In what some have dubbed a repeat of Greenspan’s “irrational exuberance” description of the dot-com bubble in the 1990s, this morning the ECB warned in its Financial Stability Review (in which it used the word “exuberance” at least 8 times), that the euro-area faces “elevated” risks to financial stability as it emerges from the pandemic with high debt burdens and “remarkable exuberance” in markets as bond yields rose. The stark warning, first reported by Bloomberg, sent risk asset reeling and cryptocurrencies tumbling and highlights mounting concerns that the flood of fiscal and monetary stimulus needed to fight the crisis is also building up dangerous imbalances.
If more upward surprises in U.S. inflation prompts investors bet on earlier monetary tightening, driving up bond yields without an accompanying improvement in economic growth, “spillovers from U.S. equity market repricing could be substantial,” the ECB said.
“A 10% correction in U.S. equity markets could therefore lead to a significant tightening of euro-area financial conditions, similar to around a third of the tightening witnessed after the coronavirus shock in March 2020,” the ECB warned said lamenting the trillions in debt added in response to the covid pandemic.
The euro zone is vulnerable to such spillovers because, like most countries, it has built up significantly higher debt during the crisis. Rising yields would depress bond prices and weaken balance sheets at the region’s banks — which have long suffered from feeble profitability. The ECB also said the uneven economic impact of the pandemic means financial stability risks are likely to materialize in sectors and countries with higher pre-existing vulnerabilities.
The table below summarizes some of the key risks the ECB sees for financial stability.
The ECB has been left picking up the pieces from surging US inflation, having been forced to step in earlier this year when rising U.S. bond yields drove up borrowing costs across the globe. Officials ramped up the pace of asset purchases, arguing that the region wasn’t yet ready for higher borrowing costs as its recovery has been hindered by a slower start to vaccinations. It will review that decision next month.
And while the Fed has also rebuffed suggestions of imminent tightening, last night we cautioned that banks are running out of space to hold the Fed’s reserves which means that it is only a matter of time before the Fed itself will have to taper sooner rather than later. U.S. consumer prices rose in April by the most since 2009, prompting officials to drive home the message that current spikes are likely to be transitory.
Finally, with the ECB planning its own digital currency it had to launch a warning shot at its biggest competitor, bitcoin, noting “exuberance” in crypto-assets, stating that “the surge in Bitcoin prices has eclipsed previous financial bubbles like the ‘tulip mania’ and the South Sea Bubble in the 1600s and 1700s.”
Still, it concluded that with such assets not widely used for payment, and with banks having limited exposure, the financial stability risks “appear limited at present.”
The ECB highlighted other risks facing the bloc’s economy, including slack in the labor market and subdued investment which could lead to a sluggish recovery. It also included a new analysis of climate-related risks, which affect a “significant share” of bank loans to companies, it said.
“We are optimistic that financial and economic conditions will bounce back,” ECB Vice President Luis de Guindos said in the report. “There is, however, a reality that the pandemic will leave a legacy of higher debt and weaker balance sheets, which — if unaddressed — could prompt sharp market corrections and financial stress or lead to a prolonged period of weak economic recovery.”
Source : https://www.zerohedge.com/markets/ecb-warns-elevated-financial-stability-risks-amid-remarkable-exuberance