Prophets of your own doom

IFR 2035 31 May to 6 June 2014
6 min read

EUROPEAN CENTRAL BANK technocrats are clearly becoming concerned about the degree of latent risk in the system. In its May Financial Stability Review, the central bank noted that, while progress has been made towards strengthening banks and sovereigns, the hunt for yield is contributing to the build-up of new risks. The “growing search for yield has benefited euro area banks and sovereigns, but could also unearth imbalances should risks be reassessed”, it concluded.

That’s technocrat-speak for “yikes” as potential risks move inexorably closer to what has every appearance of being a credit bubble with a shiny new pin.

We’ve all watched with bemusement as investors, in order to generate any kind of yield kicker – and more latterly to get out of the way of any risks emanating from Russia/Ukraine or the China slowdown – have seen no alternative but to shine the light into some of the darker corners of the financial markets and then to rush headlong into them.

It’s taken them into very low-rated credit – contributing to eurozone high-yield spreads narrowing to levels not seen since October 2007 – long-dated debt, structured debt including corporate and bank hybrids, CLOs/CDOs; covenant-lite loans; distressed debt, and commercial property.

At the same time, investors are passing on traditional protections. To back up this claim, how about this to make your toes curl slightly: close to 20% of US high-yield issuance in the first quarter was high-yield lite ie, carries no debt incurrence or restricted payments covenants, while the quantum of debt outstanding that’s rated B minus or lower now stands at US$403bn.

Choosing between curbing deflation or market over-exuberance is like asking if you’d prefer to die by hanging or shooting

THE TIGHTENING of bond spreads right across the board, including on European peripheral government bonds to pre-sovereign crisis levels, looks heavily overdone. But speak to any investor and they’ll tell you that while they agree that the risk-reward is heavily skewed towards the former, they’re choosing to treat the risks as fairly benign and in any case they have no choice but to bid low or risk missing out if they can’t source paper. In a world of peer benchmarking, that just doesn’t work.

I guess the point here is that while ECB officials are at pains to stress that legacy risks of the global financial crisis are being adequately dealt with by government action around their own balance sheets, by central bank policy and by vast swathes of new regulation, that sense of stability has led to a degree of investor complacency, which they clearly think is dangerous.

“New risks are emerging,” the ECB said, “particularly a growing search for yield across regions and market segments, driven by increased investor confidence and some rebalancing of portfolios away from emerging markets, among other factors. As the search for yield intensifies, so do concerns regarding the build-up of imbalances and the possibility of a sharp and disorderly unwinding of recent investment flows.”

The central bank says that some of the capital inflows to eurozone sovereigns and banks “appear to have been based on relative return considerations (eg, dependent on continued emerging market concerns and perceptions of inexpensive euro area assets). Such flows might prove to be fickle absent prospects of strong absolute returns differentiated by underlying country and bank-specific macroeconomic prospects”.

So what are the ECB’s specific concerns? They’re threefold:

• The risk of an “abrupt reversal of the global search for yield, amid pockets of illiquidity and likely asset price misalignments”, which it fears could lead to disorderly adjustment in financial markets thereby making the need for sufficient bank capital buffers and/or hedges to withstand it paramount;

• Weak bank profitability and balance sheet stress in a low inflation and low growth environment;

• The “re-emergence of sovereign debt sustainability concerns, stemming from insufficient common backstops, stalling policy reforms, and a prolonged period of low nominal growth”.

SOUNDS TO ME like the ECB, far from being comfortable with where we’ve got to, has considerable doubt about the robustness of the system. That’s despite the fact that, as it points out, banks have issued €267bn of quoted shares over and above retained earnings, contingent capital issuance and in some cases state aid since the global financial crisis. And since the third quarter of last year, banks have strengthened balance sheets by €95bn.

So what to do about it? There’s the rub. If anything the situation that’s leading to over-exuberance in capital markets could get a lot worse if the ECB’s policy actions include further rate cuts into negative territory, a new LTRO, and/or outright ABS purchases.

The impact of the bank’s moves at its next meeting are uncertain, but I reckon the possibility of banks re-purposing cash held at the ECB into SME lending (short of finalising rules on high-quality securitisation and the Solvency II impacts) are more remote than their predisposition to redirect cash into non-eurozone central banks or (perhaps more likely) plough it into the securities markets.

The experience of quantitative easing to-date is that it’s benefited financial arbitrage over the real economy. Sometimes central banks get themselves into that “damned if you do, damned if you don’t” scenario. Forced to choose between curbing pernicious deflationary tendencies or capping the dangers of credit-market over-exuberance and leaving the one you ignore to spiral out of control is a bit like asking someone if they’d prefer to die by hanging or shooting.