Dietrich Domanski

The Hunt for Duration: Not Waving But Drowning?

Long-term interest rates in Europe fell sharply in 2014 to historically low levels. This development is often attributed to yield-chasing in anticipation of quantitative easing by the European Central Bank. We examine how portfolio adjustments by long-term investors aimed at containing duration mismatches may have acted as an amplification mechanism in this process. Declining long-term interest rates tend to widen the negative duration gap between the assets and liabilities of insurers and pension funds, and any attempted rebalancing by increasing asset duration results in further downward pressure on interest rates. Evidence from the German insurance sector is consistent with such an amplification mechanism.

What Do Asset Price Movements in Germany Tell Monetary Policy Makers

Asset prices can play a twofold role in monetary policy. First, they may be seen as important elements in the chain along which monetary policy stimuli are transmitted to the real economy. From this perspective, asset price movements cause changes in aggregate demand or the price level through substitution, income and wealth effects. If these structural relationships were stable and could be estimated reliably, asset prices could be used as indicators of, or even target variables for, monetary policy. Second, they may be seen as predictors of the future course of the economy, independently of their active role in the transmission process. This view does not depend on the causal influence of asset prices on the macroeconomic variables to be predicted. Instead, it takes due account of the fact that the price of rationally valued assets should reflect the expected path of the asset’s income components and the equilibrium returns used for discounting the future stream of income. If these expectations were influenced by the anticipated development of certain macroeconomic fundamental factors, and if, furthermore, market expectations were not systematically biased, asset prices could be used by the central bank as predictors of real activity and inflation. The monetary policy implications of both roles depend crucially on the informational efficiency of asset markets. Market inefficiencies would cause asset prices to deviate from their fundamental values, distorting their informational content and their indicator quality. Furthermore, if asset prices play an important role in the transmission process, mispricing may adversely affect economic activity and price stability. The main body of this paper is devoted to assessing the predictive power or the informational content, respectively, of dividend yields and the term structure spread to draw some preliminary conclusions about the efficiency of the stock and government bond markets in Germany. The theoretical framework is provided by the rational valuation approach. Applied to the bond market and the stock market, this approach leads to the expectations hypothesis and the dividend discount model, respectively, both on the assumption of rational expectations. The informational content is judged by metrics from univariate regression techniques using short and long-horizon measures for future inflation, stock returns, dividend growth, and interest rate changes as dependent variables and the spread or the dividend yield as regressors. The paper closes with some implications of the results for monetary policy.

The Great Liquidity Freeze: What Does it Mean for International Banking?

In mid-September 2008, following the bankruptcy of Lehman Brothers, international interbank markets froze and interbank lending beyond very short maturities virtually evaporated. Despite massive central bank support operations and purchases of key assets, many financial markets remained impaired for a long time. Why was this funding crisis so much worse than other past major bank failures and why has it proved so hard to cure? This paper suggests that much of that answer lies in the balance sheets of international banks and their customers. It outlines the basic building blocks of liquidity management for a bank that operates in many currencies and then discusses how the massive development of foreign exchange (forex) and interest rate derivatives markets transformed banks’ strategies in this area. It explains how the pervasive interconnectedness between major banks and markets magnified contagion effects. Finally, the paper provides some recommendations for how strategic borrowing choices by international banks could make them more stable and how regulators could assist in this process.

The Hunt for Duration: Not Waving but Drowning?

Long-term interest rates in Europe fell sharply in 2014 to historically low levels. This development is often attributed to yield-chasing in anticipation of quantitative easing by the European Central Bank. We examine how portfolio adjustments by long-term investors aimed at containing duration mismatches may have acted as an amplification mechanism in this process. Declining long-term interest rates tend to widen the negative duration gap between the assets and liabilities of insurers and pension funds, and any attempted rebalancing by increasing asset duration results in further downward pressure on interest rates. Evidence from the German insurance sector is consistent with such an amplification mechanism.