Francis Breedon

Life on the outside: economic conditions and prospects outside euroland

The European economic and monetary union (EMU) is now over 4 years old. In this paper we assess whether monetary union has begun to have significant economic effects by comparing countries in EMU with the EU countries outside. We focus principally on trade creation between EMU member countries, using a methodology that controls for the fact that the decision to join the monetary union was not random but was more likely to be taken by countries whose prospects of trading with other EMU members were already high. We find that the trade effects of monetary union are significant. We estimate that had the UK been inside EMU the sum of its imports and exports could have been substantially greater. For comparative purposes, we also make preliminary estimates of the effect of monetary union on three other dimensions of economic performance: foreign direct investment, the development of financial markets and overall macroeconomic performance, though we recognize that our ability to control for other factors is more limited in respect of these other indicators. The evidence suggests that inward investment in the countries outside would have been greater had they joined EMU, but that the impact of this on GDP would be no more than 0.3% of GDP per annum for the UK and less than that for the other ‘outs’. Financial market activity shows no clear sign of having been affected by EMU, and London’s position as Europe’s financial centre remains, as yet, largely unchallenged. On standard measures of aggregate performance – inflation, unemployment and output – no clear pattern of EMU effects has yet emerged.

The Information Content of the Inflation Term Structure

This paper examines the information content of inflation forecasts derived using index- linked and conventional bonds. The paper finds that the derived inflation term structure (ITS) gives a somewhat better indication of the bond markets inflation expectation than can be derived using either the nominal term structure or a variant employing strong assumptions about real interest rate behaviour. The inflation forecasts of the ITS also seem at least as good at forecasting future changes in inflation as forecasts derived from macroeconometric models. These characteristics of the ITS and its timeliness tend to make its inflation forecasts a useful addition to policy analysis. Because the real term structure tends to underpredict the level of future real interest rates, index-linked bonds have proved, ex post, to be cheap funding for the UK government. But we cannot be sure whether this underprediction results from an inflation risk premium or expectational error and also cannot know whether this overprediction will persist.

Intraday patterns in FX returns and order flow

Using a comprehensive high-frequency foreign exchange dataset, we present evidence of time-of-day effects in foreign exchange returns through a significant tendency for currencies to depreciate during local trading hours. We confirm this pattern across a range of currencies and time zones. We also find that this pattern is reflected in order flow and suggest that both patterns relate to the tendency of market participants to be net purchasers of foreign exchange in their own trading hours. Data from a single market maker appears to corroborate that interpretation.

Electronic Versus Open Outcry Markets: The Case of the Bund Futures Contract

The Bund (10 year German Government Bond) futures contract is the most actively traded bond contract in Europe; it is traded in both London (LIFFE) and Frankfurt (DTB) on open outcry and electronic trading platforms respectively. In an attempt to reconcile the conflicting results of earlier studies this paper evalutes the relative liquidity and price discovery roles of these two markets using data from 1995 Q2. The paper finds that this conflict is largely a product of the price data used. Using both transactions prices and quotes data (on a minute by minute basis), variable transaction costs, i.e. spreads, are found to be similar on both markets. There is some evidence to suggest that the order processing component of the spread is larger on LIFFE, but that the compensation required for adverse selection risk is greater on the DTB. Also, the contribution to price formation of each market is found to be similar; there is no clear leader/follower relationship. The main differences between the two markets are the larger trade size on the open outcry market and a tendency for trading to move toward the open outcry market during volatile periods.

Exchange Rate Policy in Small Rich Economies

We look at the exchange rate policy choices and outcomes for small rich economies. Small rich economies face significant policy challenges due to proportionately greater economic volatility than larger economies. These economies usually choose some form of fixed exchange rate regime, particularly in the very small economies where the per capita cost of independent monetary policy is relatively high. When such countries do choose a free or managed floating regime, they appear to derive no benefit from those regimes; their exchange rate volatility seems to rise without any significant change in fundamental economic volatility. Thus, for these countries, floating exchange rates seem to create problems for policy makers without solving any.

Optimal Portfolios of Foreign Currencies

Empirical evidence suggests that forward exchange rates are biased predictors of future spot exchange rates. Currencies with higher nominal interest rates tend to appreciate rather than depreciate as predicted by the forward rates. Simultaneously, exchange rates also turn out to be notoriously difficult to predict using plausible macroeconomic variables. The authors demonstrate how these two hypotheses can be combined with standard mean–variance analysis to construct optimal currency portfolios. They simulate the optimal portfolio strategies on historically observed data for the period 1989–1999 for DEM, JPY, GBP, and CHF (with the USD as the base currency). These portfolios generate positive excess returns. Moreover, the returns on optimal currency portfolios do not appear to be correlated with the returns on major fixed–income and equity indexes. These findings suggest that the methodology can provide a useful benchmark against which to evaluate more elaborate active currency strategies.

Investigating Excess Returns from Nominal Bonds

Estimated real returns on nominal bonds show excess returns of some 200 bp over their index--linked equivalent. This paper considers two possible explanations for this large difference. First, we assess the likely inflation risk premium by calibrating a model of optimal bond prices under uncertainty. Employing either of CRRA or Abel (1990) relative consumption utility function to derive the stochastic discount factor and covariation risk, we suggest that the inflation risk component of this excess return is unlikely to be much above 50 bp. Secondly, we find little evidence that these excess returns can be ascribed to consistent expectational errors in predicting inflation. Copyright Blackwell Publishing Ltd, 2003.

Will the Euro be Stable

In this article Francis Breedon and Michael Chui look at the impact of EMU on exchange rate volatility. Although theoretical evidence is mixed, their empirical evidence suggests that

A Variance Decomposition of Index-Linked Bond Returns

/Euro volatility will be significantly higher on average than

Out in the Cold? Iceland's Trade Performance Outside the European Union and European Monetary Union

/DM volatility has been historically, largely because the ECB will put less weight on the exchange rate in their policy deliberations than the Bundesbank has done. This result suggests that EMU-outs such as the UK may have to cope with potentially larger exchange rates swings until they make a more formal commitment to EMU.