InvestMacro

By Costas Milas, University of Liverpool 

With UK government bonds and sterling both falling hard in recent days, the Bank of England has been forced to step in. Only a few months after it started tightening monetary policy to fight inflation by raising benchmark interest rates and ending its programme to “create” money through quantitative easing (QE), it has made a U-turn.

It plans to create perhaps £65 billion over a two-week period to buy long-dated government bonds to shore up that market, as well as temporarily putting on hold plans to start unwinding its £838 billion of QE money. So will this work?

The specific reason for the intervention appears to be UK pension funds, which suddenly became very vulnerable because of the bonds plunge. This was because pension funds rely on financial schemes known as liability-driven investment strategies or LDIs.

LDIs are essentially an insurance policy to ensure that funds have enough money to pay people’s pensions, even when bonds are paying very low returns. But when bond prices plunged after the government’s mini-budget, funds were forced to find extra money to cover their LDIs. This forced them to sell more bonds and threatened a domino effect where bond prices would keep falling and some funds could have collapsed.

The bank’s intervention has important implications for the wider economy. It comes when people are under increased financial stress because of higher interest rates, climbing energy bills, wages not keeping up with inflation and volatility in the financial markets.

The economy is growing only weakly and may well tip into recession. According to my recent co-authored work, a recession could depress the UK economy for as many as 20 months – longer than the 15 months predicted by the Bank of England.

Stress in the UK markets

These conditions are likely to be an additional reason for the bank’s intervention – despite contradicting its efforts at tightening. Since the interest rates (or yields) on bonds rise as their prices fall, stepping into the market to buy bonds aims to push down these rates.

So far it has worked: yields on UK 20-year and 30-year bonds were both north of 5% before the intervention and are now respectively 4.1% and 3.9%. Since the level of these yields sets the tone for borrowing costs in the rest of the economy, this should encourage more consumer spending and business investment.

Yields on 20-year and 30-year UK bonds

The downsides

The bank’s intervention, without even consulting its Monetary Policy Committee (MPC), is a form of what is known as yield curve control. This is a variety of QE in which, instead of just creating a certain amount of money with which to buy bonds, the central bank wants to achieve a specific yield. Such a policy is mainly associated with Japan, where the central bank has been buying bonds to keep yields at very low levels since 2016.

So far the Bank of Japan has achieved its objective, but the yen has lost a lot of value because the bank is having to create more and more money via QE: it now owns some US$3.8 trillion (£3.4 trillion) of Japanese government bonds, over half the total market. Meanwhile, the yen has virtually halved since 2010, and in recent weeks the Bank of Japan had to act to prop it up.

While Japan and the UK’s moves to control bond yields are somewhat different, the Bank of England intervention is also likely to put additional downward pressure on sterling. It is also going to be inflationary. This shows how unappealing the policy options are at present.

The implications

Will the intervention work? The impact of QE on interest rates is the subject of voluminous research. It is difficult to estimate because it depends on the level of the interest rate, as well as the economic conditions. Things are complicated further because central bank studies find QE to be more effective than academic papers do.

But going roughly by the findings in this co-authored paper of mine, an additional £50 billion of QE purchases in the UK might lower bond yields by 12 basis points (0.12 percentage points). That suggests that unless the bank continues with this new scheme far beyond the current October 14 end date, it is unlikely to have much effect.

Moreover, QE partly works by signalling to the markets that it will keep interest rates low for a protracted period. By setting a time limit and also saying that it plans to return to QT in due course, the bank is undermining its new policy.

Also, the credit ratings agencies may well downgrade UK sovereign debt. They usually reduce a country’s credit score when economic policy uncertainty rises significantly, or debt rises to unsustainable levels, or the quality of governance is on the slide.

We’re certainly seeing a big rise in uncertainty. At the same time, the latest World Bank data reveals that in terms of government effectiveness, the UK is down from the top 7% of countries to the top 13% over five years. What remains to be seen is how UK debt will rise, since we currently don’t have official forecasts following the mini-budget.

With no such estimates due to be published until November 23, not to mention the Bank of England’s failure to consult the MPC, the credit ratings agencies will be seriously tempted to downgrade. Such a move would push UK bond yields upwards again, therefore undermining the bank’s intervention.

It’s worth bearing in mind that the main source of the current instability remains the government’s mini-budget and unfunded tax cuts. This is what undermined investor confidence and caused the sell-offs of UK bonds and sterling in the first place, so the best way to reverse this is to tackle the problem at source by the government modifying its plans.

Having said that, such a U-turn would also leave investors very uneasy about economic management. One way or the other, a rocky economic road looks likely until at least the next general election.

About the Author:

Costas Milas, Professor of Finance, University of Liverpool

This article is republished from The Conversation under a Creative Commons license. Read the original article.

By Bernhard Reinsberg, University of Glasgow and Andreas Kern, Georgetown University 

Everyone from political pundits to people on the street have issued forth on the new UK government’s tax cut-laden growth plan recently. But it was a rare public rebuke from the International Monetary Fund (IMF) that really impacted financial markets.

Days after the government made its mini-budget announcement, the IMF warned that “large and untargeted fiscal packages” could work at “cross purposes” to monetary policy, referring to current efforts by central banks around the world to fight rampant inflation. It also suggested the government should reevaluate its tax measures and provide more targeted energy crisis support at its next budget, currently scheduled for November 23.

Investors responded by beating an even hastier exit from government bond markets and sending the pound plummeting. Within hours of the IMF statement, the Bank of England had announced a plan to try to calm the markets.

The IMF’s decision to comment on UK tax policy was significant and clearly had an impact on traders and investors. And while the uninitiated may be blissfully unaware of the IMF’s existence, it has played a key role in supporting economies in trouble since the middle of the last century.

Upholding global financial stability

The IMF was established in 1944 at the Bretton Woods Conference, which sought to stabilise global finances after the second world war. Based in Washington D.C., it is an international organisation with 190 member states – from Afghanistan to the UK and US, right through to Zimbabwe.

Its mandate is to uphold international financial stability, which it tries to do by monitoring global macroeconomic developments and providing governments with advice and training on economic policy management.

Most importantly, perhaps, the IMF frequently acts as a “lender of last resort” for its members. This means it provides countries in dire financial straits with much-needed money in the form of loans.

In return, these countries must agree to certain austerity measures. Depending on the situation, this can include tax hikes and drastic spending cuts, alongside other substantial economic reforms.

In the last few years, governments in Ecuador and Pakistan, among others, have hiked interest rates, cut back on public spending programmes, and reduced subsidies on household essentials such as fuel and food to meet the IMF’s performance criteria. As a result, the IMF has become one of the world’s most controversial organisations.

Since the performance criteria it uses are based on the IMF’s worldview, the question of whether its advice is adequate, proportionate, and effective is often subject to debate.

For IMF advocates, the sometimes draconian measures it mandates are necessary to restore investor confidence, boost economic growth and help countries become more competitive in the long run. As such, the IMF can work like a seal of approval for a country’s policy plans, helping governments to shore up international confidence in their economies.

To its critics, the IMF has used its policy leverage to advance reforms that have increased poverty and inequality, leaving countries with deep social and political scars for years after accepting its help. For example, during the Ebola crisis in 2014-15, the IMF was criticised for contributing to underfunded health systems that prevented effective government responses to the epidemic.

Moving markets

Regardless, as the recent case of the UK shows, an IMF verdict on government policy proposals can significantly affect financial markets. For countries with immediate financing needs – typically developing economies – restoring investor confidence with an IMF intervention can be critical to the successful resolution of financial crises.

But the IMF has also used its “magic shield” to rescue UK governments from global financial woes in the past. In fact, since the Fund’s creation, the UK has called upon the IMF 11 times.

Its last IMF rescue happened in 1976 when stagflation and political stalemate forced the UK government to ask for a loan to halt speculative pressures on the British pound. The IMF provided not only financial relief, but also stability to a newly elected British administration by helping to calm market nerves about the UK economy.

This time, the IMF offered up its thoughts on the current economic situation in Britain, rather than being invited to intervene. But instead of curbing speculation about the UK’s financial viability, the statement had the opposite effect: markets panicked.

Mortgage lenders continued to pull their offerings and investors kept unloading government bonds, forcing up yields and the cost of government borrowing. Add the plummeting British pound in the mix and the current situation is in danger of becoming a textbook financial crisis.

But the IMF’s assessment is in line with international experts and ratings agencies in doubting that tax cuts will help reignite UK economic growth. Instead, it argues that the cuts will further expand the budget deficit.

Without a sound fiscal plan, this will increase the need for new government debt. At a time of rampant inflation, deteriorating global economic conditions and rising interest rates – which affect the cost of financing for the government – such debts may become unsustainable for the UK.

Taking into account the reaction of market participants to the IMF’s statement, and that the Bank of England felt the need to intervene in the bond market afterwards, the IMF assessment seems to have carried weight.

Certainly, the UK in debt distress is the last thing the world needs. Many governments in developing and emerging markets are struggling to keep their own economies afloat right now while awaiting financial relief from western banks and the IMF.

But the UK’s central position in global financial markets means any panic in the City of London can spread quickly to global financial markets. From this perspective, the IMF’s recent comments about the UK can be seen an attempt to prevent the world from slipping further into a winter of despair.

About the Author:

Bernhard Reinsberg, Reader in Politics, University of Glasgow and Andreas Kern, Associate Teaching Professor, McCourt School of Public Policy, Georgetown University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

By Daniel O’Leary, University of Southern California 

Who will win Nobel Prizes in 2022? Wikipedia posits a handful of contenders for Physiology or Medicine, about 20 different possible winners for the Peace Prize and several dozen potential winners of the Literature Prize. But since the Swedish Academy never announces nominees in advance, there are few insights indicating who will win, or even if the eventual winner is on a given list.

Are there ways to predict the future winners?

The Delphi approach, named after the oracle in ancient Greece, gathers multiple rounds of opinions from a group of experts to generate a prediction. Gambling firms provide betting odds on the likelihood that specific competitors will win. Crowdsourced competitions, such as the Yahoo Soccer World Cup “Pick-Em,” have participants predict individual contest winners and then aggregate the results.

Another approach is a prediction market that provides insight into what people expect will happen in the future by creating a stock market-like environment to capture the “wisdom of the crowd.” Groups and crowds often are collectively smarter than individuals when many independent opinions are combined.

As an accounting and information systems professor at the University of Southern California, I investigate issues related to the crowd both in my research and in my teaching. Here’s how prediction markets harness what the crowd thinks to forecast the future.

The wisdom of the market

In prediction markets, participants buy and sell stocks. Each stock’s price is tied to a different event happening in the future. Information about the future is captured in the stock prices.

For instance, in a prediction market focused on the Nobel Peace Prize, maybe Greta Thunberg is trading at $0.10 while Pope Francis is trading at $0.15, and the stocks for the entire group of candidates add up to sum to $1. The prices reflect the traders’ aggregated beliefs about the probability of their winning – a higher price means a higher perceived likelihood of winning.

Prediction markets have various ways of setting stock prices. The Iowa Electronic Markets took following approach during the 2020 U.S. presidential election:

• Stock DEM2020 pays off $1 if the Democratic candidate wins, and $0 otherwise,
• Stock REP2020 pays off $1 if the Republican candidate wins, and $0 otherwise.

The stock prices capture the probabilities of each candidate winning, in two mutually exclusive events. If the price of DEM2020 is $0.52, then that is treated as the probability of that event occurring – a 52% chance. If DEM2020 is $0.52, then REP2020 is $0.48.

Prediction markets may use real money, or they can use play money. Google’s market used what it called “Goobles,” while the Hollywood Stock Exchange uses Hollywood Dollars. The Iowa Electronic Markets and PredictIt, both sponsored by universities, use real money. Researchers have found that there are no differences in the performance of markets using real money versus those using play money.

Although using play money makes it possible for many people to participate, one potential challenge for prediction markets that don’t use real money is gaining and maintaining interested participants. Despite using different devices to keep up engagement, such as leader boards indicating who has accumulated the biggest portfolio, there is literally no money on the table to keep participants interested in the market.

Participants bring their knowledge to the market

Prediction markets and crowdsourcing do not function in a vacuum.

Researchers have found that information about events finds its way into the prediction processes from various sources. For example, when I analyzed the relationship between the betting odds and the Yahoo Pick-Em crowd’s guesses for the 2014 FIFA World Cup, I found that there was no statistical difference between the proportion of correct guesses in each. My conclusion is that either the crowd’s guesses incorporated the betting odds information or the crowd’s guesses added up to the same result by some other means.

Generally, prediction markets use play money or are run by non-profit universities to study markets, elections and human decision making. Although gambling houses can take bets for many activities, external prediction markets are more restricted in the activities they can be used to investigate, and are typically limited to elections. However, internal prediction markets – run within a corporation, for instance – can explore almost any topic of interest.

Typically, prediction markets function better with informed participants. Although using so-called inside information is illegal in some markets, including the New York Stock Exchange, there generally are no such limitations in prediction markets, or other crowdsourcing approaches. If those with inside information were to participate in a prediction market, it would likely lead to more accurate stock prices, as insiders make trades informed by their knowledge. However, if others find out that a participant has inside information, then they may very well try to gain access to that info, follow the insider’s actions or even decide to leave the unfair market.

The accuracy of prediction markets depends on many factors, including who is in the market, what their biases are and how heterogeneous the participants are. Accuracy can also depend on how many people are in the market – more is generally better – and the extent to which they are informed about the events of interest.

Researchers have found that prediction markets have outperformed polls in presidential elections roughly 75% of the time. But accurate results are not guaranteed. For example, prediction markets did not correctly predict that Donald Trump would win the U.S. presidency in 2016.

Who will be in Stockholm for the ceremony?

In 2011, Harvard University economics faculty had a real-money prediction market site, referred to as “the world’s most accurate prediction market.” The site had been used for predicting the Nobel Prize in Economics, but Harvard advised the site to shut down.

I couldn’t find any current public prediction markets active for the 2022 Nobel Prizes.

For the moment, perhaps the closest to participating in a Nobel prediction market would be to place a bet at one of the gambling houses that takes bets on the Nobel Prizes. Or find a Nobel Prize Pick-Em site, propose such an event to an existing prediction market or build your own prediction market using some of the available software.

If you know of one, let me know, I want to play.

About the Author:

Daniel O’Leary, Professor of Accounting and Information Systems, University of Southern California

This article is republished from The Conversation under a Creative Commons license. Read the original article.