Treasury convenience yield and inflation

 

The convenience yield associated with Treasury securities is dynamic, meaning the price of safety associated with this safe asset is constantly changing with the macro environment. This important paper, "Inflation and Treasury Convenience,” on the macro dynamics of the convenience yield finds that inflationary supply shocks raise the opportunity cost of holding money and money-like assets, increasing convenience yields. Exogenous liquidity demand shocks will also elevate convenience but depress consumption and inflation. Given the difference between supply and demand shocks, there will be a weaker convenience-inflation link in the post-2000 period, which saw more liquidity demand shocks.  

This shows that convenience yield will be associated with macro dynamics and not just the demand for safety. My view is that this work makes it more difficult to discuss when there is a change in safety for Treasury assets. Yes, we can say it will be linked with macro dynamics, but ultimately most are interested in the price of safety based on some form of risk.

No momentum factor after accounting for cross-sectional liquidity

What causes momentum, or what is associated with momentum? A new paper suggests that there is a strong link between liquidity and momentum, and that changes in liquidity precede momentum gains.

The paper, titled “Momentum Returns and the Role of Liquidity Improvements” by Jeppe Bro, demonstrates that the traditional stock market momentum anomaly is actually driven by cross-sectional liquidity dynamics rather than representing an independent risk premium. 

The novel idea is that past winners systematically see their trading liquidity improve before a portfolio is formed, while losers see liquidity deterioration. The momentum price drift is the market adjusting to these new liquidity states. The author calls this the Liquidity Improvement Factor, and when including this factor, there is no momentum alpha. The data shows mixed results pre-2000 data relative to more recent data. Any momentum effect is drift toward high-liquidity stocks and is a byproduct of liquidity dynamics. This is the most recent paper that attempts to explain the momentum factor. 

This is a very interesting thesis. Investors should track or follow liquidity changes to enhance any measure of momentum. I have some issues with the Amihud measure of liquidity, which looks at absolute return divided by vol and is manipulated to form liquidity differences. Still, I do not have a better alternative at this time. 

Periods of financial stress - the long history

 

A paper that has not received much attention focuses on measures of systemic risk in "Systemic Risk Measures: From the Panics of 1907 to the Banking Stress of 2023". Much of the data from this paper is available from V-lab. The work suggests that there have been more stress periods recently, but their duration has been shorter. There has not been a stress period since the banking crisis of 2023. More importantly, the work examines what happens cross-sectionally to firms when they enter periods of stress and identifies specific institutions that face risk. 

The stress measures focus on US financial firms' stock return comovements and can predict market outcomes like realized volatility and returns, balance sheet outcomes, and bank failures. The stress periods focus on the contribution and exposure versions of CoVaR, marginal expected shortfall MES, and SRISK. 

Stress periods are identified through a two-step process based on narrative analysis, with start and end periods associated with the GZ credit spreads for more recent periods. 

The key finding is that market-based indicators offer distinct information that complements traditional balance sheet metrics for risk assessment. 

SRISK around the globe - Look at China

 

There is concern about the risk in the current markets given the high valuations. In a perfect world, investors would like early warnings of market stress as an indicator that it is time to rebalance portfolios. Identifying different stress indicators will allow investors to triangulate on the true market environment. One that I have been recently focused on is SRISK from the website V-Lab. 

SRISK measures the capital shortfall of a firm conditional on a severe market decline, and is a function of its size, leverage, and risk. The current numbers show that the world SRISK is falling. There has been a significant decline in developed markets, but emerging markets are moving to high levels specifically because of the large increase in China risk. As a large economy, China's risk is passing through to the rest of the world.

The concern is spillover risk from China to the rest of the world.