Timing asset market peaks: the role of the liquidity risk cycle of the banking system
Recent financial crisis showed how the unfolding of liquidity risks of financial intermediaries spilled over to asset markets, contributing to asset price deteriorations and the triggering of liquidity spirals. This paper derives and tests a financial fragility condition for predicting asset price peaks on a real-time basis, by combining the term spread and the aggregate funding liquidity risks of the banking system into a simple binary fragility indicator. The main empirical result of this paper is that the fragility condition predicted all major equity market peaks in Germany during the time period 1973 to 2010, including the subprime crisis of 2007, the New Economy Bubble of 2000, and the 1987 stock market crash. The average lead time of the indicator is 2.9 months. About 80% of the declines were later on associated with significant declines in Industrial Production.
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