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.