Wednesday, August 22, 2018


"Turkey Contagion Fears are Overblown"

August 22, 2018

It’s been quite a hot summer for the Turkish Economy.  Following the presidential election and the inauguration of the new president, in a matter of days if not hours the Turkish Lira plunged to its historical depths.  Lira had never lost so much value at such a speed at such a short time period. On top of the economic problems and the failure of the new government to implement measures to support Lira, the row with the U.S. over the jailed pastor Brunson and President Donald Trump’s off-the-cuff twits have made things worse for the Turkish Lira. 

Now the question economists try to address is whether the initial tremors of a financial crisis in Turkey will turn into a full-blown crisis and whether it will generate contagion and send shock waves to other emerging market economies. So far, the answer to the first question is all depends on the Central Bank and the government’s ability to implement necessary measures to support Lira.  All economists agree that without the proper response from the Central Bank the whole economy will be in jeopardy.

Our analysis of Turkish bank stock returns and volatility connectedness show that the current tremors in the financial sector led to substantial increase in the connectedness of bank stocks, implying that this is a system-wide phenomenon that affects all banks. Volatility connectedness among the 11 bank stocks has increased from 52% at the end of March to 60% by July 10.  From July 10 onwards, the volatility connectedness continued to increase, from 60% on July 10 to 65% on July 31 and 68% on August 17. The rapid increase in volatility connectedness was mostly driven by the biggest four banks. Furthermore, if the current pressure on Turkish Lira and financial markets continues in the next couple of weeks, the volatility connectedness is likely to increase further to reach 80% and above. Such a development would imply that the whole banking system will be in disarray if the government will not announce the required policy actions immediately after the Bayram Holiday.  Everyone knows that the Central Bank must increase the policy interest rate to match the current market interest rates and give a message to investors as the protector of the value of Turkish Lira. There is not much time left.



Figure 1. Return and Volatility Connectedness – Turkish Banks

As for the question about whether the Turkish tremors has led to financial contagion around the globe, we address this question in the current update of our Financial & Macroeconomic Connectedness website.  So far we have updated connectedness graphs for global stock and foreign exchange markets. 

Let us summarize the main conclusion. At least for the time being, our analysis supports the FT’s viewpoint: “Turkey contagion fears are overblown.”  The Turkish crisis has not generated contagion (or what we call connectedness) among the 45 stock markets from developed and emerging market economies around the world.  (See http://financialconnectedness.org/Stock.html) There is no qualitative change in the results when only emerging market economy markets are included in the analysis. One reason for the lack of any contagious effects on others is the size of the Turkish economy and financial markets: Turkey accounts for around one percent of the world GDP and global trade, and even less than one percent of the global financial markets.  Another reason why the tremors of the Turkish crisis are not felt around the globe because, unlike the East Asian countries, Turkey is not viewed as part of a group of countries from a region that share similar economic and financial characteristics.  The 1997 East Asian crisis started in Thailand and spread to other countries in the region that faced difficulties in financial markets. In the Turkish case, there is no such group of countries that the Turkish troubles would pull into a state of financial crisis. 

While the tremors of the Turkish crisis are not generating connectedness to other markets, earlier this year in February both the stock and foreign exchange markets got hit by a surge in volatility following the announcement of a better than expected employment report in the U.S. Markets took this piece of news as the turning point that would lead to a strong policy reaction by the Fed.  Within a week, the main U.S. equity index, S&P 500 fell a by 10 percent.  The reflection of the surge in volatility over the week from February 5 to February 12 was a 9-point increase in the stock market volatility connectedness from 45% to 54%.  The index went up another 4 points in March and early April and 3 points in June to reach 61% in July.  Since then the index hovers around 60-62 % with no upward move.  As of August 17, the volatility connectedness among the global stock markets was 61%.

As of January 15, FX market volatility connectedness dropped below 50%, the lowest level since April 2007. (See http://financialconnectedness.org/FX.html) However, it did not stay below 50 for long. Within a month-and-a-half the FX market volatility connectedness index jumped to 56%. Unlike the stock markets however the volatility connectedness across FX markets experienced a correction in the next few months. The recent uptick in the FX market connectedness has not been caused by the travails of the Turkish Lira.  Lately in June, following the U.S. trade policy pressure against China and other countries’ volatility connectedness increased back to 56% by August 17. Indeed, Turkish Lira continues to play a very minor role in global FX markets, being a recipient of the volatility shocks rather than generator of the connectedness to other countries.

The cracks in the Turkish financial markets appeared rather too quickly because of the recent diplomatic row with the U.S. on top of the country’s economic woes and the lack of any policy action.  Yet, it appears that irrespective of the speed with which the crisis is developing, the Turkish crisis has not generated volatility connectedness or contagion in global stock and foreign exchange market.

Even when we exclude all developed markets and analyzed connectedness among the emerging markets, the results do no change. Turkey is a small fish in the pond.  Unless we hear troubles coming from elsewhere the travails of the Turkish financial markets are not sufficient to pull down the global markets down.






Saturday, September 5, 2015

Stock Market Volatility Connectedness – September 2015 Update

We updated the connectedness measures for stock, sovereign bond, and FX markets using data up to the end of August.  The results provide us with lots of material to write about.   In this blog I analyze the behavior of the volatility connectedness in global stock markets. Bond and FX markets will follow next.

Before I start with the stock market volatility connectedness, I want to highlight one development that affected volatility connectedness in all three markets, albeit at varying degrees. Having a quick look at dynamic connectedness graphs show that there is an upward move in the volatility connectedness of stock, sovereign bond and FX markets immediately around mid-October 2014. Actually, all three markets were affected by the volatility jump in the U.S. bond market on October 15, 2014.  Market observers linked the jump in daily bond market volatility to electronic trading and named the developments on October 15, 214 as the “flash crash”.

Following the “flash crash” volatility connectedness across stock markets increased gradually to reach 65% in mid-February.  After that peak the volatility connectedness came down steadily. The stand-off between Greece and the EU in late June about the implementation of economic policies dictated by the IMF, the European Commission and the ECB led to a quick increase in the stock market volatility connectedness from 56.7% on June 24 to 61.1% on July 10. Once the Greek government decided to implement the dictated policies the volatility connectedness across stock markets declined gradually to 53.8 on August 20.

Chinese stock market declined by around 40% from its peak in June to mid-August. This downward trend in the volatility connectedness index was realized despite the troubles in the Chinese stock market. However, there was a big jump in the index on August 24. From 55.4% on Friday August 21, the total volatility connectedness index jumped to 64.4% on Monday, August 24. That is the day when the Chinese market dropped 8.3%.  During the day all eyes focused on the Chinese market.  Many followed the jump in the VIX index from 19 to 41, the highest level since the European debt crisis in 2011. Yet, a look at the directional volatility network as of August 31 reveals that the European countries were the most important generators of volatility connectedness. Actually, European stock markets were generating connectedness towards each other more than the stock markets in other parts of the world. One can talk about the presence of a European cluster where the country nodes located towards the center of the cluster all have red color, while the ones on the periphery have orange and brown colors.


Leaving the European countries aside, U.S. stock market generated the highest connectedness to others. It generated most of the connectedness toward Latin American and European markets, Canada, India and Indonesia. China, on the other hand, was a net recipient of volatility connectedness from others.  China’s pairwise connectedness with Hong Kong was the highest. It was a net recipient of connectedness from all European countries.

Tuesday, March 10, 2015

Our "Financial and Macroeconomic Connectedness" book published by Oxford University Press

I am very happy to announce that the Diebold-Yilmaz book is now available in hardcover.  The kindle and paperback versions were available for more than a month ago at Amazon. With the publication of the hardcover version the publication process is over.

Our work has not finished, though.  We promised to the publishers that we would make the larger versions of the full-page figures available on our Financial and Macroeconomic Connectedness (F&MC) website.  We kept our promise and  posted pdf versions of close to a dozen figures on our FandMC website.           

In addition, we are going to make the updates of the major results of each chapter available on our website. We have actually updated the connectedness measures for the majority of the empirical chapters of the book as of February 2015

Tuesday, September 30, 2014

Return Connectedness in Credit Default Swap Markets

Credit default swaps (CDS) on private and sovereign debt have become one of the major investment vehicles for investors since early 2000s.  That is why we applied our connectedness analysis framework to CDS markets as well. More specifically, we study the return connectedness among credit default swaps for sovereign debt of a group of developed and emerging market economies for the period from January 2010 to July 2014.  We focus on return connectedness rather than volatility connectedness in CDS markets, because the daily returns in CDS markets measure the fear in sovereign bond markets.

The full-sample static connectedness graph depicts a very interesting picture.  Returns for CDS on developed and emerging market government bonds form two sub-networks.  There are 15 countries in the developed country network sub-graph.  As denoted by node colors most of the developed country sovereign debt CDS generate low return connectedness to others. Among the developed countries, Belgium and Italy had the highest connectedness to others, followed by Spain, France, Netherlands and Austria.  U.S. has very low return connectedness to others, which means that it is likely to be a net recipient of return shocks from others.  The Southern, Spain, Italy, and Portugal, and the Northern European countries, Sweden, Denmark, Finland and Norway, form two subgroups that have high pairwise connectedness among each other.

The second sub-network graph includes Central and Eastern European economies as well as the major emerging market economies.  Among the 24 countries in this group there are only two developed economies: Japan and Israel.  While having very weak ties with this group of countries, Japan has no pairwise connectedness to other developed economies. Similarly, being located in a politically volatile region Israel also has stronger connectedness with emerging market economies than developed economies of Europe and the North America.

South Africa, Russia and Turkey are located at the center of the emerging market group and they have the highest return connectedness  to others over the 2010-2014 period, as shown by scarlet red color of their nodes.  In the emerging market group, Slovakia, Croatia, Bulgaria, Kazakhstan and Poland are located closer to the developed country group, which indicates that they are generating connectedness to developed country groups more than other countries in the emerging market group.  From their location, we can contemplate that Turkey, South Africa and Russia have more significant return connectedness to other emerging market economies in the CDS markets.

Central and Eastern European countries are mostly (with the exception of Kazakhstan and Poland) located in the northern half of the emerging market sub-network graph.  Among these countries Croatia, Romania, Hungary, Poland, Kazakhstan and Bulgaria generate more return connectedness to others. Latin American countries are located in the southern of the emerging market sub-graph.   Among the Latin American countries Brazil, Mexico, Panama and Colombia have higher connectedness to others compared to Chile, Venezuela and Peru. 

Wednesday, September 17, 2014

Episodes of high volatility connectedness among the global stock markets

Over the last two weeks we’ve being working on network graphs for 8 episodes in our dynamic global stock market connectedness analysis.  All these important dates are associated with significant increases in the total volatility connectedness index. In this rather long blog post, I analyze the pre- and post-event network graphs for each episode briefly.

Episodes  
     A.      Fed’s unexpected rate hike and the unwinding of carry trades – May 2006
     B.      First signs of the subprime mortgage crisis, late February-March 2007
     C.      Liquidity crisis, July-August 2007
     D.      As bank losses mount worldwide Fed was forced to cut rates drastically, Jan 22, and Jan 30, 2008
     E.       The U.S. financial crisis went global after the Lehman Bankruptcy on Sep. 15, 2008
     F.       EU's failure to act to contain the Greek crisis led to frenzy in the European markets, May 2010
     G.      Following the troubles of Italy and Spain, S&P’s decision on , August 5, 2011 to downgrade U.S. government’s credit rating from AAA to AA+ had worldwide impact
     H.      Bernanke’s speech on May 21, 2013 about the possibility of the start of QE tapering in late summer caught the markets off guard.

A. Let me start with the first episode, namely with the Fed’s unexpected decision to raise the interest rates an additional 25 basis points on May 10, 2006 and its indication that it would raise the policy interest rates one notch in its subsequent meeting on June 2006. This decision caught the markets off-guard, as the majority of market participants were expecting an end to the rate hikes in its May 2006 meeting.  While the bulk of the impact of this decision was felt in FX and bond markets, stock markets were also affected from the decision.  As a result, the volatility connectedness among the European stock markets increased significantly, as can be seen from the increase in the number of European stock markets with red and scarlet nodes as well as the increased thickness of the edges among the European stock markets.  European stock markets moved towards the center of the network with stronger volatility connectedness with each other as well as to the EU periphery and the major emerging market economies.  The “to” connectedness of the major emerging market economies also increased. U.S. stock market’s volatility connectedness to others, however, did not increase as a result of the decision.  This is expected because most of the carry trade originated from the U.S. and led to investments in the European and emerging market economies.  When the unexpected rate hike decision was taken it implied capital outflows from target countries toward the home country, the U.S.

B. Next in our list is the emergence of first signs of the subprime crisis in February 2007.  In the last week of February news about the troubles of major mortgage lenders, including the New Century Financial Corp, one of the biggest, became public.  While the total connectedness index jumped from 50% on Feb. 25, to 62% on February 28, 2007, while the net volatility connectedness of the U.S. stock market jumped from -3% to 20%.   In the network graphs, the U.S. stock market’s node turned from brown on Feb. 22 to red on Feb. 28, with significant increase in its volatility connectedness to Brazil, Canada, Mexico, and Argentina.  Major European stock markets’ nodes continued to stay red, but as can be seen from thick edges among them, high to-connectedness of the European stock markets was due to high pairwise volatility connectedness within Europe.

C. Liquidity crisis of July-August 2007 was a serious game changer.  For one thing, the connectedness index continued to climb from 60% in March to 70% level by late July 2007. This is the period when banks started to feel the pressure from the rapidly declining subprime mortgage market. By mid-June 2007, two subprime hedge funds of Bear Stearns had lost nearly all of their value. Then, in late July BNP Paribas decided to close three hedge funds of its own. This was the trigger that initiated the sell-off bank assets in the U.S. and Europe. The connectedness index jumped from 70% in late July to 78% by early September 2007. The “to” connectedness of the U.S., European, and Latin American stock markets were already high by the end of June 2007, as can be understood from red and dark red colors of their respective nodes.  By September 4, 2007, they all were turned in darker red colors and the edges among them became thicker.

D. In the last quarter of 2007, major U.S. banks worked hard to raise equity from investors all around the world. At the same time, they replaced their CEOs who were seen responsible for the large losses they suffered. But these moves were not sufficient to solve their problems. In the first couple of weeks of the new year, major banks started to announce further losses they suffered in the last quarter of 2007.  Finally grasping how desperate the situation of the U.S. financial system, Federal Reserve held an unscheduled meeting on an official holiday (January 22) and decided to cut the federal funds target rate by 75 basis points. Then, one week later, in their scheduled January 30 meeting, they decided to cut the fed funds target rate by another 50 basis points to 4.0%.  The comparison of the network graphs for January 7 and 28 reveal a situation we observe during the liquidity crisis episode. While the U.S., European and the Latin American stock markets (all on the “western hemisphere” of the network graph) had very high volatility connectedness to others on both dates, there is a definite increase in the “to” connectedness of these markets between the two dates.  Furthermore, the pairwise connectedness of these markets with each other also increased from January 7 to January 28, as shown by the thickness of the edges. Furthermore, the group of stock markets that generated high “to” connectedness moved slightly to the center of the network graph.

E. The total connectedness index declined steadily for the next 7 months; even during the takeover operation of Bear Stearns. By the end of August 2008, the index declined to 62%. With the U.S. Treasury’s decision to take Government Sponsored Enterprises Fannie Mae and Freddie Mac under full government custody in the first week of September led to an increase in the index. Then came the Lehman bankruptcy on September 15, 2008. The index jumped to 70% on September 15, and all the way up to 78% by November 27, 2008. These were the major steps toward the globalization of the U.S. financial crisis.  As of October-November 2008, all major stock markets and economies of the world were affected from the whirlwind of the financial crisis. Three of the four network graphs we display in this episode of the crisis definitely show the worsening of the situation in the rapidly increasing total and directional volatility connectedness measures. By November 27, the edges at the center of the network graph were so thick that the white background can be seen only as white dots.

F.   After hitting a low of 60% at the end of June 2009, the total connectedness index increased in the rest of the summer to reach 66% by mid-November. While earlier on troubles in European banks led to the increase in connectedness, starting from November, it was an outcome of the revelations about the Greek fiscal deficit and debt stock. As the newly elected Greek government revealed that the government budget deficit and the debt stock was actually much higher than announced by the incumbent government, it became clear that the losses of the European banks holding the Greek debt would mount to billions of euros. Markets reacted and the volatility connectedness index moved up by 5 percentage points from December to late April 2010.  However, after a brief lull in April 2010, the index jumped by 6 percentage points in May 2010, as it became evident that the EU leaders were not really serious about a resolution to protect the European banks. 

G. The index did not stay low for too long, thanks to the increased worries about the sovereign debt and banking problems in Italy and Spain, two EU members with sizable economies compared to the members that had problems before. Then following very intense political negotiations U.S. Republicans and Democrats finally agreed on August 2 to raise the debt ceiling temporarily. A couple of days later S&P decided to lower the credit rating of the U.S. government from AAA to AA+. In this episode, the connectedness index went up from around 60% to 76% in just a couple of days. The pre- and post-downgrading network graphs clearly show the increased number of stock markets that had high volatility connectedness to other countries.

H. The last episode we focus on is the one that occurred in May-June 2013.  In his speech to the U.S. Congress, on May 21, 2013 Federal Reserve Chairman Ben Bernanke caught market participants by surprise by spelling out that the tapering of the quantitative easing program can be sooner than markets anticipated.   While he wanted to prepare the market participants for the eventual initiation of tapering, the markets showed significant reaction to his speech.  For a couple of weeks financial market gyrations increased. During this period, the index increased from 52% to 60%. Aside from the usual European suspects, countries such as Austria, Czech Republic, South Africa, Russia, Chile and Brazil started generating substantial volatility connectedness to other countries during this episode. 

Tuesday, September 2, 2014

Financial and Macroeconomic Connectedness website is up today !!!

I started this blog more than two years ago. At the time my aim was to build the Financial and Macroeconomic Connectedness (FandMC, for short) website and use this blog to analyze important developments in financial markets around the world as revealed by applications of the Diebold-Yilmaz Connectedness Index (DYCI) methodology.  The website is finally up thanks to the hardwork of my student/assistant/coauthor Mert Demirer.


At the moment, the FandMC website presents the static (full sample) and dynamic connectedness analyses for global stock, bond, foreign exchange and CDS markets.  The website aims to provide academics and policy makers with a powerful tool to analyze how return or volatility shocks to individual assets/markets other assets/markets in a country or around the world.  If you are not already familiar with the DYCI framework I would recommend that you have a look at our Journal of Econometrics (DY 2014) paper listed in the Research section of the website.

In 2014, with the help of shrinkage techniques, such as lasso and elastic net, we have expanded the DYCI framework from small to large scale network analysis.  Three of the four (excluding bonds) financial connectedness analyses presented in the Indices section are estimated using the elastic net procedure.  As the dimension of the network increases, the connectedness analysis through tables becomes rather difficult.  The volatility connectedness analysis of Bond market Thanks to Gephi, a powerful network graphical display program, we can now generate network graphs for the full sample (“static network) and for each instance in our dynamic analysis. 

Obviously it is impossible to create network graphs for every day, but from now on we will try to create network graphics that display the connectedness of assets/markets before, on or after important dates, such as September 15, 2008, that witnessed the bankruptcy announcement of Lehman Brothers. To give an example, in our dynamic volatility connectedness index graph for global stock markets, we highlighted four days. When you click on letter C you will see the network graphics that show how volatility shocks spread among the major stock markets of the world on September 25, 2008, ten days after Lehman’s collapse.  
In addition to the static network graphs,  FandMC website presents graphs of directional connectedness indices (to, from and net) for each asset/market that allows for the dynamic analysis of connectedness in financial markets. The displayed graphs are small, but by clicking the enlarge button it can be viewed quite easily.  Furthermore, all graphs in our website can be printed or downloaded.  The data  underlying the static and dynamic connectedness graphs can be download from the Data section.

All in all, we have tried to include as much as possible in this first run of the FandMC  website.  We will continue building and developing the website further.  In this endeavor we welcome your comments, and suggestions. 

Tuesday, March 20, 2012

Second Round of LTRO and Volatility Connectedness


The European Central Bank completed the second round of its long-term refinancing operation (LTRO) at the end of February. In the second round the ECB lent another 500 billion to Eurozone banks, increasing total funds used by European banks to 1 trillion.
The second round of LTRO had its impact on financial markets.  With the expectation of the second round, the market sentiment improved significantly in February. As a result, the total volatility connectedness across 14 major European banks declined. On February 14, two weeks before the second round of LTRO was completed, the index hit the lowest level in more than two year, 71.8%. The index fluctuated between 72% and 73% for three more weeks, including the week of March 5-9.
Certainly, the decline from close to 90% all the way down to slightly above 70% shows that the ECB has been following the right policy mix by providing unlimited liquidity to European banks.  However, it is important to note that much of the gains, measured by the decline in connectedness index, accrued in the first round. In the first round, the index declined by 9.4 percentage points, from 84.9% on December 1, 2011 to 75.5% on December 30, 2011. Compared to the first round the impact of the second was rather limited.  In the second round, the decline in the index was not more than 3.5 percentage points. 
This comparison definitely shows the limits of the effectiveness of liquidity operations such as LTRO. Furthermore, the behavior of the index over the week of March 12-16 is a more serious warning to those who thinks that things will be smoother in the near future.  The index lost much of the ground it gained in the week of March 12-16, reaching 75% as of March 16. 
The Eurozone debt crisis is not part of the history, yet.   Banks still carry huge sums of sovereign debt as part of their assets.  The ECB’s LTRO has provided a breathing space for the Eurozone economy.   Unless the EU leaders agree on a permanent solution this spring, the next episode of the Eurozone debt crisis is likely to take place in 2012.