ECB headquarters
The European Central Bank’s twice-yearly financial stability review says markets are vulnerable to higher-than-expected inflation and rising interest rates © REUTERS

Increased “exuberance” in housing markets, junk bonds and crypto assets have created vulnerabilities that will be exposed if higher than expected inflation leads to a sharp rise in interest rates, the European Central Bank has warned.

This year’s rebound in the eurozone economy from the coronavirus pandemic has reduced short-term risks to the financial system, but it has also led to a build-up of longer term risks, the ECB said on Wednesday in its twice-yearly financial stability review.

“Concerns particularly relate to pockets of exuberance in credit, asset and housing markets as well as higher debt levels in the corporate and public sectors,” the ECB said.

Rising inflation and falling real interest rates have prompted investors to take greater risks in their search for yield, which has left parts of the property, debt and crypto asset markets “increasingly susceptible to corrections”, it warned.

“A correction in markets could be triggered by a weaker than expected economic recovery, spillovers from adverse developments in emerging market economies, a re-intensification of stress in the non-financial corporate sector or abrupt adjustments in market expectations regarding the prospective path of monetary policy normalisation,” it said.

Eurozone inflation rose to a 13-year high of 4.1 per cent in October, well above the ECB’s 2 per cent target. The central bank, however, has predicted inflation will fall back below its target in the next few years and said it did not expect to raise rates next year.

But it noted on Wednesday there was “a risk that recent strains in global supply chains and the spike in energy prices could have longer-lasting effects on inflation than expected”.

The ECB’s warning has echoes of how former US Federal Reserve chairman Alan Greenspan described the dotcom bubble of the 1990s as “irrational exuberance”. Luis de Guindos, vice-president of the ECB, told reporters that he did not think markets were irrational, but he said “it is a risk” because the current low interest rate environment will “not be there forever”

EU house prices increased 7.3 per cent year on year in the second quarter, the fastest rise since just before the 2008 financial crisis. The ECB said there were “growing signs of overvaluation” that left many European housing markets “prone to a correction” and warned of a “deterioration in lending standards”.

It said these developments “strengthened the case” for national authorities to introduce more “macroprudential policy measures”, such as limits on bank lending or higher capital requirements on mortgages.

The ECB said “more exotic market segments, such as crypto asset markets, also remain subject to speculative bouts of volatility”. It also expressed concern about interlinkages between conventional financial markets and stablecoins, a type of cryptocurrency that is nominally pegged to underlying assets to limit price fluctuations.

Rapid growth in the size and usage of stablecoins “call for urgent implementation of regulatory, supervisory and oversight frameworks”, it said.

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The ECB said the non-bank financial sector “continues to face elevated credit risk” owing to increased investments in riskier “junk bonds” that are rated below investment grade. It added: “Were bond yields to rise, valuation losses could trigger outflows from investment funds which — when coupled with the low liquidity buffers — could force bond funds to liquidate assets to meet investor redemptions.”

The central bank said its own ultra-loose monetary policy, under which it cut interest rates deep into negative territory and bought trillions of euros of bonds, had increased “incentives to engage in more risk-taking which could become excessive and lead to the build-up of systemic risk”.

However, it said the main tools for tackling these risks were macroprudential rules rather than “leaning against the wind” by tightening monetary policy more than is needed to achieve its inflation target.

Earlier this month, the US Federal Reserve warned that stresses in the Chinese real estate sector caused by financial difficulties at heavily indebted property group Evergrande “posed some risk to the US financial system”. But the ECB played down these worries, saying: “So far, the impact on global growth projections and financial markets has been limited, as foreign exposure seems relatively small.”

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