MARKET CRASH: 5 things that worry big central banks
A fortnight ago, the Federal Reserve (FED) and the European Central Bank (ECB) has published its semi-annual financial stability reports while the Bank of England (BoE) has published its latest quarterly monetary policy report.
Collectively, these three central banks are responsible for monetary policy. more than 40% of global GDP.
- Therefore, investors pay close attention to the information generated by these large central banks. Especially since these periodic macroeconomic reports highlight several major concerns monitored by central banks in the pursuit of the optimal political actions necessary to support a post-COVID19 global economic recovery.
- From a Nigerian perspective, the prevalence of technology that enables the diversification of foreign asset wealth in the United States, Europe and the United Kingdom simply means that Nigerian investors should be aware of the main concerns contained in these macroeconomic reports. .
Nairametrics has reviewed these macroeconomic reports and brings you 5 key concerns to consider.
1. Asset price assessments
- For the US Federal Reserve, high valuations of risky assets are cause for concern (i.e. stock market, residential real estate) as current valuations appear to be supported by a low interest rate environment, therefore there is a risk as future increases in interest rates reduce the net cash flow these investments thus cause investors to flee these assets. This would lead to a significant drop in these risky assets.
- For the European Central Bank (ECB), the financial stability risk posed by high valuations of risky assets is viewed from the perspective of bank and non-bank balance sheet exposure.
Specifically, many companies are either exposed to US stock markets or have large loans on their books. Therefore, an increase in interest rates would mean that companies would face two challenges: higher debt service costs and falling asset values.
- For the Bank of England (BoE), in its report on monetary policy, the surge in the prices of risky assets was recognized, however, from a monetary policy perspective, low productivity, low inflation and exchange rate problems have outstripped the concerns of the BoE on risk asset valuations.
2. Levels of household and corporate (non-bank) debt.
- Second, the we Federal Reserve expressed concern about the level of corporate and household debt, which remains high relative to GDP.
- Specifically, as households take out larger mortgages to finance purchases of ever higher house prices, a scenario is created in which a rise in interest rates for these large mortgages will suddenly lead to affordability issues. . Additionally, current mortgage default statistics are likely toned down due to the special COVID-19 policies in place, such as forbearance of mortgage and the level of stimulus consumed by the accommodation.
Likewise, for small caps and unlisted companies with exceptional credit that have had to reduce their operations, the Paycheck Protection Program (PPPLF) liquidity facility served as government support to keep businesses afloat.
- Therefore, as these special COVID-19 policies end, there may be an increase in delinquencies that create financial stability risks given the cascading effects of increasing delinquencies on banks’ balance sheets and risk. for liquidity pools.
- the European Central Bank also expressed significant concerns about the increase in delinquencies creating solvency risks in all categories of borrowers, from non-banks (businesses) to households as well as banks.
Therefore, if interest rates rise, the cost of credit increases, resulting in affordability issues that negatively impact businesses and, therefore, households. This could lead to a decrease in business spending, especially labor costs, leading to an increase in jobless claims in the economy and signaling the onset of a recession.
- the Bank of England examines this concern from the perspective of households’ propensity to save.
- Specifically, the accumulation of savings that occurred during the pandemic was driven by higher incomes and older citizens (i.e. a demographic that generally has a greater propensity to save) .
- Hence, if more households start saving or paying down debt rather than spending due to uncertainty. This will likely lead to a sub-optimal outcome, including the risk of economic contraction.
3. Leverage / risk effect in the financial sector
- The US Federal Reserve describes a mixed review of this risk for the United States. Specifically, traditional banks are seen to be on the right track as they have experienced rapid growth in total assets thanks to the rise in low risk assets such as central bank reserves, treasury bills and guaranteed loans. by the state such as the PPPLF.
- In addition, capital adequacy restrictions, such as limitations on bank dividend payments and share buybacks, continue to be in place.
On the other hand, the Fed has expressed concerns about the debt levels of life insurance companies and hedge funds.
- For life insurance companies, this concern is further compounded by the fact that insurance companies generally invest in commercial and industrial real estate (CRE), thus additional exposure in the event of a drop in asset valuation.
- The European Central Bank (ECB) points out that it has heightened the concerns of euro-zone banks over the United States. Especially in terms of emerging risks to their profitability due to the potential growth in loan losses, corporate insolvencies, as well as climate change risks.
- In other words, the decline in asset values ââwill likely lead to an increase in loan loss provisions for euro area banks, which could impact their profitability.
In addition, exposure to loans to businesses exposed to threats from climate change (e.g. flood insurance claims, Forest fires etc.) can harm the profitability of euro area banks.
4. Global economy
- the we Federal Reserve concerns about external factors outside of its jurisdiction that can create downturns in the global economy and ultimately impact the United States relate to issues such as:
- The risk that Europe or the major emerging market economies (India, Brazil, ASEAN, etc.) will not completely overcome the pandemic, as this could lead to stability risks in the United States;
- The risk that emerging countries rapidly increase interest rates to attract capital flows or cope with domestic inflation; as good as
- The risk that governments in emerging countries will not have the fiscal capacity to provide continued support to their economies
- The European Central Bank (ECB), and the Bank of England (BoE) have similar external concerns.
These are linked to improving yields on US Treasuries attracting capital flows out of Europe and the UK, while any sudden drop in the value of risky assets in the US can have a negative impact. ripple effect on Europe and the UK.
- In addition, common concerns persist about emerging markets that are suffering the prolonged impact of the pandemic due to low vaccination rates, as well as the risk that the ME region will raise interest rates to attract capital flows, thus triggering a sharp rise in global interest rates.
So what’s the point? Why are all central banks really concerned? In a nutshell, it is inflation.
Specifically, central banks, through various monetary policy measures such as quantitative easing, stimulus packages and low interest rates, have provided a significant amount of liquidity to their respective economies. (balance sheet size grew from $ 16.2 trillion to $ 23.3 trillion in less than 12 months).
As GDP recovers and the speed of currency increases due to increased consumer spending, this should trigger subdued inflation which should boost business investment and capital spending until the central bank price stability objectives are met.
- As a general rule, most of the world’s central banks prefer moderate inflation between 2% and 3%. A prolonged period of higher than expected inflation would mean more drastic action is required
However, investors are very concerned that the excess liquidity already created by central banks to deal with the pandemic could cause higher-than-expected inflation that central banks will not be able to tame. without drastic actions (like the Fed did in the 80s).
- On the one hand, large institutional investors who fear high and sustained inflation rates (i.e. over 3% to 5% for several quarters) insist that interest rates be raised as soon as possible. sooner rather than later to prevent inflation from spiraling out of control. It also helps prevent central banks from having to overcompensate and possibly induce recessions, damaging all the work done to manage the economic fallout from the pandemic.
- However, on the other hand, central banks have relaxed inflation targets and are ready to exceed their preferred range of 2% to 3% for a while. The position of central banks is driven by projections that there are multiple downside risks to financial stability associated with rapidly rising interest rates, as reflected in their macroeconomic reports.
Sadly, this pandemic has created uncharted monetary policy territory, and there is a lot of uncertainty as to how the global recovery will play out. So we continue to monitor this space.