5. BONDS, INTEREST RATES, AND MARKET MICROSTRUCTURE Flashcards
“Is There a Zero Lower Bound? The Effects of Negative Policy Rates on Banks and Firms” by Altavilla, Carlo, Lorenzo Burlon, Mariassunta Giannetti, and Sarah Holton. (2020).
What are the problems with the low-interest rate environment?
Macroeconomic problems (zero lower bound) - When the interest rates are low and the economy is in a liquidity trap (i.e. monetary policy is severely limited), banks cannot lower the deposit rate. If they do so, their clients will just start hoarding (storing for themselves, out of the bank) the paper money. However, this would severely affect banks because a big part of their Balance Sheet comprises of deposits.
Negative interest rate policies - Negative rates reduce banks’ profits and lead banks to reduce lending. However, negative rate policies still could work if there was particular mechanism to increase the costs of hoarding paper currency.
“Is There a Zero Lower Bound? The Effects of Negative Policy Rates on Banks and Firms” by Altavilla, Carlo, Lorenzo Burlon, Mariassunta Giannetti, and Sarah Holton. (2020).
Why author uses Monetary Policy Transmission?
To look at how much
of the interest rate cut is passed through to corporate
deposit. This helps to understand, which stakeholders are affected by lowering the interest rates.
“Is There a Zero Lower Bound? The Effects of Negative Policy Rates on Banks and Firms” by Altavilla, Carlo, Lorenzo Burlon, Mariassunta Giannetti, and Sarah Holton. (2020).
“When Selling Become Viral: Disruptions in Debt Markets in the Covid-19 Crisis and Fed’s Response” by Haddad, Valentin, Alan Moreira, and Tyler Muir. (2021).
What is the motivation of this paper?
Unusual behavior of CDS and bond spread - the
disconnection between the bond and CDS spreads. Bond market in March 2020, when covid-19 hit, were distressed and the spread widened to nearly 150bps, while 5-year Credit default swap(CDS) didn’t even move.
“When Selling Become Viral: Disruptions in Debt Markets in the Covid-19 Crisis and Fed’s Response” by Haddad, Valentin, Alan Moreira, and Tyler Muir. (2021).
What are the two channels from theory, that explain depression in asset prices?
Cash flow - COVID was seen as a disaster which must have had an impact on future expected cash flows in the
economy. The bad economic outlook of the country would in turn affect the bond market. However, this
theory does not explain why the CDS spreads were nearly unaffected.
Risk premium - Increased default risk premium could have been another factor driving the bond spreads up. However, this
still does not explain the static CDS spreads.
“When Selling Become Viral: Disruptions in Debt Markets in the Covid-19 Crisis and Fed’s Response” by Haddad, Valentin, Alan Moreira, and Tyler Muir. (2021).
What could be the intuitive explanation for the phenomenon, when bond spread went up, but CDS spreads didn’t move?
Intuitive explanation for this phenomenon is that bond investors felt themselves in trouble and in desperate need
for cash. Naturally, they sold the most liquid bonds they had which weer IG bonds, putting large downward
pressure on prices and driving the yields up. This theory also explains why the CDS spread was relatively
unchanged compared to bond spreads, at that time.
