Claudio Borio has been pounding the table on complacency and mounting market risk for quite some time.
It was exactly one year ago that the BIS’ Head of the Monetary and Economic Department penned the following warning about the market’s dependence on central bank omnipotence:
To my mind, these events underline the fragility - dare I say growing fragility? - hidden beneath the markets' buoyancy. Small pieces of news can generate outsize effects. This, in turn, can amplify mood swings. And it would be imprudent to ignore that markets did not fully stabilise by themselves. Once again, on the heels of the turbulence, major central banks made soothing statements, suggesting that they might delay normalisation in light of evolving macroeconomic conditions. Recent events, if anything, have highlighted once more the degree to which markets are relying on central banks: the markets' buoyancy hinges on central banks' every word and deed.
Then, in March, he spoke out about the dangers of increasingly illiquid secondary markets for corporate bonds:
As a result, market liquidity may increasingly come to depend on the portfolio allocation decisions of only a few large institutions. And, more broadly, investors may find that liquidating positions proves more difficult than expected, particularly in the context of an adverse shift in market sentiment.
What do the changes in market-making described here mean for markets and policy? There are at least two key issues. First, reduced market-making supply and increased demand imply upward pressure on trading costs, reduced secondary market liquidity, and potentially higher financing costs in new-issue markets. Second is the question of how markets will behave under stress - that is, whether they will be able to function in an orderly fashion in response shocks or broad changes in market sentiment...
Finally, in September, Borio delivered the following rather dramatic assessment of an overleveraged world hooked on central bank stimulus:
Hence a world in which debt levels are too high, productivity growth too weak and financial risks too threatening. This is also a world in which interest rates have been extraordinarily low for exceptionally long and in which financial markets have worryingly come to depend on central banks' every word and deed, in turn complicating the needed policy normalisation. It is unrealistic and dangerous to expect that monetary policy can cure all the global economy's ills.
Well, perhaps because the market thinks there’s something unsavory and altogether disingenuous about the BIS criticizing the same people who make up its board of directors, or perhaps investors are just clueless and complacent, but whatever the case, no one has listened to poor Claudio. But that doesn’t mean the BIS is set to rein in the doom and gloom and in the bank’s latest quarterly review, Borio and co. are back at it and coincidentally, one of the key topics is EM debt, which we covered on Saturday in “Will 2017 Be The Year Of The EM Corporate Debt Crisis?.”
Unlike Deutsche Bank, the BIS doesn’t see anything “benign” about the situation.
“In general, the leading indicators of economic activity [in EM] pointed to weakness ahead [as] countries in the throes of a severe recession, such as Brazil and Russia, struggled on [and] activity in China showed little signs of strengthening,” Borio says, concurring with our assessment from Saturday. “And, as the period wore on, commodity prices, including those for oil, copper and iron ore, plunged towards new depths,” he adds.
That would be bad enough on its own, but set against that rather abysmal backdrop is a USD-denominated debt pile that amounts to some $3 trillion. “The financial vulnerabilities in EMEs have not gone away,” Borio continues. “The stock of dollar-denominated debt, which has roughly doubled since early 2009 to over $3 trillion, is still there [and] in fact, its value in domestic currency terms has grown in line with the US dollar's appreciation, weighing on financial conditions and weakening balance sheets.”
Again, the nightmare situation is that you accumulate an enormous amount of foreign currency liabilities only to see your currency crash just as market demand for EM assets dries up.
Drilling down further, the bank notes that of the $9.8 trillion in non-bank, USD dollar debt outstanding, more than a third ($3.3 trillion) is concentrated in EM. “Since high overall dollar debt can leave borrowers vulnerable to rising dollar yields and dollar appreciation, dollar debt aggregates bear watching,” Robert Neil McCauley, Patrick McGuire and Vladyslav Sushko warn. The right pane here gives you an idea of how quickly borrowers’ ability to service that debt is deteriorating.
"Any further appreciation of the dollar would additionally test the debt servicing capacity of EME corporates, many of which have borrowed heavily in US dollars in recent years," Borio reiterates, ahead of the December Fed meeting at which the FOMC is set to hike just to prove it's actually still possible.
All in all, central banks have managed to preserve an "uneasy calm," Borio concludes, but "very much in evidence, once more, has been the perennial contrast between the hectic rhythm of markets and the slow motion of the deeper economic forces that really matter." In other words: the market is increasingly disconnected from fundamentals and the rather violent reaction to a not-as-dovish-as-expected Mario Draghi proves that everyone still "hangs on the words and deeds" of central banks.
In the end, Borio is telling the same story he's been telling for over a year now. Namely that the myth of central banker omnipotence is just that, a myth, and given the abysmal economic backdrop, the market risks a severe snapback if and when that myth is exposed. One of the pressure points is EM, where sovereigns may have avoided "original sin" (borrowing heavily in FX), but corporates have not. With $3.3 trillion in outstanding USD debt, a rate hike tantrum could spell disaster especially given the fact that the long-term, the fundamental outlook for EM continues to darken.
Borio's summary: "At some point, [this] will [all] have to be resolved. Markets can remain calm for much longer than we think. Until they no longer can."
Thanks for your honesty Claudio, now just tell your Board: