ECB Warns There Is "Significant Risk Of Abrupt Market Reversal"

One week after the BIS issued an unexpectedly stern, if completely ignored warning, that the surge in the USD is leading to an abrupt tightening in financial conditions around the globe, making the repayment of trillions in USD-denominated cross-border debt increasingly more difficult and suggesting that the Dollar index itself is the new "fear indicator", overnight another central bank, the European Central Bank warned that the risk of "abrupt" global asset market corrections "have intensified" on the back of rising political uncertainty, posing a threat to banks, stability and economic growth.

More volatility in the near future is likely and the potential for an abrupt reversal remains significant amid heightened political uncertainty around the globe and underlying emerging market vulnerabilities,” the ECB wwarned in its twice-yearly Financial Stability Review published on Thursday.

“Elevated geopolitical tensions and heightened political uncertainty amid busy electoral calendars in major advanced economies have the potential to reignite global risk aversion and to trigger a major confidence shock.”

In its report, the ECB warned about the recent period of dramatic, unexpected political results that started with the Brexit vote and culminated with Donald Trump’s victory, which have increased volatility and herald profound economic-policy changes whose implications for the euro area are still hard to gauge. “Financial stability implications for the euro area stemming from changes in U.S. economic policies are highly uncertain at this point in time.”

The Central bank noted out that while the currency bloc’s economy and financial system have remained resilient so far, more political instability in coming months may put pressure on weak banks and countries with high sovereign debt.

The ECB also focused on domestic banks and admitted that “vulnerabilities remain significant for euro-area banks,” confirming the ongoing Deutsche Bank lament that “profitability prospects overall remain low across the euro area in a subdued economic growth environment.” The good news is that - largely unexpectedly - the Trump victory has spurred a pick-up in bank stocks as investors saw the risk of ever tighter regulation recede. If sustained, this would “provide some support for euro area banks’ profitability prospects,” according to the ECB. The ECB also said that steeper yield curves “may provide some support for euro-area banks’ profitability prospects."

The good news is that “despite relatively volatile global financial markets, bank and sovereign systemic stress indicators for the euro area have remained fairly stable at low levels.”

The ECB also warned about the risk of a return of market pressure on the region’s highly-indebted countries as the spread of populism hinders reforms. “Higher political uncertainty may lead to more domestically focused, growth-hindering policy agendas,” the report said. “This, in turn, could delay much needed fiscal and structural reforms and could in a worst-case scenario reignite pressures on more vulnerable sovereigns” and that “concerns about debt sustainability might re-emerge despite relatively benign financial market conditions.”

It also cautioned about Europe's failure to address its hundreds of billions in NPLs, noting that “banking sector structural challenges stem from high stocks of non-performing loans, high operating costs and excess capacity, with different incidence across countries.”

Speaking at a press conference in Frankfurt, ECB Vice President Vitor Constancio said that “we are in a new phase of weaker world trade” and that “if, on top of that, there would be a wave of protectionist measures, world trade, and world growth would suffer.”  Constancio confirmed that the despite the risk build-up, the ECB still sees euro-area growth around 1.6 percent in 2017, with inflation rising to about 1.25 percent in the spring. Even so, he stressed that some of the region’s lenders remain weak and need to continue addressing excessive costs and a high burden of non-performing costs.

Ultimately, the ECB threw the problem at the politicians' feet, warning them that if they succumb to "populist" whims, i.e., democracy, then all bets are off and the ECB's "whatever it takes" will be retracted: “Higher political uncertainty may lead to more domestically focused, growth-hindering policy agendas. This, in turn, could delay much needed fiscal and structural reforms and could in a worst-case scenario reignite pressures on more vulnerable sovereigns.”