cut their view on the odds of default across all time horizons. However, the market’s analysis of the ESM has become much more nuanced since then. On September 1st, the market’s view of the probability of default within two years was lower than before the ESM was announced, but higher over longer time frames. Read more »

The Dangers of Debt: Russia and China’s GSE Dumping

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In his recently published memoir, former Treasury Secretary Henry Paulson claims that Russian officials approached the Chinese in the summer of 2008 suggesting that both countries sell large amounts of debt issued by U.S. Government-Sponsored Enterprises (GSEs), such as Fannie Mae and Freddie Mac, in order to pressure the United States into explicitly backing these companies. Paulson, who found the report “deeply troubling,” claims that China opted not to collaborate with Russia. Nonetheless, both countries dumped GSE debt that summer, as illustrated in the figure above. Russia sold $170 billion during 2008, while China sold nearly $50 billion between June 2008, when its holdings peaked, and the end of 2008. During this fire sale the yield spread between GSE debt and U.S. Treasury debt soared, as illustrated in the figure below. As GSE debt was widely used as collateral in the U.S. repo market, U.S. financial institutions were obliged to quickly pony up more securities to support their borrowing. This exacerbated the growing credit crunch. The U.S. government was forced to put the GSEs into conservatorship in September 2008. Secretary Paulson was more right than he realized to be concerned. The episode highlighted the clear risks to the United States, and indeed the wider world, of growing American dependence on foreign government lending. Read more »

Venezuela’s Risk Unhinged

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2009.12.16.VEN

The credit risk of oil exporting countries such as Venezuela and Russia tends to move with the price of oil. As a country’s oil export revenue improves, so does its ability to pay its debts. Recently, however, Venezuela’s CDS spreads have increased even while the price of oil has been stable. The market’s perception of an increased risk of default coincides with the Venezuelan government’s move to close banks representing 8% of the country’s deposits. On Tuesday December 15th the Venezuelan National Assembly passed a law increasing depositors’ insurance in an effort to prevent a run on the banks. Problems in the financial sector have become the primary driver of Venezuelan sovereign credit risk. Read more »

Commercial Paper

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demise2

The size of the market for commercial paper in the U.S. has fallen dramatically since its peak in July 2007. After the disruptions of the Asset-Backed Commercial Paper (ABCP) crisis in August 2007 and the Lehman bankruptcy, the Federal Reserve created a commercial paper funding facility to restore liquidity. However the market for commercial paper has continued to shrink in 2009 straining financial intermediaries who have relied on the market for funding. Read more »