When FED pulls the plug Financing the Future International - PowerPoint PPT Presentation

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

Agenda 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 • 2 15. december 2014

Taper Tantrum US Treasuries US Equities 3,0% 102 101 2,5% 100 2,0% 99 10-jun = 100 1,5% 98 1,0% 97 S&P 500 0,5% Dow Jones 3Y US treasury bill 96 5Y US treasury bill Nasdaq 100 10Y US treasury bill 95 0,0% International Equities VIX index 21 102 20 100 19 98 10-jun = 100 18 MSCI Asia Pacific 96 $ Index 17 Stoxx Europe 600 94 FTSE Eurofirst 300 16 Germany Dax-30 92 15 KOSPI 90 14 3 15. december 2014

The Greenspan Conundrum US Equities US Treasuries 6,0% 140 130 5,0% 120 jan 2002 = 100 4,0% 110 100 3,0% 90 2,0% 80 3Y US treasury yield S&P 500 5Y US treasury yield 1,0% Dow Jones 70 10Y US treasury yield Nasdaq 100 Effective Federal Funds Rate 60 0,0% 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 International Equities VIX index 250 45 MSCI Asia Pacific Index Stoxx Europe 600 40 FTSE Eurofirst 300 200 Germany Dax-30 35 KOSPI jan 2002 = 100 30 150 25 $ 20 100 15 50 10 5 0 2002 2003 2004 2005 2006 0 2002 2003 2004 2005 2006 4 15. december 2014

The US Inflation scare (Jan. 92 – Sep. 95) 9 8 7 Percentage 6 5 4 3 2 Federal Funds Rate 30-year treasury 5 15. december 2014

The Long Run - Correlation between stocks and bonds Correlation of Stocks & Bonds 10Y Treasury & Equity 2500 18 1,0 S&P 500 (LHS) 0,8 16 10Y US treasury (RHS) 2000 0,6 14 0,4 12 Percentage Index 1500 0,2 10 0,0 8 1000 -0,2 6 -0,4 4 500 -0,6 2 -0,8 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 0 0 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 Break-even inflation Correlation of Stocks & Bonds, the VIX index 3,0 0,8 70 60 2,5 0,6 50 2,0 0,4 Percentage 40 0,2 $ 1,5 30 0 1,0 20 -0,2 0,5 10 Correlation (LHS) US breakeven VIX-index (RHS) EU breakeven -0,4 0 0,0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2003 2004 2004 2005 2006 2007 2008 2009 2010 2011 2011 2012 2013 2014 6 15. december 2014

Comparison of US/EU & Japanese financial crisis Real GDP Stock markets 120 140 115 US Quantitative Easing 120 1 (Jan. 2009) 110 100 105 100 80 95 60 90 85 Japan (1991) 40 80 United States (2007) US S&P 500 (Q2-2007) 20 Euro Stoxx 600 (Q2-2007) Euro area (2007) 75 Nikkei 225 (Q4-1989) 70 0 -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 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 Years from onset of crisis Years from peak QE and Benchmark rates Corporate Profits 10% 160 US QE (YoY), as % of GDP (Q3-08) JP QE (YOY), as % of GDP (Q1-90) 140 Fed Target Funds Rate 8% Overnight Call Rate 120 6% 100 4% 80 60 2% 40 Japan (Q4-1989) 0% 20 US (Q2-2007) Germany (Q2-2007) JP Zero Interest Rate Policy US Zero Interest Rate Policy 0 -2% -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 Years from onset of crisis Years from onset of crisis 7 15. december 2014

From data to theory Explaining Inflation Scare and Japan? Conundrum explanation? Expectation hypothesis: 𝑠 𝑜 is the risk-free long term rate, 𝑠 𝑛 is the short term rate and 𝜌 𝑜,𝑛 is the term premium. Gordon’s growth model 𝑙−1 𝑜 = 1 𝑛 ] + 𝜌 𝑜,𝑛 𝑠 𝑢 𝑙 𝐹 𝑢 [𝑠 𝑢+𝑛𝑗 𝐸 1 𝑠 − 𝑕 𝑗=0 𝑄 0 = The risk-free rate i s driven by the sum of current and expected future short term rates plus the term premium. … if r’=g’ then p’=0 The term premium is mainly driven by inflation expectations. Conundrum and Taper Tantrum Other explanatory factors explanation? Risk-free rate = Real rate + Break Even Inflation r is the discount rate Taylor’s Rule 𝑠 = 𝑠 𝑔 + 𝛾(𝑠 𝑛𝑏𝑠𝑙𝑓𝑒 − 𝑠 𝑔 ) Risk premium ∗ + 𝛽 𝜌 𝜌 𝑢 − 𝜌 𝑢 ∗ + 𝛽 𝑧 𝑧 𝑢 − 𝑧 𝑢 𝑗 𝑢 = 𝜌 𝑢 + 𝑠 𝑢 , ℎ𝑤𝑝𝑠 𝑏 𝜌,𝑧 > 0 … the risk premium is correlated with VIX 8 15. december 2014

Summary - 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 9 15. december 2014

Bonus Slides 10 15. december 2014

11 € Trillion $Trillion 15. december 2014 The Federal Reserve (TOP) & ECB (BOT.) Balance Sheets Source: ECB & The Federal Reserve Bank. -5,00 -4,00 -3,00 -2,00 -1,00 -3,5 -3,0 -2,5 -2,0 -1,5 -1,0 -0,5 0,00 1,00 2,00 3,00 4,00 5,00 0,0 0,5 1,0 1,5 2,0 2,5 3,0 3,5 Bonds januar 2008 januar 2008 marts 2008 marts 2008 Loan, banks maj 2008 maj 2008 juli 2008 juli 2008 september 2008 september 2008 Main Refinancing Operations november 2008 november 2008 Loan, non-banks januar 2009 januar 2009 marts 2009 marts 2009 maj 2009 maj 2009 juli 2009 juli 2009 september 2009 september 2009 Currency swaps november 2009 november 2009 januar 2010 januar 2010 Longer-term refinancing operations marts 2010 marts 2010 maj 2010 maj 2010 Mortgage backed securities juli 2010 juli 2010 september 2010 september 2010 november 2010 november 2010 Liabilities Liabilities Assets januar 2011 Assets januar 2011 marts 2011 marts 2011 maj 2011 maj 2011 juli 2011 juli 2011 Other assets september 2011 september 2011 november 2011 november 2011 Other assets januar 2012 januar 2012 marts 2012 marts 2012 Currency maj 2012 maj 2012 juli 2012 juli 2012 september 2012 Deposit Facility september 2012 Reserves november 2012 november 2012 januar 2013 januar 2013 marts 2013 marts 2013 U.S. Treasury maj 2013 maj 2013 juli 2013 juli 2013 Other liabilities september 2013 september 2013 november 2013 november 2013 Other Liabilities januar 2014 januar 2014 marts 2014 marts 2014 maj 2014 maj 2014 juli 2014 juli 2014 Capital september 2014 5,00 4,00 3,00 2,00 1,00 0,00 -1,00 -2,00 -3,00 -4,00 -5,00 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0 -0,5 -1,0 -1,5 -2,0 -2,5 -3,0 -3,5 € Trillion $Trillion

Taper Tantrum – Ben Bernanke press conference 19th of June 2013 ”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 ” . 12 15. december 2014

Liquidity Premium – The syndrome of Lyngbyvej - 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? 13 15. december 2014