Introduction of a new & market-oriented section to the blog

In the last couple of years, this blog has served as an occasional notepad in an attempt to stay on top of some of the larger cross-border capital flows of the post-crisis era.

Demand–Supply–Invariant–Inflation (DSII)

The dominant market theme throughout 2022 was the considerable uncertainty surrounding U.S. inflation and the associated repricing of interest rate markets, with ripple effects across asset classes.

Heading into 2023, the largest demand and supply shocks experienced in decades are still complicating projections of where inflation, and thus rates, will eventually settle once shocks subside.

The note below, “Demand-Supply-Invariant-Inflation — An alternative gauge of underlying price pressures”, introduces a toolkit that can perhaps provide some guidance on the difficult road ahead. The memo does two things:

• It creates a new demand- and supply-invariant measure of underlying U.S. inflation, building on recent work from Adam Shapiro. This gauge, DSII, should be able to look trough transitory shocks much more robustly than existing measures.
• It then embeds DSII in a simple VAR model, in an attempt to probabilistically answer the question of how much of a slowdown or recession is necessary to return to the 2% inflation target.

As a spoiler, the framework estimates that inflation would currently settle at around 4% if shocks naturally subside in the coming months and the economy returns roughly to its long-run output gap. A return to 3% or 2%, in the absence of serendipitous demand or supply shocks, would require a downturn roughly comparable to the tech crunch of the 2000s and the early 1990s or 1970s recessions, respectively.

These are point estimates, and a look at the confidence intervals in Fig. 8 is certainly advised. Nevertheless, this relatively simple model provides fertile ground for estimating alternative specifications, such as placing additional priors over the historically estimated relationships or imposing future shocks on the modelled variables to explore where inflation is likely to settle in each case.

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The CBC’s onshore FX deposits, a surprising mainland China connection & flighty hedging counterparties

The path of the Taiwan dollar since the previous post here last August was not quite smooth, yet it still likely understates the various pressures acting on the currency and the regulatory action seen in response.

This post will not attempt to provide a comprehensive summary of developments since last summer. Still, a rough sketch may provide a clearer context for the write-up to be discussed subsequently.

In light of mounting FX appreciation pressures during November and December 2020, the CBC decided to intervene heavily in what over stretches of time was a purely one-sided market. Once more, this forestalled a transition to a less undervalued currency, while also keeping the positive feedback loops stemming from large private sector FX risk taking at bay. Actual FX intervention was paired with at first clumsy attempts of public moral suasion, followed by more insistent private follow-ups along with numerous turning of regulatory screws (i.a., a clamp down on speculative forward transactions, greater scrutiny of small ticket remittances, restrictions of inter-company cross-border borrowings, upping lifers’ cap of FX policy sales).

These actions happened to coincide with substantial sales of Taiwanese equities by foreigners, slightly weaker trade surpluses than in prior months and a stronger US dollar across the board, which first halted upward pressure on the TWD and then allowed the recent depreciation back to mid-28 levels.

Despite the more tranquil environment in the past weeks, the structural forces and imbalances discussed at length previously seem largely unresolved. A returning focus on these seems likely with the next US Treasury FX report, in which Taiwan’s heavy intervention likely means it will receive full points in the Treasury’s three criteria quantitative assessment, thus opening the door to an even more thorough examination. Growing internal resistance at the CBC to the existing central bank direction further provides opportunity for the country to explore whether the decades-old policy it relies on is still appropriate going forward.

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The note below, written during the volatile days in early December 2020, seeks to add three points to this discussion:

Revisiting Taiwan: new disclosures, pricey hedges, late-day jumps & a new policy direction?

During early March, when the current pandemic started to spread globally, Taiwan’s central bank for the first time publicly responded to concerns about its FX derivative interventions raised by our joint work with Brad Setser last year. In this context, it seems appropriate to revisit this matter again. There will be three broad sections:

1. The publication of the hitherto only individually published chapters as one comprehensive paper, intended to ease navigation of the argument presented last year.
2. A new Addendum chapter was added to the paper and is also printed in full below. It recaps the official response to the paper since initial publication last October through April 2020.
3. The actual core of this post, which starts with data updates of the CBC’s and lifers’ activities since last October, before then pondering how the CBC’s new transparency, the richness of TWD offshore and the renewed occurrence of late-day depreciations of the currency may provide insights into the CBC’s policy direction going forward.

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Addressing overseas USD funding conditions & the Fed as global collateralized LoLR

The domestic policy response by the Federal Reserve to the current health crisis has thankfully been swift. While monetary policy makers across the world understandably focus on dislocations in their domestic markets first, in a globalized and, more crucially, dollarized world, it falls to the Fed to attenuate global USD funding pressures in order to guarantee the medical response to unfold as unconstrained as possible.

US policy makers have to date largely followed the 2008/09 playbook by reestablishing FX swap lines with foreign central banks. While no doubt necessary, these highly unusual conditions, further strained by understaffed desks, may impede transmission mechanisms and require streamlining or expansion of the Federal Reserve’s international response.

Two ideas will be discussed in this post:

• Expanding the role foreign central banks play in the transmission of USD liquidity by installing them as temporary, localized ‘primary dealers’.
• Instead of reliance on only passive, auction-style provision of USD via currency swap lines, which require pledging of preexisting collateral by local banking systems, central banks might consider also offering USD via regular FX swaps, allowing much more seamless transmission by intermediaries to the buyside. This format would open the possibility of intraday backstopping and/or targeting of X-CCY markets by the recipient central bank alone, or in conjunction with the Federal Reserve via US regulated intermediaries.

Implementation of both ideas would seem relatively straight forward, leave the Federal Reserve in a at minimum as secured position as under current programs, move the USD liquidity provision offshore to an intraday format (as onshore) and eliminate unnecessary strains on US dealers, which currently have to absorb international spillovers.

Shadow FX intervention in Taiwan: Mercantilism, excessive private FX risks & the hedging backstop

This is the sixth and concluding chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

Chapter VI. connects the rather abstract previous five chapters with the real world by laying out their implications in a variety of dimensions:

• The impact of far larger than previously known FX interventions by Taiwan’s central bank on the U.S. Treasury’s currency policy.
• The CBC’s (deliberate?) influence in incentivizing private sector institutions in Taiwan to assume FX risks worth almost USD 500bn (~80% of GDP). Previous Balance of Payment turmoil usually followed FX mismatches originating from the liability side of a nation’s balance sheet – is Taiwan the first case the asset side is the driver?
• The CBC’s dominant influence in the pricing of X-CCY basis markets in Taiwan. Would lifers’ overseas investments be even profitable without the central banks off-market FX swaps?

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A quick personal end note, I can return to markets professionally next year, but details are not yet finally set. Should you find the thinking in these pages helpful, feel free to get in touch.

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Shadow FX intervention in Taiwan: the CBC’s USD 130+ bn FX swap book

This is the fifth chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

Chapter V. forms the core of the essays and seeks to answer how and to what degree the Central Bank of the Republic of China (CBC) is active in TWD FX derivative markets.

Taiwan’s central bank, unusually, does not disclose its position in FX derivative markets, and thus its true foreign exchange exposures. But its true exposures can be estimated using similar statistical techniques applied in evaluating an investment fund’s underlying positions from its profit and loss statements. Based on profits and losses which Taiwan’s central bank does disclose, it appears that its true FX exposures exceed its disclosed foreign exchange reserves by USD 130bn, and perhaps as much as USD 200bn.

Chapter V. has four broad sections:

• An analysis of the CBC’s own statements about its activities in FX derivative markets.
• The peculiarities in accounting for FX swaps on a central bank’s balance sheet.
• A general method to estimate FX derivative exposures a central bank takes based on its published PnL.
• The application of this model to Taiwan.

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Shadow FX intervention in Taiwan: Counterparties I

This is the fourth chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

Given life insurers’ USD 250bn FX hedging needs, chapter IV. examines potential counterparties to these positions by private sector actors. Overseas investors, Taiwanese banks and Taiwanese non-financial corporates are all long USD in FX forward markets – but nowhere near matching lifers’ requirements.

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Shadow FX intervention in Taiwan – Current Account surpluses & the Rise of Life Insurers

This is the second and third chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

Chapter II. focuses on Taiwan’s Balance of Payments and the transition from the central bank to the life insurance industry recycling the country’s large current account surpluses. A deep dive of lifers’ management of their vast overseas fixed income books follows, with a special eye on the FX risk they lay off in FX derivative markets.

Chapter III. is a quick primer on the instruments most commonly used by institutional investors to manage FX risk, ahead of more technical chapters next week.

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Shadow FX intervention in Taiwan: Solving a USD 100+ bn enigma – Introduction

This is the first chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

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U.S. repo markets & the ‘Inverted Supply’ response of the Fed’s Foreign Repo Pool

After more than a decade without appearing in major news headlines, U.S. repo markets did their best last week to catch up and highlight what may happen in money markets in an environment of lesser reserve abundance than previously.

The general story has been told extensively in other places and the deeper final causes are yet to be established. In brief, U.S. Treasury repo rates began climbing broadly last Monday, before spiking notably on Tuesday to, in some segments, levels not seen for decades. Spillovers extended into adjacent markets, the Effective Federal Funds Rate traded far above IOER and its policy band, highly rated overnight financial Commercial Paper rates increased by 25 bps, while its less liquid companions in the non-financial and asset-backed realm increased by more than 200 bps at their peak.

Although slow to heed calls for a standing repo facility to address potential bottlenecks to date, the NY Fed was, after initial technical difficulties, in markets, offering up to USD 75bn in an overnight repurchase agreement operation with primary dealers. USD 53bn was pulled on Tuesday, and the full amounts offered of USD 75bn for the remainder of the week, in repeats of Tuesday’s operation.

As a result, temporary stress in repo (and adjacent) markets has receded, while the NY Fed upped its schedule of liquidity provisions by announcing it “will offer daily overnight repo operations for an aggregate amount of at least $75 billion each, until Thursday, October 10, 2019” and “will offer three 14-day term repo operations for an aggregate amount of at least $30 billion each” this week.

Coincidentally, the size of to date conducted overnight repos of USD 75bn almost mirrors the increase in the Federal Reserve’s foreign repo pool since the start of the year. Since a series on said pool was published three years ago in these pages, it seems an opportune moment to update developments surrounding it and its, at minimum indirect, effects on the repo stress last week.