Evans-Pritchard - ECB fears 'abrupt reversal' for global assets on Fed tightening

The Telegraph
by Ambrose Evans-Pritchard
28 May 2015

 The global asset boom is an accident waiting to happen as the US prepares tighten monetary policy and the Greek crisis escalates, the European Central Bank has warned.

The ECB’s financial stability report described a “fragile equilibrium” in world markets, with a host of underlying risks and the looming threat of an “abrupt reversal” if anything goes wrong.

Europe's shadow banking nexus has grown by leaps and bounds since the Lehman crisis and has begun to generate a whole new set of dangers, many of them beyond the oversight of regulators.

While tougher rules have forced the banks to retrench, shadow banking has picked up the baton. Hedge funds have ballooned by 150pc since early 2008.

 Investment funds have grown by 120pc to €9.4 trillion with a pervasive “liquidity mismatch”, investing in sticky assets across the globe while allowing clients to withdraw their money at short notice. This is a recipe for trouble in bouts of stress. “Large-scale outflows cannot be ruled out,” it said.

The ECB warned that a rush for crowded exits could set off a wave of forced selling and quickly spin out of control. “Initial asset price adjustments would be amplified, triggering further redemptions and margin calls, thereby fueling such negative liquidity spirals,” it said.

 Adding to the toxic mix, the shadow banks are taking on large amounts of “implicit leverage” through swaps and derivatives contracts that are hard to track.

The issuance of high-risk “leveraged loans” reached €200bn last year, nearing the extremes seen just the before the Lehman crisis. Half of all issues this year had a debt/EBITDA ratio of five or higher, implying extreme leverage. The number of junk bonds sold reached a record pace of €60bn in the first quarter.

“A deterioration in underwriting standards is evident in the increasing proportion of highly indebted issuers, below-average coverage ratios and growth in the covenant-lite segment,” the report said, warning that this nexus of debt is primed for trouble if there is an interest rate shock.

 While banks are in better shape than five years ago, their rate of return on equity has dropped to 3pc, far lower than their cost of equity. They remain damaged.

The immediate trigger for any market rout is the nerve-racking crisis in Greece, with just a week left until the Greek authorities must repay the International Monetary Fund €300m.

Vitor Constancio, the ECB’s vice-president, said it is impossible to rule out a default since Greek officials themselves have openly threatened to do so, and this in turn could set off bond market contagion across southern Europe.

The ECB’s report said the former crisis states still have extremely high levels of public and private debt and have yet to clean up government finances. “Fiscal positions remain precarious in some countries,” it said.

“Financial market reactions to the developments in Greece have been muted to date, but in the absence of a quick agreement, the risk of an upward adjustment of the risk premia on vulnerable euro area sovereigns could materialise,” it said.

The warnings echo cautionary words by the US Treasury Secretary, Jacob Lew, who said EU creditors were playing with fire if they thought a Greek ejection from the euro could be contained safely.

“No one should have a false sense of confidence that they know what the risk of a crisis in Greece would be,” he told a forum in London.

Yet the ECB said the bigger worry is what happens once the US Federal Reserve begins to raise interest rates, resetting the cost of long-term credit across the international system. It will be an ordeal by fire for those emerging markets with the highest dollar. The total exposure is $4.5 trillion.

 Less likely, but equally worrying, is a “sudden slowdown” in the global economy that would bring Europe's unresolved debt problems back into focus.

The report said aggregate debt levels are much higher than in 2008 at the onset of the last recession. A fresh relapse would change the trajectory of nominal GDP and play havoc with debt dynamics.

 Simon Tilford, from the Centre for European Reform, said the latest cyclical recovery in the eurozone is too weak to undo the damage caused by the crisis and is unlikely to be enough to restore debt sustainability before the next recession hits.

Nor has the currency bloc sorted out its essential deformities or embraced any form of fiscal union. “As it stands, the eurozone is a mechanism for divergence among its members, not convergence: real interest rates are highest in the weakest countries, lowest in the strongest,” he said.

He warned that the region will probably go into the next downturn with rates still at zero – and therefore with no powder left – along with contractionary fiscal rules, and with unemployment already corrosively high.

“Many eurozone governments could face the prospect of further deep recessions despite having barely recovered, amid persistently strong support for populist parties. The politics of this is likely to be combustible. The euro is not out of the woods,” he said.