Photographer: Andrew Harrer/Bloomberg

A Breakdown in Old Rules Leads to a Rethink on How Global Markets Work

The textbooks are no longer right.

A standard textbook relationship that every student of economics learns in school has been flipped on its head, and it’s leading to a major rethink on the connection between bank balance sheets, exchange rates, global asset prices, and monetary policy.

The prices of derivatives used for hedging currency risk are violating no-arbitrage rules, a development that points to a significant decline in global banks’ ability to intermediate capital flows from global investors, in part because of new regulations that have been introduced in recent years.

That decline in intermediation capacity appears to have heightened the sensitivity of exchange rates and global asset prices to monetary policy since the crisis, and helps explain some of the unusual gyrations witnessed recently in markets — like extreme moves in the so-called cross-currency basis, which according to traditional theory should be non-existent, and mostly was before the crisis that began in 2007.

"Financial markets, for their part, appear to be tethered more closely than ever to global events, and the real economy appears to dance to the tune of global financial developments, rather than the other way round," Hyun Song Shin, head of research at the Bank for International Settlements, said Wednesday in a speech on the topic during a gathering at the World Bank in Washington.

Shin cited recent research from New York University economist Xavier Gabaix and Harvard economist Matteo Maggiori, who developed a theory of exchange-rate determination based on capital flows in the presence of constraints on bank balance sheets.

"Since financiers require compensation for holding currency risk in the form of expected currency appreciation, exchange rates are jointly determined by capital flows and by the financiers’ risk bearing capacity," Gabaix and Maggiori say. "Financiers both act as shock absorbers, by using their risk bearing capacity to accommodate flows that result from fundamental shocks, and are themselves the source of financial shocks that distort exchange rates."

This is not at all the traditional understanding of what determines exchange rates, which has largely to do with macroeconomic fundamentals. The theory, however fits well with what we see in the foreign-exchange derivatives market, where a long-standing relationship known as covered interest parity, or CIP — which states that the interest rate implied by the forward exchange rate in a currency swap should match the short-term interest rate in the home country of the currency that is borrowed in the swap — has completely broken down.

The deviation, known as the cross-currency basis, became extreme during the 2008 financial crisis, flared up again during the euro crisis in 2011 when banks were in trouble, and returned to a lesser extent at the end of last year as global banks adapted to new regulations on leverage.

"I used to tell my students that CIP is about the only relationship that can be relied upon in international finance," Shin said in his speech. "I know better than to say this now. Textbooks still say that CIP holds, but it is no longer true."

An examination of the movements in the cross-currency basis provides some empirical backing to Gabaix’s and Maggiori’s work. The swings, which have lately become more pronounced around the end of the quarter as banks pare down their balance sheets to meet regulatory requirements, "point to key frictions in financial intermediation and their interactions with global imbalances during the post-crisis period," according to Federal Reserve economists Wenxin Du and Alexander Tepper, and MIT economist Adrien Verdelhan.

"Before the global financial crisis, global banks actively arbitraged funding costs across currencies and enforced the CIP condition," they wrote in a paper posted online last month. "Since the crisis, a wide range of regulatory reforms has significantly increased the banks’ balance sheet costs associated with arbitrage and market making activities."

The trade is one of many that banks have pulled away from because the returns are too low to justify the increased capital that must be held against them. Moreover, other market participants like hedge funds are less able to step in and take advantage of the arbitrage opportunity than before as well because they rely on funding from banks to do the trades, and banks are less willing to provide it because doing so inflates their balance sheets.

The upshot is that exchange rates are now more susceptible to capital flows than before. And according to Shin, that in turn means more volatility in global markets during periods of U.S. dollar appreciation, because the cost of hedging currency risk will rise for global investors holding dollar-denominated assets. He finds a strong negative relationship between the value of the dollar and the growth of dollar credit extended by banks.

"During the period of dollar weakness, global banks were able to supply hedging services to institutional investors at reasonable cost, as cross-border dollar credit was growing strongly and easily obtained," Shin said in his speech. "However, as the dollar strengthens, the banking sector finds it more challenging to roll over the dollar credit previously supplied."

Increased fragility in currency markets, and higher sensitivity of asset prices to currency swings, means the Fed will have to take additional caution in raising interest rates, especially while many other major central banks are going in the opposite direction and demand for safe, dollar-denominated assets worldwide remains elevated.

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