Quantitative Easing

You are probably familiar with the various bank bailout plans floating around (in the U.S., U.K., Belgium in conjunction with the Netherlands and so on). These plans require government to lay out cash which can come from one of two sources:

1. Treasury borrowing
2. The central bank "printing" money (or Quantitative Easing)

This last source is achieved by the central bank buying usually (and lately in the U.S., not only) Treasury securities from investors (usually dealers). How does the central bank pay for these purchased securities securities? By an electronic transaction that debits the traders' accounts in their respective commercial banks. These electronic checks represent new reserves for the commercial banking system that can now proceed to extend new credit to customers (the Money Multiplier). The problem of late is that even as the Federal Reserves Bank increases the banking system's reserves, these banks do not use them to extend additional credit to customers. Read an article in today's Financial Times about it: "Bank set to deploy quantitative easing"

International Capital Markets

Several articles relating to international capital market could be found in recent newspaper articles. The New York Times reported on Friday (“Global Worries Over U.S. Stimulus Spending”) that Mexico’s ex-president (Ernesto Zedillo) expressed in a Davos talk concerns about the Obama stimuli plan. His concerns are well founded; the money for financing the suggested plan will have to be raised by issuing Treasury securities. As an example, on January 22 the U.S. Treasury auctioned $40 billion in new 2-year notes—a new record. Investors who use their money to buy these Treasury notes cannot (or, rather, do not want to) use it to purchase developing countries’ bonds. Why? Treasuries are a safe heaven during these volatile times.
In today’s Wall Street Journal, please look up for “Why Venturing Abroad Still Makes Sense for Funds Investors”. The article focuses on the one of the main conclusions of Modern Portfolio Theory that investors who include more asset classes in their portfolios benefit from improved mean-variance investment opportunities. In the MPT lingo: Sharpe’s capital market line becomes steeper. The lower the correlation between the various classes, the better is the investment opportunities. The question therefore is whether the correlation coefficient between the S&P 500 and the Nikkei 225 is low enough for investors to be tempted to allocate some of their portfolio weights to this latter index. The common wisdom is that
1. Globalization causes the correlation between national equity markets to increase over time
2. The correlation between various national stock markets is particularly strong during turbulent periods.
Several books provide data regarding the correlation structure of the global capital market. Bekaert and Hodrick (Exhibit 13.6) provide a matrix of cross correlations between 22 developed markets. Countries that have close trade relations are characterized by highly correlated stock market returns. For example: the correlation between the monthly rates of return on the U.S. and Canadian capital markets are 0.73 while the equivalent figure with Japan is 0.31. These authors used the 1980 to 2008 period. Bruno Solnik, one of the highly regarded scholars in this area reports similar figures by using 1971-1994 data. Quite a stability.
What about the claim that during turbulent periods the correlation tends to strengthen? I computed the correlation between the S&P 500 and the Nikkei 225 indices over the last three month and it was amazingly low, approximately 0.16. Observing the data, it appeared to me that the rate of return on the Nikkei tends to follow that of the previous day’s S&P rate. When I correlated the lagged Nikkei on the S&P, the correlation jumped up to 0.62. This seems to confirm the above point 2.