tag:blogger.com,1999:blog-5908830827135060852.post5577435091235573231..comments2024-03-01T02:40:14.946-05:00Comments on Bond Economics: Why Parameter Uncertainty Is An Inadequate Modelling StrategyBrian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.comBlogger16125tag:blogger.com,1999:blog-5908830827135060852.post-52592183065325371392017-12-01T07:28:00.117-05:002017-12-01T07:28:00.117-05:00Most pensions only offer at most partial indexati...Most pensions only offer at most partial indexation, so they’re not that exposed too inflation. In any event, inflation has been highly stable since 1990, and hopes of a 1970s-style bear market just represent a fantasy by pension managers to take them away from the reality that they should have duration-matched a long time ago.Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-2380698374493530962017-12-01T04:01:12.998-05:002017-12-01T04:01:12.998-05:00(1) The pension industry is massively short durati...(1) The pension industry is massively short duration versus their liabilities.<br /><br />If their liabilities are mostly driven by inflation the short duration might be in order as it's highly correlated with the short end of the yield curve.Jussinoreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-88868410872209384932017-11-29T18:01:52.599-05:002017-11-29T18:01:52.599-05:00I framed my comments in a realistic context based ...I framed my comments in a realistic context based on actual past episodes with systemic threats appearing in the corner cases as rapid inflation or rapid deflation. Finance theory assumes that arbitrage in the financial dealer markets always makes liquidity available to refinance positions. This liquidity provision would seem to hold during a rampant private credit fueled inflation (1960s, 1970s, 1980s in the US) and would seem to be violated during a money market crisis that precipitates a potential deflation (2007, 2008 global financial crisis). Minsky wrote about the structural and agent based causes of euphoric inflation and the cash flow causes of recession and depression in this 91 page paper prepared for the Federal Reserve Board:<br /><br />https://fraser.stlouisfed.org/files/docs/historical/federal%20reserve%20history/discountmech/fininst_minsky.pdf<br /><br />To me it seems that we should just recognize that Fed acts like a financial dealer of last resort which allows the possibility to kill inflation via a forced disruption of money markets (take some liquidity out) and the possibility to prevent significant deflation by responding to a disruption in money markets (replace some liquidity that was previously being provided by market participants in the money markets).Joe Leotehttps://www.blogger.com/profile/01292763300917387201noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-32769949865634244012017-11-29T16:37:12.228-05:002017-11-29T16:37:12.228-05:00That’s a theory that ignores the reality that infl...That’s a theory that ignores the reality that inflation is not running anywhere, and you are completely ignoring the risk profile of the aggregate private sector. Rates cannot really fall from here, and rising rates reduces risk. This was not the case when Minsky was writing.Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-67790381823805547862017-11-29T15:27:58.831-05:002017-11-29T15:27:58.831-05:00I respect your engineering and finance perspective...I respect your engineering and finance perspective based on experience, however, if your finance models slants toward finance theory and away from the underlying financial dealer models also discussed by experts such as Hyman Minsky and Perry Mehrling, then I would not expect your models to capture the corner cases concerning market caused runaway inflation or deflation. Minsky thought the financial structure evolves from hedge, to speculation, to ponzi finance over time when there has not been a money market crisis for a significant period of time. Then a small shock can precipitate a money market crisis. If inflation is rapid in a modern economy, and it is not being caused exclusively by a large government deficit, then it must be partially caused by market credit expansion driving prices up under too much aggregate demand for limited goods and services. The government could jack up wholesale interest rates which will bankrupt units that must be taking on speculative and ponzi finance otherwise there would be no credit boom and no inflation. Every unit cannot be hedged since long term lending at higher interest rates means extending credit to units that do not qualify for wholesale or hedged interest rates.Joe Leotehttps://www.blogger.com/profile/01292763300917387201noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-47913863690504156502017-11-29T15:11:22.800-05:002017-11-29T15:11:22.800-05:00I worked as a senior interest rate quant. Nobody i...I worked as a senior interest rate quant. Nobody is going to worry too much about pension funds as counterparty risk in interest rate swaps, so long as they are hedging their liability risk.Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-41819592893703363112017-11-29T14:41:00.514-05:002017-11-29T14:41:00.514-05:00AIG is an example of the potential for systemic co...AIG is an example of the potential for systemic counter-party risk. According to conventional literature when a party hedges interest rate risk it must trade-off by taking liquidity and counter-party risk instead. In the system as a whole only the central bank or central government tends to have enough balance sheet to provide liquidity and reduce counter-party risk in a systemic crisis.Joe Leotehttps://www.blogger.com/profile/01292763300917387201noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-91496506515236351802017-11-29T14:06:23.985-05:002017-11-29T14:06:23.985-05:00AIG did not have *interest rate risk*.AIG did not have *interest rate risk*.Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-57093731483354389182017-11-29T13:45:03.247-05:002017-11-29T13:45:03.247-05:00During the global financial crisis the federal res...During the global financial crisis the federal reserve took operational control over AIG because it was about to default on all sorts of derivative and hedge finance contracts. This contradicts a theory that there will always be a market based counter-party which will never default on its position. If a modern central banker had to fight rampant inflation rather then deflation the way to do it is to jack up wholesale interest rates as Volcker did in the early 1980s. This will change the perception of counter-party risk in money and credit markets and will induce a recession with bankruptcy of some units at the margin. The resolution of the systemic bankruptcy will take some pressure off rising prices in the real economy.Joe Leotehttps://www.blogger.com/profile/01292763300917387201noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-2595424070864956752017-11-29T12:44:21.045-05:002017-11-29T12:44:21.045-05:00(1) The pension industry is massively short durati...(1) The pension industry is massively short duration versus their liabilities. Other financial intermediaries will always find a counterparty for their hedges.<br /><br />(2) Modern central bankers faint at the prospect of the policy rate being 100 basis points too high versus the "correct level." Your concerns are only valid if they cranked up rates by thousands of basis points, which ain't gonna happen.Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-37299097810898113502017-11-29T12:15:44.249-05:002017-11-29T12:15:44.249-05:00I am fairly certain there must always be interest ...I am fairly certain there must always be interest rate risk that cannot be adequately hedged when considered for the whole financial system. This is due to the long maturity of financial assets in credit markets relative to the short duration of wholesale funding in money markets. When money market rates rise rapidly the deals that make financial theory work in practice are disrupted by the psychology of financial dealers. Finance theory goes out the window in a money market crisis. The central bank can inject a money market crisis by jacking up money market rates if it creates the institutional structure in which it is always operating as the wholesale dealer of last resort.Joe Leotehttps://www.blogger.com/profile/01292763300917387201noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-66842228224978181882017-11-29T11:37:12.207-05:002017-11-29T11:37:12.207-05:00Thanks. Some of the technical digressions were in ...Thanks. Some of the technical digressions were in there to deal with some of the more trivial complaints that people who are wedded to parameter uncertainty could come up with.Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-66770931786025867192017-11-29T11:36:03.553-05:002017-11-29T11:36:03.553-05:00Interest rate risk is the most easily hedged risk ...Interest rate risk is the most easily hedged risk in the world now, and almost all competent banks are indeed hedged. I could have added a qualifier stating the assumption that the currently timid behaviour of central bank rate setting is maintained.Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-74045697818824413782017-11-29T11:11:03.949-05:002017-11-29T11:11:03.949-05:00If in aggregate banks and other financial intermed...If in aggregate banks and other financial intermediaries hold a portfolio of loans with long repayment terms and relatively fixed interest terms, and if these FIs issue a significant float of liabilities which must be renegotiated overnight or every few months at prevailing money market interest rates, then a central bank or central government with power to rapidly raise interest rates should be able to bankrupt some financial intermediaries. This would induce recession and impact the real economy. It should kill any credit system fueled rapid price inflation but would also have other unwanted side effects that play out with time lags. Central banks probably do not want to take drastic action under typical conditions. So the impact of interest rate policy on financial markets and the real economy is subject to much uncertainty when the system is operating with business as usual conditions. I have never read a paper describing the models for monetary policy transmission that fails to recognize that the exact mechanisms are unknown although there are several channels through which MPT might operate in theory.Joe Leotehttps://www.blogger.com/profile/01292763300917387201noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-31086419402313027152017-11-29T10:55:50.697-05:002017-11-29T10:55:50.697-05:00Great post. Some of it beyond me, but I followed t...Great post. Some of it beyond me, but I followed the underlying point (I think!). Thanks Brian.Be A Debasernoreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-37681331803941623652017-11-29T10:36:30.159-05:002017-11-29T10:36:30.159-05:00For those who want to explore this further in the ...For those who want to explore this further in the browser, here's in a 'Insight' about <a href="https://insightmaker.com/article/133/Balancing-Loop-with-Delay" rel="nofollow">Balancing Loop With Delay</a><br /><br />This is one of the reasons why you want your stabilisation to be done on the spend side via a Job Guarantee. Its response is near instant. <br /><br />Even on the tax side there is a delay from taxation to the payment that removes the spend from the economy - often variable delay - all of which introduce these oscillations.<br /><br />NeilWhttps://www.blogger.com/profile/11565959939525324309noreply@blogger.com