5 ways rising rates could disrupt financial markets – POLITICO

It’s the end of an era of accommodative monetary policy — and financial markets.

Since the financial crash of 2008, central banks have pumped huge sums of money into the financial system and kept interest rates at record highs to stimulate the economy. These floor rates underpinned the dogma and logic of investors as they turned to riskier investments in search of higher returns.

The economic shock of the COVID-19 pandemic has heightened the need for easy and cheap money, while businesses and households have locked down and then reopened.

Today, the pandemic disruption of global supply chains and the impact of Russia’s war in Ukraine on energy and food markets has unleashed economic strength unseen in much of the world since the 1970s: inflation.

As prices soar, many central banks are aggressively raising rates while turning off the stimulus spigots in an attempt to rein in prices. The European Central Bank is expected to join this trend next week by raising rates for the first time in over a decade.

This need for tightening has major implications for the stability of the financial system.

Alex Brazier, Deputy Director of the BlackRock Investment Institute, said he expects this new environment to bring further volatility to investors as central banks struggle to find a trade-off between fighting inflation and promoting growth.

“We are in a period, anyway, of a combination of higher inflation than we were used to in the past or weaker and more volatile growth than we were used to in the past,” he told POLITICO.

While there isn’t a dramatic shift from a low interest rate environment to sky-high rates, Brazier, a former Bank of England policymaker, said volatility could dampen investors’ appetites. investors for riskier assets.

“It reminds us that higher returns often come with higher risk,” he said.

The recent dramatic fall in the price of crypto assets – which has yet to trickle down to the mainstream financial system – shows how quickly sentiment can change.

“To the extent that certain businesses, like crypto assets, were actually becoming very popular due to a hunt for yield, due to the persistence of a low interest rate environment, the future may be different” , Klaas Knot, chairman of the Financial Stability Board, told reporters on Tuesday.

As prices soar, many central banks are aggressively raising rates while turning out of stimulus taps in an attempt to rein in prices | Kevin Dietsch/Getty Images

These risks have prompted financial authorities to closely monitor parts of the markets that may be vulnerable to the changing environment. POLITICO unpacks the five risks at the top of their minds.

piles of debt

Households, businesses and governments have taken on debt amid historically low interest rates and the economic challenges of the pandemic. This has raised concerns about higher servicing costs as interest rates rise, and has already prompted a sell-off in credit markets and spikes in Italian government bond yields.

Banking supervisors fear that these pressures will also increase the amount of debt on lenders’ balance sheets. The European Central Bank has warned banks to look carefully at sectors vulnerable to pressures from soaring energy and food prices.

The Bank of England has also warned that debt pressures are getting worse for households, businesses and governments.

“These higher prices, weaker growth and tighter financing conditions will make it harder for households and businesses to repay or refinance their debt,” the BoE warned in its semi-annual financial stability report. “Given this, we expect households and businesses to become more strained over the coming months. They will also be more vulnerable to further shocks.

Similar warnings have come from the ECB, which has repeatedly pointed to highly leveraged market segments – such as leveraged loans – where the appetite for loans has been fueled by the search for yield.

Shadow bank

Following the failure of hedge fund Archegos, which collapsed due to high leverage bets on certain stocks that turned sour, financial authorities have been examining the “hidden leverage” lurking in the system – namely, the ways in which an entity can appear financially healthier than it really is when you add up its derivatives.

That’s near the top of the list for the FSB, which outlined its concerns in a letter to G20 finance ministers this week.

The authorities are also concerned about the rise of “shadow banking” and the role that non-banks, such as investment funds, could play in spreading risk in the financial system. The behavior of money market funds at the start of the pandemic only added to these fears.

“Potential vulnerabilities arising from liquidity mismatches and hidden leverage in non-bank financial intermediation (NBFI) persist,” FSB Chairman Knot warned in the letter.

Housing markets

Decades of historically low interest rates have also helped fuel rising property prices in many European countries. Now there are fears that these bubbles will burst.

The European Commission warned in an April report that rising house prices could create the risk of a correction. “Building medium-term vulnerabilities in EU residential property markets warrant continued close monitoring by national and European authorities, as housing and credit booms and busts have triggered banking and financial crises major events in the past,” wrote the EU executive. .

The Commission said the risks of a crash were lower than at the start of the 2008 financial crisis, partly due to stronger bank balance sheets. But a wider concern among economists is that the cost of living crisis and rising rates could put the brakes on, as borrowers become less likely to stretch their finances for a new home.

Goods

Russia’s invasion of Ukraine has triggered wild movements in commodity prices – impacting clearinghouses as they seek more liquidity from banks to cover increasingly risky positions, a process known as “margin calls”.

The concern of the authorities is that these calls for funds can put real pressure on the financial actors who must quickly constitute the guarantee, and can have a direct impact on the energy sector and the economy at large.

These pressures contributed to the recent turmoil in nickel markets on the London Metal Exchange, again raising concerns about the lack of transparency about risky positions lurking beneath the surface in some markets.

With another potential spike in energy prices looming this fall, the FSB is working to identify vulnerabilities in commodity markets and assess how these might spill over to the rest of the financial system.

Accident?

Perhaps most worryingly, financial watchdogs are mounting warnings that certain areas of the market could be vulnerable to a dramatic shift in sentiment. In other words, a crash.

A brutal and widespread stock market crash remains a “serious risk”, warned the European Systemic Risk Board at the end of June. The EU’s financial system watchdog noted that asset price declines have so far been orderly – but that’s only because equity markets, more broadly, are optimistically pricing in a contained impact from the war in Ukraine on global growth, as well as central banks controlling inflation in the medium term.

If these assumptions do not hold, “the materialization of tail risk scenarios could … pose a risk of further widespread and possibly sharp corrections in asset prices,” the Frankfurt-based body said.

Still, the FSB’s Knot, who also heads the Dutch central bank, isn’t particularly concerned about a “sudden” change in sentiment, as central banks clearly signal any change in policy.

“So far…the adjustment has been relatively smooth,” he said. “And as long as that’s the case, then financial players should have time to think ahead.”