By Claudio Borio – December 2017
It is as if time had stood still. Financial market participants had basked in the light and warmth of their “Goldilocks economy” in the previous quarter. They continued to do so in the most recent one.
The macroeconomic backdrop brightened further. The expansion broadened and gained momentum. Above all, despite vanishing economic slack, inflation – central banks’ lodestar – generally remained remarkably subdued. Nothing, it seemed, could upset a future of sustained growth and low interest rates. Accordingly, sovereign benchmark yields in core markets largely moved sideways.
The risk-on phase intensified. Headline equity market indices approached or surpassed previous peaks. Before the jitters towards the end of the period, corporate spreads narrowed further, with the US high-yield index flirting with levels not seen since the run-up to the 1998 Long-Term Capital Management crisis and, later, to the Great Financial Crisis (GFC).
Emerging market economy (EME) sovereign spreads followed a similar, if less extreme, pattern, while credit default swaps – a proxy for EME sovereigns’ insurance cost – reached new post-GFC troughs. As capital inflows into EMEs persisted, albeit at a diminished pace, markets remained unusually receptive to issuance from marginal borrowers. In the background, implied volatility across asset classes – equities, fixed income and currencies – if anything, sank further. Indeed, equity and bond yield volatility touched the all-time troughs previously reached briefly in mid-2014 and before the GFC; currency volatility was approaching similar lows.
There would be nothing really surprising in this picture were it not for one thing: all this ebullience has taken hold even as the Federal Reserve has proceeded with its tightening. Indeed, despite the announcement and start of the balance sheet unwinding, term premia (premium) have compressed further. Granted, other major central banks have either left their previous accommodative stance unchanged (the Bank of Japan) or taken steps that, on balance, have been perceived as easing, at least relative to expectations (the ECB). Even, the Bank of England’s 25 basis point interest rate hike has been seen as “dovish”, given the accompanying communication. But the Federal Reserve is the issuer of the dominant international currency and its sway on markets remains unparalleled. To be sure, the beginning of the run-off in the large-scale asset purchases did appear to stop the US dollar’s depreciation – a source of carry trades. That said, the currency has actually depreciated, too, since the beginning of the tightening at the end of 2015, when the Fed first raised its policy rate.
Hence a paradox. Even as the Fed has proceeded with its tightening, overall financial conditions have eased. For instance, a standard indicator of such conditions, which combines information from various asset classes, points to an overall easing regardless of the precise date at which the tightening is assumed to have started. Indeed, that indicator touched a 24 year low. If financial conditions are the main transmission channel for tighter policy, has policy, in effect, been tightened at all?
In fact, this paradoxical outcome is not entirely new. As we discuss in the Overview, it is reminiscent of the Fed policy tightening in the 2000s – the phase that spawned the now famous “Greenspan conundrum”. Then overall financial conditions hardly budged, and in some respects eased, as the Federal Reserve progressively raised rates. The experience contrasted sharply with previous tightenings, not least the one in 1994. At that time, long-term rates soared, the yield curve steepened, asset prices fell, corporate spreads widened and EMEs came under pressure.
Why such a difference? One can only speculate.
The answer may lie partly in the macroeconomic backdrop. True, in all cases the economy was expanding and inflation remained subdued. Still, market participants today are anticipating a future of even lower interest rates and possibly inflation than the central bank has communicated.
Less appreciated perhaps, the very mix of gradualism and predictability may also have played a role. The pace of tightening has slowed across episodes, and it is now expected to be the slowest on record. And, scorched by the outsize reaction in 1994 – not to mention the “taper tantrum” in 2013 – the central bank has made every effort to prepare markets and to indicate that it will continue to move slowly. Indeed, today’s experience is reminiscent of the repeated reassurance of the 2000s’ “measured pace”, except that the adjustment has been, if anything, even more telegraphed. If gradualism comforts market participants that tighter policy will not derail the economy or upset asset markets, predictability compresses risk premia. This can foster higher leverage and risk-taking. By the same token, any sense that central banks will not remain on the side-lines should market tensions arise simply reinforces those incentives. Against this backdrop, easier financial conditions look less surprising.
Two considerations follow.
First, and most obvious, the jury is still out. There is a sense in which the tightening has not really begun. The vulnerabilities that have built around the globe during the unusually long period of unusually low interest rates have not gone away. As underlined in this Quarterly Review’s special features, high debt levels, in both domestic and foreign currency, are still there. And so are frothy valuations, in turn underpinned by low government bond yields – the benchmark for the pricing of all assets. What’s more, the longer the risk-taking continues, the higher the underlying balance sheet exposures may become. Short-run calm comes at the expense of possible long-run turbulence.
Second, a deeper question is what defines an effective tightening. Can a tightening be considered effective if financial conditions unambiguously ease? And, if the answer is “no”, what should central banks do? In an era in which gradualism and predictability are becoming the norm, these questions are likely to grow more pressing.
Hyun Song Shin
Beginning with this issue of the BIS Quarterly Review, we are revamping the “Highlights” section. Previously, the Highlights provided commentary on current developments in global banking and financial flows through the lens of the BIS international banking and financial statistics. Going forward, a concise and more timely commentary will accompany the statistical release. The Highlights section will be devoted to an in-depth analysis of a topic that can be illuminated by the BIS banking and financial statistics.
In that section of this issue of the Quarterly Review, Iñaki Aldasoro and Torsten Ehlers shine a light on credit risk transfers, the practice of banks laying off their credit risk through arrangements such as guarantees, derivative contracts or collateral. The BIS keeps track of risk transfers by distinguishing between international claims on an immediate counterparty basis (which disregards such transfers) and those on an ultimate risk basis (which incorporates them).
The authors document how global banks shift credit risks out of financial centres in advanced economies (such as the UK and Luxembourg), offshore financial centres and emerging market economies (EMEs) into advanced economies. Sometimes, this transfer reflects a guarantee by a corporation’s home bank for its operations abroad. Sometimes, it represents an exchange of collateral or the purchase of a credit derivative.
There has also been a significant change in patterns vis-à-vis EMEs. While banks continue to use risk transfer mechanisms to reduce their exposures to most EMEs, they have actually (on net) used risk transfers to increase their credit exposures to emerging Asia. In part this may reflect greater confidence in Asian economies, and in part the growing global footprint of Asian companies, who obtain guarantees from their home country banks. These developments reflect underlying real economic activities, but they still bear watching to the extent that instruments that mitigate risk can also be used to magnify it.
The two special features in this Quarterly Review cover different aspects of the post-crisis increase in private sector debt. As highlighted in the Annual Report and in previous Quarterly Review issues, this represents a possible vulnerability in the economic outlook.
Around the world, countries that suffered most severely from the Great Financial Crisis experienced significant deleveraging. The recent increases in debt have brought them to levels previously seen before the crisis. However, for many countries that were spared the worst of the crisis, debt levels are now significantly higher than pre-crisis. The two special features shed light on how the stock of debt affects macroeconomic developments and financial stability. Their findings may also shed light on the topical issue of how monetary policy normalisation will affect economic activity.
The special feature by Anna Zabai (BIS) looks at household debt. Credit allows households to borrow against future income to purchase housing and finance consumption. However, having too high a burden of debt can tighten household budgets and leave them vulnerable to macroeconomic and financial shocks. The overall impact of household debt on economic activity depends on a number of factors, including the level of debt, whether rates are fixed or variable, whether households have buffers in the form of liquid savings and the burden of debt service.
Higher borrowing tends to boost economic activity in the short run, but there is evidence that it acts as a drag on growth at horizons of three years or more. Household debt also has direct (through loan exposures) and indirect (through the impact of debt on GDP) effects on financial stability. For these reasons, macroprudential measures taken today may provide greater room for monetary policy manoeuvre in the future.
The special feature by Boris Hofmann (BIS) and Geert Peersman (University of Ghent) analyses the impact of monetary policy shocks on the debt service ratio (DSR), defined as interest and principal payments as a share of income of the private non-financial sector. In line with previous BIS research, the DSR is an important channel through which monetary policy affects real activity. Using data from 18 economies, the authors find that a tightening of monetary policy is followed by a significant and persistent increase in the DSR, as well as a slowdown in growth, inflation, house prices and credit. The impact is particularly strong in economies where private non-financial debt is higher.
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