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An occupational hazard of observing markets is a recurring sense of déjà vu. Even so, 2014 is proving a vintage year for echoes of the pre-crisis world.
First, we have the return of the Great Moderation, that period of eerie stability before 2007 which economists and central bankers hailed as the harbinger of a new era of non-inflationary growth. Today market volatility has again collapsed across all asset classes. Ten-year US Treasuries, the global bond market benchmark, have been trading in a relatively narrow range all year.
Note, next, that the Bank of England’s latest systemic risk survey shows that the perceived probabilities of a high-impact event in the UK financial system over both the short and medium term continue to fall, setting new lows since the survey began in 2008. This brings back memories of the last Banking Banana Skins survey produced by the Centre for the Study of Financial Innovation before the crisis, which revealed that the financial community’s biggest worry at the time was over-regulation. Risk management featured low on the list of concerns.
Then there is the return of structured products with embedded leverage such as collateralised loan obligations. CLO issuance in 2013 reached $82bn, a mere 15 per cent below its peak in 2006.
At the same time, global leveraged loan issuance for leveraged buyouts and other highly borrowed transactions saw record volumes last year, rising 55 per cent from 2012 to $1.6tn. The credit risk premium in the US bond market is very low by historic standards, while the quality of bond issuance and covenant protection has deteriorated. Credit risk is clearly underpriced.
Before concluding that we are once again on the road to perdition, though, it is important to recognise the echoes that are not present. With the odd exception such as the London housing market, residential and commercial property – so often at the heart of financial crises – are not seriously overheating in the G7 economies.
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Nor is there any sign of a credit bubble. The credit channel in much of the developed world is still broken. And the difference between actual and trend private sector credit growth measured relative to gross domestic product shows a significant negative credit gap in the G7 countries. Since the credit to GDP ratio is used by the Basel III capital regime for setting banks’ counter-cyclical capital buffers, this would point to a relaxation rather than a tightening of policy. We also know there has been significant deleveraging in the banking system.
This leads to a question. If the banks are not pumping out credit and inflating bubbles, why are lending standards falling? One potentially ominous answer might be that there is increased competition for the banks from the shadow banking system and that official data fail to capture the full extent of the lending activity now taking place.
While there may be something in that, a simpler explanation is that the banks are also in competition with the capital markets. And these markets are awash with excess savings. As well as the huge surpluses of savings over investment currently being generated in Asia, the eurozone has emerged as a net saver since the crisis. Taken in conjunction with the bond buying programmes of the central banks, this has caused a further round of yield compression as financial institutions search for yield with a diminishing regard for risk.
The implication is that while a financial crisis is not imminent, the seeds of one are being sown in the way described by Hyman Minsky, the great theorist of capital market instability. The bubbles will come in due course. And an interesting take on potential vulnerabilities comes from the Institute of International Finance, a club of leading global banks. The IIF argues that as well as monitoring the credit to GDP ratio, it makes sense to look at the asset to GDP ratio.
Using this metric, it finds that the asset to GDP ratio shows a large positive deviation of 9 percentage points from its long-term trend in the G7. This highlights the risk that unless growth accelerates significantly in the future, economic growth may not create sufficient resources to service the developed world’s huge pool of assets, whose value will therefore have to correct at some point.
The decline in secondary market liquidity due to the reduction in the banks’ market making capacity since the crisis could, the IIF warns, magnify a bond market correction, making it disorderly and contagious. Volatility would return with a vengeance.
The IIF’s warning feeds into existing concerns about the impending normalisation of monetary policy and of central bank balance sheets in the US and UK. The only (faintly) reassuring thing about this particular systemic risk is that macroprudential policy makers are well aware of it.
The writer is an FT columnist
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