The BIS’ Claudio Borio was vindicated in January - and it was a long time coming.
When last we checked in with Claudio, it was December and the bank’s Head of the Monetary and Economic Department was busy explaining what may befall $3.2 trillion in EM USD debt in the persistently strong dollar environment. “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,” he warned.
We also laid out the progression of Borio’s most recent warnings as delineated in the banks’ widely-read, if on occasion perfunctory, quarterly reports. Below, is a brief review.
From 2014, 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.
From March of 2015, speaking 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...
And in September of last year, 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.
Right. So pretty much everything Claudio could be worried about, Claudio was worried about, and the most amusing thing about his concern over undue central banker influence is that the BIS board looks like this:
Well in any case, Borio is back at it and now he can say "I told you so." In the BIS' latest quarterly report, the bank wastes no time in describing the first two months of the year: "uneasy calm gives way to turbulence."
After noting that January was one of the most abysmal months for stocks in market history, the bank breaks the meltdown into two distinct "phases":
- At first, markets focused on slowing growth in China and vulnerabilities in emerging market economies (EMEs) more broadly. Increased anxiety about global growth drove the price of oil and EME exchange rates sharply lower and fed a flight to safety into core bond markets. The turbulence spilled over to advanced economies (AEs), as flattening yield curves and widening credit spreads made investors ponder recessionary scenarios.
- In a second phase, the deteriorating global backdrop and central bank actions nurtured market expectations of further reductions in interest rates and fuelled concerns over bank profitability. In late January, the Bank of Japan (BoJ) surprised markets with the introduction of negative interest rates, after the ECB had announced a possible review of its monetary policy stance and the Federal Reserve issued stress test guidance allowing for negative interest rates.
- On the back of poor bank earnings results, banks' equity prices fell well below the broader market, especially in Japan and the euro area. Credit spreads widened to a point where markets fretted about a first-time cancellation of coupon payments on contingent convertible bonds (CoCos) at major global banks.
And then came the obligatory nod to dwindling counter-cyclical capacity:
Underlying some of the turbulence was market participants' growing concern over the dwindling options for policy support in the face of the weakening growth outlook. With fiscal space tight and structural policies largely dormant, central bank measures were seen to be approaching their limits.
But the real punchline comes in the end, when the BIS touches on a topic that we've been discussing since mid-January. Namely that this seems to be the year in which the world woke up to the fact that central bankers are not, in fact, omnipotent. We went further:
That rather unpleasant revelation has in turn caused some to reconsider the wisdom of the policies that drove stocks to nosebleed levels off the 2009 lows. That is, if it’s now clear that ZIRP, NIRP, and QE have failed when it comes to stimulating global demand and trade and reinvigorating the inflationary impulse, one is left to wonder what happens when the world careens back into recession against a backdrop of extreme capital misallocation and exhausted counter-cyclical policy maneuverability.
Almost as if the BIS had simply read the quoted excerpt above and paraphrased it for their own report, here is what the central bank for central bankers says:
Underlying some of the turbulence of the past few months was a growing perception in financial markets that central banks might be running out of effective policy options. Markets pushed out further into the future their expectations of a resumption of gradual normalisation by the Fed. And as the BoJ and ECB signalled their willingness to extend accommodation, markets showed greater concerns about the unintended consequences of negative policy rates. In the background, growth remained disappointing and inflation stubbornly below targets. Markets had seemingly become uncertain of the backstop that had been supporting asset valuations for years. With other policies not taking up the baton following the financial crisis, the burden on central banks has been steadily growing, making their task increasingly challenging.
We couldn't have said it better ourselves. Except that we did.