It's when markets are running hot that flags need raising

Column by Mr Agustín Carstens, General Manager of the BIS, in the Financial Times, 25 June 2018. 
Read the original on the Financial Times website here.

BIS speech  | 
25 June 2018
Given how much levels of debt have risen over the decade, risks ahead are material

At first glance, the skies above financial markets look sunny, notably for credit markets. Term and credit spreads as well as volatility are very low by historical standards, while valuation and asset prices are high. But, as we argue in our just-released BIS Annual Economic Report, clouds are gathering on the horizon.

Indeed, showers have already dampened spirits in some emerging markets. And worse could come if a further rise in the US dollar tightened financial conditions around the world: after all, post-crisis, companies in emerging economies and elsewhere have been all too eager to tap markets, while investors have been all too eager to oblige them.

Will the stresses remain isolated? Or should we be worried about a more intense and widespread build-up of pressure? 

Central banks still find it hard to forecast financial markets, just as meteorologists are not always successful in predicting the weather. At the BIS, we have come to appreciate how unrewarding it can be to flag risks when markets are running hot. Yet that is precisely when risks tend to be highest.

Indeed, our analysis indicates that the risks ahead are material. A decade of unusually low interest rates and large-scale central bank asset purchases may have left many market participants unprepared, and have contributed to a legacy of overblown balance sheets. Financial conditions are easier than before the financial crisis, when many investors, households, corporations and sovereigns were caught out in the rain with no umbrella. And there is no denying that the room for manoeuvre in terms of monetary and fiscal policies is narrower today than at that time.

What are the specific threats and how could they affect credit markets?

One threat could be a sudden decompression of historically low bond yields, a "snapback", in core sovereign markets. When participants expect inflation to remain negligible far into the future, even mild inflation surprises can scare overstretched markets, as we saw earlier this year. This risk is more acute at a time when larger budget deficits and the gradual unwinding of the Fed's large-scale asset purchases require investors to digest a bigger supply of bonds and bills.

Another threat is a reversal in global risk appetite. This could be triggered by concerns about the sustainability of some sovereigns' debt burdens, as we saw recently in the euro area periphery. Or it could be set off by an escalation of protectionist measures. We had a foretaste of what might happen in the past week, as markets tend to bring forward the potential effects of future policies, even if their adoption is not certain. Hopefully, common sense will prevail: the economic costs of a trade war would be very high for all, with major spillovers to financial markets.

Or a reversal in risk appetite could be spurred by developments in some emerging markets, where financial cycles have turned or policies have failed to sufficiently strengthen fundamentals. In contrast to the snapback scenario, a reversal would further compress term premia in sovereign markets that benefit from the flight to safety. But, just as in a snapback scenario, emerging markets would be hit hardest.

Should stresses emerge, market liquidity will evaporate again: the insidious illusion of permanent liquidity has not gone away. But, compared with the past, the asset management sector will be more prominent in any market ructions, as it is now channelling much more money. Thus, the precise market dynamics are now harder to anticipate.

Do these risks scream hurricane warning, summer storm or scattered showers? Hard to tell. It is worrying that post-crisis global debt, both public and private, has continued to rise in relation to GDP. This is especially so in those economies, both advanced and emerging, that the crisis left largely unscathed. Fortunately, emerging markets have generally strengthened their defences. And, while pockets of vulnerability remain, banks are much better capitalised thanks to the completion of Basel III - a testimony to the value of international co-operation.

Moreover, the future is not pre-ordained. The right policies can help. While the path ahead is a narrow one, it can be taken. We should seize the day to rebalance the policy mix and sustain the current expansion. That means regaining room for policy manoeuvre and reviving the flagging efforts to implement structural policies. Let's use macroprudential tools to strengthen resilience where financial vulnerabilities are building up. Let's ensure that public finances are on a sound footing. And let's normalise monetary policy with a steady hand, in line with country-specific circumstances, while remaining alert to the risks ahead. One reason for the current vulnerabilities is that central banks have had to bear the burden of the post-crisis recovery. We cannot rely on them for ever.

As the British novelist Mary Renault wrote: "There is only one kind of shock worse than the totally unexpected: the expected for which one has refused to prepare." We must not let this opportunity slip from our grasp.