When FED pulls the plug

Financing the Future – International conference in

honour of Niels Thygesen

Jesper Berg, Member of Executive Board, Nykredit Bank

05-12-2014

”If you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions.” Sir Winston Churchill on John Keynes

• Taper Tantrum (10th of June 2013 – 1st of July 2013)

• The Greenspan Conundrum (2002-2006)

• US Inflation Scares

• The Long Run

• A Comparison of the US/EU and Japanese financial crisis

Agenda

15. december 2014 2

Taper Tantrum

15. december 2014 3

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

US Treasuries

3Y US treasury bill

5Y US treasury bill

10Y US treasury bill95

96

97

98

99

100

101

102

10

-ju

n =

10

0

US Equities

S&P 500

Dow Jones

Nasdaq 100

90

92

94

96

98

100

102

10

-ju

n =

10

0

International Equities

MSCI Asia Pacific

IndexStoxx Europe 600

FTSE Eurofirst 300

Germany Dax-30

KOSPI

14

15

16

17

18

19

20

21

$

VIX index

The Greenspan Conundrum

15. december 2014 4

0,0%

1,0%

2,0%

3,0%

4,0%

5,0%

6,0%

2002 2003 2004 2005 2006

US Treasuries

3Y US treasury yield

5Y US treasury yield

10Y US treasury yield

Effective Federal Funds Rate60

70

80

90

100

110

120

130

140

2002 2003 2004 2005 2006

jan

20

02

= 1

00

US Equities

S&P 500

Dow Jones

Nasdaq 100

0

50

100

150

200

250

2002 2003 2004 2005 2006

jan

20

02

= 1

00

International Equities

MSCI Asia Pacific Index

Stoxx Europe 600

FTSE Eurofirst 300

Germany Dax-30

KOSPI

0

5

10

15

20

25

30

35

40

45

2002 2003 2004 2005 2006

$

VIX index

The US Inflation scare (Jan. 92 – Sep. 95)

15. december 2014 5

2

3

4

5

6

7

8

9

Percen

tag

e

Federal Funds Rate 30-year treasury

The Long Run - Correlation between stocks and bonds

15. december 2014 6

-0,8

-0,6

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

19

55

19

58

19

61

19

64

19

67

19

70

19

73

19

76

19

79

19

82

19

85

19

88

19

91

19

94

19

97

20

00

20

03

20

06

20

09

20

12

Correlation of Stocks & Bonds

0

2

4

6

8

10

12

14

16

18

0

500

1000

1500

2000

2500

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

Percen

tag

e

In

dex

10Y Treasury & Equity

S&P 500 (LHS)

10Y US treasury (RHS)

0

10

20

30

40

50

60

70

-0,4

-0,2

0

0,2

0,4

0,6

0,8

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

$

Correlation of Stocks & Bonds, the VIX index

Correlation (LHS)

VIX-index (RHS)

0,0

0,5

1,0

1,5

2,0

2,5

3,0

2003 2004 2004 2005 2006 2007 2008 2009 2010 2011 2011 2012 2013 2014

Percen

tag

e

Break-even inflation

US breakeven

EU breakeven

Comparison of US/EU & Japanese financial crisis

15. december 2014 7

70

75

80

85

90

95

100

105

110

115

120

-5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Years from onset of crisis

Real GDP

Japan (1991)

United States (2007)

Euro area (2007)

0

20

40

60

80

100

120

140

-5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10Years from peak

Stock markets

US S&P 500 (Q2-2007)

Euro Stoxx 600 (Q2-2007)

Nikkei 225 (Q4-1989)

US Quantitative Easing 1 (Jan. 2009)

-2%

0%

2%

4%

6%

8%

10%

-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14Years from onset of crisis

QE and Benchmark rates

US QE (YoY), as % of GDP (Q3-08)

JP QE (YOY), as % of GDP (Q1-90)

Fed Target Funds Rate

Overnight Call Rate

US Zero Interest Rate Policy JP Zero Interest Rate Policy 0

20

40

60

80

100

120

140

160

-3 -2 -1 0 1 2 3 4 5 6 7 8 9 10

Years from onset of crisis

Corporate Profits

Japan (Q4-1989)

US (Q2-2007)

Germany (Q2-2007)

From data to theory

15. december 2014 8

Conundrum explanation?

Gordon’s growth model

𝑃0 =𝐷1𝑟 − 𝑔

… if r’=g’ then p’=0

Explaining Inflation Scare and Japan?

Expectation hypothesis: 𝑟𝑛 is the risk-free long term rate, 𝑟𝑚 is the short term rate and 𝜋𝑛,𝑚 is the term premium.

𝑟𝑡𝑛 =1

𝑘 𝐸𝑡[𝑟𝑡+𝑚𝑖

𝑚 ] + 𝜋𝑛,𝑚𝑘−1

𝑖=0

The risk-free rate i s driven by the sum of current and expected future short term rates plus the term premium.

The term premium is mainly driven by inflation expectations.

Conundrum and Taper Tantrum

explanation?

r is the discount rate

𝑟 = 𝑟𝑓 + 𝛽(𝑟𝑚𝑎𝑟𝑘𝑒𝑑 − 𝑟𝑓)

… the risk premium is correlated with VIX

Other explanatory factors

Risk-free rate = Real rate + Break Even

Inflation

Taylor’s Rule

𝑖𝑡 = 𝜋𝑡 + 𝑟𝑡∗ + 𝛼𝜋 𝜋𝑡 − 𝜋𝑡

∗ + 𝛼𝑦 𝑦𝑡 − 𝑦𝑡 , ℎ𝑣𝑜𝑟 𝑎𝜋,𝑦

> 0

Risk premium

Summary

15. december 2014 9

- Central banks have become key players in financial markets

- When they act and expectations change, markets move

- If the world is good and the central banks act according to expectations

then the financial markets are likely to be in a good state

- If the central banks fall behind the inflation curve, interest rates can

increase quickly

- The average correlation between the long-term rate and the stock market

is negative, but fluctuations in the risk premium can create large positive

correlation

- If the Euro area goes ”Japanese”, we have other worries than a rise in

interest rates

- Understanding risk-, term- and liquidity premiums, and the reaction

functions of central banks is important for our understanding of financial

markets.

“You can check-out any time you like, but you can never leave!”

Eagles, Hotel California, 1976

Bonus Slides

15. december 2014 10

The Federal Reserve (TOP) & ECB (BOT.) Balance Sheets

15. december 2014 11

-5,00

-4,00

-3,00

-2,00

-1,00

0,00

1,00

2,00

3,00

4,00

5,00-5,00

-4,00

-3,00

-2,00

-1,00

0,00

1,00

2,00

3,00

4,00

5,00

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Bonds Loan, banks Loan, non-banks Currency swaps Mortgage backed securities Other assets Currency Reserves U.S. Treasury Other Liabilities Capital

Assets

Liabilities

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-3,0-2,5-2,0-1,5-1,0-0,50,00,51,01,52,02,53,03,5

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Main Refinancing Operations Longer-term refinancing operations Other assets Deposit Facility Other liabilities

Assets

Liabilities

Source: ECB & The Federal Reserve Bank.

• ”The slowing in the pace of purchases is akin to letting up on the gas

pedal as a car picks up speed rather than applying the brakes”.

• ”(…) if the incoming data support the view that the economy is able to

sustain a reasonable cruising speed, we will ease the pressure on the

accelerator by gradually reducing the pace of purchases. However, any

need to consider applying the brakes by raising short-term rates is still far

in the future”.

• ”I would like to emphasize once more the point that our policy is in no

way predetermined and will depend on the incoming data and the

evolution of the outlook as well as on the cumulative progress torward our

objectives”.

Taper Tantrum – Ben Bernanke press conference 19th of June 2013

15. december 2014 12

Liquidity Premium – The syndrome of Lyngbyvej

15. december 2014 13

- The central banks have flooded the markets with liquidity and

thereby removed volatility

- The liquidity premiums are historically low

- The advantage of being liquid has fallen

- Regulation has increased the costs of being liquid for market makers

- The general pressure on deleveraging the financial system has

increased

- The capacity of market makers is at an all time low

- Is there a gap between the low liquidity premiums and the buffer

capacity of market makers?

- How we in our effort to increase the resilience of

institutions reduced the capability of the system

to absorb choks?