BIS Quarterly Review, December 2018 - media briefing
Claudio Borio's remarks | Hyun Song Shin's remarks
It was not the first, and it will not be the last. It was just another bump along the narrow path of monetary policy normalisation.
Starting in October, financial markets jolted. And this time it was the US markets' turn to jolt the most - precisely the markets that had powered ahead in the previous quarter even as the others in advanced economies had hesitated and those in emerging market economies (EMEs) had hit a wall. And after the market experienced a calmer but uneasy phase, the tremors returned in early December.
The tremors in October had all the hallmarks of a snapback in bond yields, albeit a comparatively mild one. Amid the usual accompanying volatility spike, equity prices erased all the gains accumulated since the beginning of the year as term premia decompressed and both nominal and real interest rates increased. Indeed, the yield on 10-year US Treasuries rose and traded consistently above the psychological 3% barrier. Corporate spreads widened, especially in the high-yield segment.
The tremors in early December had more of a flight-to-safety character. Equity prices dropped, again in the United States and globally, but this time bond yields declined, dipping again well below the 3% barrier. In the background, credit spreads continued to widen.
Two factors appear to have been at the root of the financial market repricing: despite strong earnings announcements, mixed signals from the economy and changes in the perception of the Federal Reserve's stance. Until then, investors had seen a gradual, yet steady, tightening ahead. But as December began they revised downwards their expectations of its pace, in part taking their cue from policy statements, and became more concerned about the growth outlook. Their anxiety about the economy grew when the yield curve flattened and inverted at the shorter end, often interpreted as a sign of an impending recession. And, importantly, the ebb and flow of concerns about trade tensions and political uncertainties also played a role throughout the period. Indeed, the uncertainty that surrounds the unprecedented monetary policy normalisation process no doubt makes markets more sensitive to such developments.
Political uncertainties were very much in evidence in European financial markets. Worries about a hard Brexit shook markets in the United Kingdom, with sterling taking a knock. In the euro area, the source of tension was, once again, the darkening outlook of Italy's already delicate fiscal condition, as the government defied the European Commission over the budget. True, the market tensions did not reach the same level as in May. Even so, credit default swap spreads pointed to a jump in redenomination risk and, while contained, there were signs of contagion to other sovereign markets in the euro area periphery. Only later in the period did some signs of relief appear, even as the situation stayed fragile.
Events again put the spotlight on the comparative weakness of the European banking sector. Bank shares plunged further than those in other advanced economies. Ostensibly, investors remained nervous about the sector, which is struggling to improve its lacklustre profitability, in some cases is still burdened by non-performing loans, and is highly exposed to the sovereign's fortunes. Price-to-book ratios continue to hover markedly below unity and stand-alone credit ratings, which strip out the expectation of government support under stress, have actually declined since the Great Financial Crisis (GFC).
Surprisingly perhaps, even as US financial markets wobbled, those in EMEs plodded on. To be sure, the stock market rout was global. And the Chinese stock market was especially weak. This reflected specific institutional factors and, more generally, the delicate balancing act policymakers face as they seek to deleverage the economy while keeping up growth - an unprecedented challenge. Similarly, the renminbi's depreciation caused ripples in other EMEs. Even so, credit spreads of sovereigns and corporations did not soar, currencies did not plunge and portfolio outflows did not gather pace - in fact, despite the generally adverse price action, equity investment funds actually saw inflows.
There may be a number of reasons for this relatively good performance. No doubt, the efforts EMEs have generally made to improve their macroeconomic and financial frameworks have been paying off. Maybe the oil price drop provided some relief to the weaker oil importers. Probably more importantly, the markets had been badly shaken in the previous quarter, so that much adjustment had already taken place. Looking ahead, however, EMEs will continue to face challenges as normalisation proceeds.
Despite the tightening in the period under review, from a longer-term perspective US financial conditions are still comparatively easy. This is so even if one considers the stock market rout - in fact, valuations remain rather elevated. Despite the steady increase in credit spreads, nowhere are easy financial conditions more evident than in the leveraged loan market, which continues to be overstretched. And the bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors. Should this debt be downgraded if and when the economy weakened, it is bound to put substantial pressure on a market that is already quite illiquid and, in the process, to generate broader waves.
These and other financial vulnerabilities deserve close attention. This is not only because, should inflation at some point rise more than expected, they would further weaken an economy saddled with higher policy rates; but also because, as experience indicates, even if inflation did not raise its ugly head, a downturn could take place. In fact, since the early 1980s economic downturns have been triggered more by financial booms gone wrong than by monetary policy tightening to quell inflation flare-ups.
What does this all mean for the prospects ahead? It means that the market tensions we saw during this quarter were not an isolated event. As already noted on previous occasions, they represent just another stage in a journey that began several years ago. Faced with unprecedented initial conditions - extraordinarily low interest rates, bloated central bank balance sheets and high global indebtedness, both private and public - monetary policy normalisation was bound to be challenging especially in light of trade tensions and political uncertainty. The recent bump is likely to be just one in a series.
This issue of the BIS Quarterly Review showcases three pieces that use BIS banking statistics to provide a better understanding of global financial flows.
In "The geography of dollar funding of non-US banks", Iñaki Aldasoro and Torsten Ehlers examine the geographical pattern of dollar funding of non-US banks - that is, banks with headquarters outside the United States. Given the dollar's pivotal role as the currency that underpins the global banking system, tracking the shifting pattern of dollar funding can inform assessments of how financial conditions fluctuate and how vulnerable they are to a reversal of sentiment. How has the pattern of dollar funding changed since the GFC?
In aggregate terms, US dollar liabilities of non-US banks have returned to pre-GFC levels, reaching $12.8 trillion at end-June 2018. However, there have been marked shifts in the pattern of dollar funding in the meanwhile. Before the GFC, non-US banks (especially European banks) used their branches and subsidiaries in the US to borrow in dollars in financing their purchases of mortgage-backed securities. The rapid growth of this business was associated with the build-up in overall risks before the crisis. Since the crisis, non-US banks have reduced their reliance on their US affiliates. Instead, the share of dollars raised in their home jurisdiction - often supplied cross-border by US residents - has risen.
In "The growing footprint of EME banks in the international banking system", Eugenio Cerutti, Catherine Koch and Swapan-Kumar Pradhan use the BIS banking statistics to examine the growing international role of banks from EMEs. EMEs have been the engine of global growth in the post-GFC years, but more recently their outlook has become more uncertain, clouded by the strong dollar, the normalisation of monetary policy in the advanced economies, and issues specific to their own economies. The authors of this special feature point to the growing role of EME banks as a source of finance, especially their cross-border activity in lending to other emerging market borrowers. As of end-June 2018, EME-headquartered banks had cross-border claims of $3.7 trillion, of which $1.4 trillion had been provided to borrowers in EMEs. In terms of the pattern of lending, EME banks tend to extend cross-border lending more through their foreign affiliates than directly from their headquarters.
In "The 2008 crisis: transpacific or transatlantic?", Robert McCauley uses the BIS banking statistics to revisit the debate on the nature of financial flows prior to the GFC and their role in the build-up of vulnerabilities. One aspect that attracted attention from commentators at the time was the sustained capital flows into the United States that went hand in hand with the continued net current account surpluses of a number of Asian countries and oil exporters - the so-called "global savings glut". The concern was that the savings glut fuelled purchases of safe US assets and thereby kept financial conditions loose through low yields on safe assets. In contrast, this special feature points to a different source for the continued loose financial conditions, namely the inflow of funds from European banks into the US mortgage securities market - the "banking glut". European-headquartered banks used dollar funding, partly raised in the United States as described in the aforementioned article by Aldasoro and Ehlers, to accumulate US mortgage assets.
In "Clearing risks in OTC derivatives markets: the CCP-bank nexus", Umar Faruqui, Wenqian Huang and Előd Takáts assess one of the key achievements of post-GFC regulatory reform, namely the greater use of central clearing of derivatives transactions via central counterparties (CCPs), marking a shift away from the pre-GFC practice of relying on a dispersed network of bilateral over-the-counter (OTC) derivatives transactions. These welcome developments have resulted from the reform efforts of the official sector that have focused on ensuring that key derivative contracts are cleared centrally and also that banks properly manage the risks when trading and using derivatives. This special feature offers a conceptual framework for examining how the risks of banks and CCPs can be considered together, including possible interactions between banks and CCPs. While central clearing has reduced risk in the financial system overall: if banks and CCPs were to interact in ways that lead to a more indiscriminate retreat from risk-taking during times of stress, the bank-CCP interactions may generate feedback loops that could amplify stress in certain cases. The lesson is that assessments of the bank-CCP nexus should take incentives of system participants into account and consider banks and CCPs jointly in the analysis.
In "The financial cycle and recession risk", Claudio Borio, Mathias Drehmann and Dora Xia revisit the changing nature of recessions and compare the relative performance of financial cycles and the term spread - a popular variable - as early warning indicators of downturns. Financial cycles tend to operate on a longer time horizon than conventional business cycles and reflect the interactions between asset values, risk perceptions and funding constraints in the economy. The authors document how, since the early 1980s, economic downturns have typically been preceded by financial booms rather than marked monetary policy tightening designed to quell inflation. Consistent with this, based on a large sample of advanced and emerging market economies, the authors find that indicators of the state of the financial cycle do a better job than a flatter yield curve in signalling recession risks.
