University of Groningen Financial markets: market Information, investment strategies and spillovers Dreher, Ferdinand Torin

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University of Groningen

Financial markets: market Information, investment strategies and spillovers

Dreher, Ferdinand Torin

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Publication date: 2019

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Dreher, F. T. (2019). Financial markets: market Information, investment strategies and spillovers. University of Groningen, SOM research school.

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531888-L-bw-Dreher-SOM 531888-L-bw-Dreher-SOM 531888-L-bw-Dreher-SOM 531888-L-bw-Dreher-SOM Processed on: 4-6-2019 Processed on: 4-6-2019 Processed on: 4-6-2019

Processed on: 4-6-2019 PDF page: 175PDF page: 175PDF page: 175PDF page: 175

Summary

Financial markets exhibit a large degree of co-movement and reflect developments in the economy and policymaking. The links between markets have increased over time. They also have a profound impact on the relevant economies and policymakers. Monetary policy in particular requires functioning financial markets, a good understanding of which is therefore essential. Since financial markets also reflect the state of an economy and government policies, all three empirical chapters in this thesis include a link to a different aspect of financial markets.

In Chapter 2, we analyse the prevalence of fiscal policy manipulation before elections. The political economy literature has studied extensively whether incumbent governments manipulate their budget in the run-up to a general election. The motivation for such political budget cycles (PBCs) is that the incumbent tries to signal his competence to voters thereby improve his chances of re-election. Understanding the conditions under with PBCs occur has taken centre stage. We confirm that political budget cycles exist in the European Union and analyse two potentially limiting factors to such manipulation -fiscal rules and press freedom. We show that both factors limit PBCs in the European Union, where the levels of press freedom and fiscal rules show considerable variation. In addition, we uncover an interaction effect between the two factors. A threshold for press freedom exists, beyond which fiscal rules no longer limit opportunistic spending. We make a case for interpreting this effect as political pressure from strong media that prevents a government from breaking fiscal rules and potentially using creative accounting measures to hide fiscal policy manipulation. Recognising the potential of a strong press and taking into account the interaction with fiscal rules should guide lawmakers

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164 Chapter 4

and policymakers, in particular with regard to policies in the European Union that have placed much emphasis on ﬁscal rules.

In Chapter 3, we focus on the link between interest rates and exchange rates. We assess how interest rates carry information about returns on currencies. We first show that exchange rates are predicted by a factor describing the different interest rates prevailing across a range of maturities. A popular market strategy, the carry trade, involves trading currencies according to the short-term interest rate differentials between countries. This strategy is found to generally exhibit high returns with occasional large losses. Using the predictive ability of interest rates across a range of maturities for currencies, we show that investing according to this information leads to higher economic returns. Rather than investing in countries with a high interest rate where currency returns are a by-product, our proposed strategy, the ’curvy trade’, invests in currencies that are likely to gain in value according to the predictive relationship uncovered. We compare the currencies involved in the curvy trade to those of the carry trade, finding a different composition of currencies used. This leads to a smaller susceptibility to the severe losses occasionally encountered in the market strategy. While the returns of the strategy are not linked to risk explanations discussed in the literature, we hypothesize that our predictive factor signals future rises in short term interest rates reflecting the monetary policy in the respective country. This is of interest to investors, especially with regard to the particular monetary policy environment after the global financial crisis and the normalisation of policy measures.

In Chapter 4, we study the international linkages of several financial markets in a model with multiple countries and assets. International financial markets are highly connected and have become more integrated over time. Assets thus cannot be considered in isolation, but are driven in part by other assets in the respective economy and international counterparts. After the global financial crisis and its impact on the world economy, central banks across the world provided major support to their economies. As interest rates were lowered, they reached a lower bound, so that central banks had to introduce unconventional monetary policy measures to provide support to the economy. Our analysis therefore distinguishes between a period of regular monetary policy and the period following the onset of the crisis during which

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Summary 165

central banks around the world switched to unconventional monetary policy tools. We assess the degree to which assets are driven by their counterparts, nationally and internationally, for four of the largest economic regions in the world and how they have changed in a period of new monetary policy tools. As was the case before the crisis, we find a large influence of US markets on international counterparts. In times of unconventional policy tools, the international asset linkages however also undergo some change, with short-term interest rates and government bonds influenced more strongly by international factors. Policymakers depend on an understanding of international asset price linkages in the context of potentially side-effects from foreign policies. These findings also have implications in particular for policymakers looking toward exiting from unconventional policies. As interest rates rise in one economic region, markets in other countries and other assets are likely to experience these changes as well, making a case for policymakers to coordinate their actions on an international level.

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