Deutsche Bank: The 5 largest puzzles of the market

FILE PHOTO: The head quarters of Germany's Deutsche Bank are photographed early evening in Frankfurt, Germany, January 31, 2017. REUTERS/Kai Pfaffenbach/File Photo
If experts believe that the “bubble” in the market is greater, less or equal to the dotcom bubble, few are ready to admit that the daily events on the securities market are as intricate as those that are marked in the world of crypto-currencies.

Recently, Bloomberg published the material “What is there to worry about in this surreal market of bulls, which, however, rather superficially touched on the topic of what madness really reigns in the capital market, in a market over which even the heads of central banks have lost control.

Masao Muraki from Deutsche Bank decided to present the five most common market puzzles.

The change in the mood of the market since September: from 2016 to August 2017 on world interest rates, courses in the forex market and stock prices was strongly influenced by the movement of the 10-year Treasury yield.

This prompted investors around the world to focus on rates in the US.

However, since September the picture has changed, creating headaches for bonds, the forex market and investors in the stock market.

Our group of financial researchers believes that “the current combination of strong economic conditions, low interest rates, low inflation and tight credit spreads supports the growth of the value of risky assets”: “If the risks (such as the difficulties in negotiating a debt ceiling increase as we approach Dec. 8 ) are not implemented, and the conditions remain stable, then the prices for risky assets are likely to grow. “

The main direction for 2018 will be the sustainability of conditions for low interest rates / spread / volatility and the “golden mean” market.

Five market puzzles

  • Puzzle number 1: the divergence of the Japanese stock market with the approximation model (US stocks / foreign exchange market).
  • Puzzle number 2: continuing rally in stocks (growth of P / E due to a reduction in the risk premium).
  • Puzzle number 3: the ongoing alignment of the yield curve.
  • Puzzle number 4: a constant decrease in the volatility of interest rates and stock prices.
  • Puzzle number 5: constant narrowing of credit spreads.

Puzzle number 1: the divergence of the Japanese stock market with the approximation model.

90% or more movements in the Japanese stock market for August were explained using a multiple regression model using the prices of US stocks and currencies.

The movements in the forex market can be explained mainly by movements in US interest rates.

After the elections on October 22 in the lower house, the Japanese stock market deviated from the approximation model of Deutsche Bank.

The Japanese stock market fell sharply after the shock of volatility on November 9 and by November 15 returned to the approximate model of the bank. At that moment, the main attention was paid to the question of whether the stock market will return to the trend outlined by our model, or will part with it again.

Recently, volatility has declined, and the stock market began to deviate again from the model.

Since September, the volatility of the stock market is the main factor underlying the divergence of TOPIX with the model. It seems that this situation has developed, due to the fact that a number of funds that entered the market during the rally on the Japanese stock market this year, corrected the stock positions based on the implied volatility.

In our view, the determinants of the current levels of Japanese stock prices are the US stock market, dollar and yen dynamics, implied volatility of stock prices in the US and Japan.

Puzzle number 2: the ongoing rally of shares.

Stock prices in Japan and the US continue to grow.

This reflects the influence of the fundamental factors in the form of high indicators for July-September and the growth of the P / E ratio against the background of market conditions of the “golden mean” created against the background of low interest rates and a weak US dollar.

Obviously, the stock prices are equal to EPSxP / E, and the ratio, reverse P / E, is profitability. Profitability in profit in Japan, the US and Europe is mainly due to premiums for urgency, mainly observed in the bond market, and risk-neutral rate.

One deviation in the direction of reducing the premium for urgency leads to an increase in stock prices by 2.5% in the US, 1% in Europe and 5% in Japan. One standard deviation upward from the short-term rate forecast leads to an increase of 2%, 2.75% and 7.8%.

The recent decrease in premiums for urgency led to an increase in the P / E ratio due to lower risk-free rates and risk premiums on shares.

Puzzle number 3: the ongoing alignment of the yield curve.

Aligning the yield curve in Europe and the US is a source of frustration for investors who forecast growth.

The Fed rate hikes in the context of low interest rates raised the average forecast for short-term rates, lowered the premium for urgency.

Dominik Konsta from the Team Rates forecasts the level of 2.25% for the end of 2017 for a 10-year yield.

Analyst Francis Jared considers the tax reform in the United States to be one of the main drivers for the next 2-3 months.

Our base scenario is based on the fact that in early 2018 there will be a decrease in taxes (an increase in the budget deficit by $ 1.5 trillion).

We expect that long-term rates will grow due to the above factor and the growth of the US economy.

Matthew Luzetti of our research team estimates a neutral real short-term rate of 0.3% and a neutral real 10-year rate of about 1.5%. If we assume that the Fed will reach the inflation target of 2%, it means that the neutral nominal 10-year rate will be around 3.5%.

Peter Hooper from the research group does not expect that changes in the attitude of the head of the Federal Reserve will have a significant impact on monetary policy.

The chairman appointed by Powell is likely to be categorically against the Taylor rule or other restrictions on the behavior of the Fed. Powell does not have special knowledge in the field of economics and monetary policy of previous Fed chairmen, but has experience working in financial markets and capital markets.

He may also be more receptive to the arguments about a structural reduction in inflation than Chairman Yellen.

However, it is not clear whether it will support an approach combining regulatory and supervisory responsibility for excessive risk and monetary policy to optimize inflation and employment. In addition, the biggest difference in his position with Yellen’s position is likely to be his position on deregulation of the largest banks.

Puzzle number 4: a constant decrease in the volatility of interest rates and stock prices.

The volatility of interest rates and stock prices is at extremely low levels.

US interest rate volatility is approximated using the share of MBS held by common investors (excluding FRS or banks), a neutral interest rate minus the real rate of the Fed, a net inflow into bond funds, net of net inflow to equity fund and repo positions compared to debt securities papers.

This model suggests that the decrease in interest rate volatility was due to a decrease in the overall investor ratio for MBS stocks, narrowing the gap between the neutral interest rate and the real rate of the Fed, the inflow of funds into bond funds.

In the stock market, the structural decline in volatility was due to an increase in the number of investors implementing the strategy of targeting volatility; an increase in the number of hedge funds and individual investors, showing the desire for option premiums and capital gains from the sale of volatility; transferring capital from active to passive funds; an increase in investment with a minimum variance in the form of an alternative to bonds.

Although we recognize the structural factors that reduce volatility, we are also concerned about the risk of a sudden surge. We outlined a historical picture of a moderate decline in volatility, followed by a sudden sharp increase in volatility.

Puzzle number 5: constant narrowing of credit spreads.

Since late October, credit spreads of corporate bonds and CDS have expanded. This trend recently declined due to excess liquidity and investors’ desire for profitability.

The default indicator clearly shows that the corporate credit cycle has reversed.

The restoration of energy prices and a more intense competition for bank lending are contributing to a change in the sphere of “bad” corporate loans. SLOOS data, published on November 6, showed that the credit position of banks has weakened.

Nevertheless, the level of corporate debt remains high.