Listen, when the world finally does come to an end and the handful of people who survive the collapse are all sitting around a pile of burning trash and reminiscing about record high stock prices while eating expired cans of baked beans with rusty spoons, no one is going to be able to say that the BIS’ Claudio Borio didn’t try to warn everyone.
Borio – who is named after knockoff Oreos – has been pointing out the myriad risks embedded in global financial markets every quarter for years and that’s ironic because a lot of those risks stem directly from central bank largesse and the BIS is the central bank for central banks.
Well, the BIS is out with its latest quarterly financial review and that means Borio is going to regale you with his characteristically cautious take.
In his media briefing, Borio explains what’s happened (or, more appropriately, what hasn’t happened) since last quarter. He also touches on the paradox that has been variously debated over the past year: namely the fact that financial conditions have continued to ease despite the Fed’s persistence in proceeding with gradual normalization.
This apparent “conundrum” isn’t really that paradoxical and more than a few folks have pointed out the extent to which it is not, as Borio himself concedes, unprecedented. Consider, for instance, the following chart from Kevin Muir:
Still, it’s a defining feature of the current market environment. We’ll have more on the BIS’ latest later today, but in the interest of not watering down Borio’s always entertaining opening remarks, we present them in full below…
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 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.