December 2017 BIS Quarterly Review: Paradoxical tightening echoes bond market "conundrum"

Markets shrugged off moves by some major central banks to wind back stimulus over the last quarter: global financial conditions paradoxically eased further amid heightened concerns about overvalued asset prices.

Continued low bond yields and low volatility, particularly in the United States, are reminiscent of the bond market "conundrum" referred to by former US Federal Reserve Chair Alan Greenspan in 2005, when market yields remained low despite Fed rate hikes.

Easier US financial conditions coincided with a decline in the term premia components of yields, or the extra return investors seek for holding a longer-term bond rather than shorter ones. For asset pricing, there are lingering uncertainties about how precisely this compression works over time, or how yields would react once central bank policies normalise.

"Can a tightening be considered effective if financial conditions unambiguously ease? And, if the answer is 'no', what should central banks do?" asked Claudio Borio, Head of the Monetary and Economic Department. "In an era in which gradualism and predictability are becoming the norm, these questions are likely to grow more pressing."

The December 2017 issue of the Quarterly Review also:

• Analyses the reallocation of risk in the global banking system over the last decade through credit risk transfer vehicles such as guarantees, derivatives or collateral. Global banks continue to shift credit risks out of financial centres and riskier emerging market economies, and into advanced economies. Even so, banks have increased credit exposures to emerging Asia. This reflects the bigger international footprint of companies and banks from these countries, and creditors' greater willingness to keep such exposures on their balance sheets.
• Finds an initial positive response to a US move to expand the availability of central clearing in the repo market to a broader set of institutional investors. Prices in US repo markets have started to converge, signalling a potential reduction in post-crisis market segmentation.

Two special features analyse the implications of debt for policy, the economy and financial stability:

"The two special features shed light on how the stock of debt affects macroeconomic developments and financial stability," said Hyun Song Shin, Economic Adviser and Head of Research.

"Their findings may also shed light on the topical issue of how monetary policy normalisation will affect economic activity."

• Anna Zabai (BIS)^* finds that increasing household debt has direct and indirect consequences for the economy and financial stability. While higher debt tends to boost growth in the short term, it dampens growth in the longer term and amplifies the impact of interest rate hikes on both borrowers and lenders. Rate cuts, on the other hand, have less impact.
• Boris Hofmann (BIS) and Gert Peersman (Ghent University)* argue that monetary policy shocks have a significant impact on private sector debt service ratios. Higher official interest rates increase both the interest rate that borrowers pay and the ratio of interest and principal payments to income. The impact is higher in economies with high debt levels.

* Signed articles reflect the views of the authors and not necessarily those of the BIS.