GLOBAL FI NANCI AL STABI LI TY REPORT: TRANSI TI ON CHALLENGES TO STABI LI TY

8 International Monetary Fund | October 2013

Overextended fixed-income allocations and duration
risk are likely to magnify losses.
To illustrate how such a shock would afect fnancial
markets, an instantaneous hike of the same magnitude
is applied to major bond portfolios. Recall that as
part of the yield-seeking behavior under quantitative
easing, there was a broad-based shift into fxed-income
assets and an extension in portfolio duration well
above the historical norm (Figures 1.9 and 1.10). Tis
increase in duration signifcantly raises the sensitivity
of portfolios to rising interest rates: a 100 basis point
increase in interest rates from current levels generates
higher aggregate losses on global bond portfolios (5.6
percent or $2.3 trillion) than a similarly sized increase
has generated on prevailing portfolios during previous
historical tightening episodes (Table 1.2).
5
Tis is the
case for global, U.S., and emerging market bond port-
folios. Of course, the impact of such losses depends
on the nature of the underlying shock, distribution,
time frame, and other conditions. A normalization
in response to improved economic conditions and
broadly distributed losses would likely be more easily
absorbed, whereas losses concentrated in entities with
large unhedged positions or asset-liability mismatches
would increase instability.
Structural reductions in market liquidity could amplify
these effects, leading to an overshooting of interest rates.
It is important to stress that a more probable out-
come would be a smooth portfolio rebalancing out of
longer-duration, fxed-income assets on the back of a
gradual rise in interest rates and repricing of credit risk.
However, overshooting may occur as a result of any
number of unanticipated events. For instance, some
fund managers may seek to adjust portfolios ahead of
future monetary policy tightening to avoid crystallizing
losses, thereby exacerbating market volatility.
Recent changes in structural market liquidity could
also magnify an increase in long-term rates as fnancial
conditions normalize.
6
Securities dealers inventories
of fxed-income instruments have declined since 2007
5
For instance, during the last three tightening episodes in
199495, 19992000, and 200406, an instantaneous 100 basis
point increase would have resulted in an average 4.8 percent loss on
U.S. bond portfolios prevailing at the time.
6
Liquidity risk premiumsdefned as the ability to trade in large
size without having a signifcant impact on market pricesare not
directly captured in this term premium model.
Corporate and Yankee bonds
M
A
T
T
E
Municipal debt
Agency debt and GSE-backed securities
Treasury and open market paper
Treud (for fxed iucome}
Equities
2000 01 02 03 04 05 06 07 08 09 10 11 12 13
Figure 1.9. U.S. Mutual Fund Cumulative Flows
(Trillions of U.S. dollars)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
$1.3
trillion
Sources: Federal Reserve; and IMF staff estimates.
Note: GSE = government-sponsored enterprise.
3
4
5
6
7
8
2000 02 04 06 08 10 12
Advanced economies
Emerging market hard currency
Emerging market local currency
United States
Figure 1.10. Global Bond Portfolio Duration
(Benchmarks; years)
Sources: Barclays Capital; and IMF staff estimates.
*What concerns us greatly in this bond-loss contect is that with long yields
exceptionally low, movement to the short end of the spectrum should only
cause an increased steepening of the yield curve, perhaps more dramatically
impacting the rise in long rates than was originally intended. What's worse
is that Sovereign debt will likely be judged by a different standard. Since
"those who don't taper" won't likely burn their investors as badly: ie: by
continuing to prop up the bond market with their own Central Bank buying,
Sovereign debt will be judged as "safe" based on who *refuses to taper,
which is counterintuitive to the underlying country who perhaps wishes to
protect the end value of its own currency....or not! shawnm@pamria.com.cn
Taper Talk: Why we will taper and effectively "torch" our global sovereign investors.
We know that our sovereign investors' bank balance sheets all around the world, and
certainly in China, Europe are leveraged 30X or more. We will taper anyway and
collapse the European banking system who ultimately has to sell portfolio positions to
meet depositor redemptions. Wait--- that makes absolutely no sense. QE(i) Infinity is
here to stay for a long, long, long time. S.Mesaros Pacific Asset Management, Ltd.