Tail risks aplenty folks – tail risks aplenty...
To be sure, it’s tempting to chuckle wryly when central banks talk about financial stability.
After all, pretty much anyone you care to consult will tell you that central banks themselves are now far and away the greatest risk factor when it comes to markets and more than a few commentators are steadfast in the contention that persisting in accommodation nine years on from the crisis has served to inflate bubbles in financial assets the likes of which the world has (almost) never seen (something about tulips and Pets.com).
At the same time, there’s a kind of paradox here. Because if ZIRP, NIRP, and QE are responsible for the bubbles, then it stands to reason that a removal of ZIRP, NIRP, and QE is likely to be the proximate cause for an eventual bursting of those very same bubbles.
Well, it’s up to central banks when that accommodation gets removed so in a way, they are indeed the guardians of financial stability even if the potential for instability is of their own making. It’s an amusing paradox.
Anyway, in their latest fund manager survey, BofAML finds that when it comes to what clients think are the biggest tail risks to markets, central banks are on top of the list. Indeed, nothing else – including the debt ceiling or an algo apocalypse – comes anywhere close. To wit:
The dilemma for the Fed and ECB is that while their primary mandate is price stability, they find themselves beholden to being the buyer of the last resort and guardians to financial stability.
However, the reality of the past thirty years has been a succession of bursting financial bubbles (1987, 1997, 2008), rather than inflationary spikes. The legacies of this have been their ballooning balance sheets and increased financial regulation. The latter was the subject of Yellen’s speech, while the former may be contributing to the next cycle of instability if financial conditions are not appropriately calibrated.
Herein lays the challenge, if policy is tightened too much to target financial conditions it could tilt the economy into a recession. This challenge is best captured by our survey of clients’ risk perception in Exhibit 1 below that ranks it as the number one tail risk.
Of course “crash in global bond markets” might fairly be rolled up into “Fed/ECB policy mistake”, because it’s certainly reasonable to suggest that the most likely cause for a bond market crash would be a miscalculation by a central bank. Just look at what happened after Sintra.
And indeed, one could also argue that “ETF/Quant-driven liquidity flash crash” is also inextricably bound up with central bank policy mistakes. While it wasn’t a “flash crash”, the post Sintra selloff in DM rates certainly played havoc with CTAs and to a lesser extent with risk parity.
In any event, this just underscores the precarious nature of the situation and in the end, it kind of makes you wonder whether Deutsche Bank’s Aleksandar Kocic is correct to suggest that maybe this “state of exception” has become permanent simply because it cannot be lifted.