After years of fire and brimstone sermons, also known as the Bank of International Settlements’ annual reports delivered with doom and gloomy aplomb by Jaime Caruana, who year after year warned about the adverse side-effects of central bank intervention, today the BIS released its most upbeat reports in years, in which it praised the recent rebound in global growth and predicted that GDP may soon revert to long-term average levels after the sharp improvement in sentiment over the past year.
Or maybe not, because even as talk of a “global coordinated rebound” continues, it has once again rolled over, with the US economy barely growing above stall speed, while the BIS explicitly notes that “despite the best near-term prospects for a long time, paradoxes and tensions abound” among these are the VIX…
Financial market volatility has plummeted even as indicators of policy uncertainty have surged.
… and the record disconnect between equities and bonds.
Stock markets have been buoyant, but bond yields have not risen commensurately.
Meanwhile, optimism – at least as measured by various sentiment surveys such as the PMI and consumer confidence, is the highest since the financial crisis even as globalization, “a powerful engine of world growth, has slowed and come under a protectionist threat.”
While praising the recent economic rebound, the BIS notes that the main theme of this year’s Annual Report is the “sustainability” of the current expansion, specifically “What are the medium-term risks? What should policy do about them? And, can we take advantage of the opportunities that a stronger economy offers?”
Of particular focus are the following four main risks (aside from geopolitical) listed by the BIS that could undermine the sustainability of the upswing.
- First, a significant rise in inflation could choke the expansion by forcing central banks to tighten policy more than expected. This typical postwar scenario moved into focus last year, even in the absence of any evidence of a resurgence of inflation.
- Second, and less appreciated, serious financial stress could materialise as financial cycles mature if their contraction phase were to turn into a more serious bust. This is what happened most spectacularly with the Great Financial Crisis (GFC).
- Third, short of serious financial stress, consumption might weaken under the weight of debt, and investment might fail to take over as the main growth engine. There is evidence that consumption-led growth is less durable, not least because it fails to generate sufficient increases in productive capital.
- Fourth, a rise in protectionism could challenge the open global economic order. History shows that trade tensions can sap the global economy’s strength
Conveniently, just yesterday we reported that as Goldman noted on Friday. virtually every post-WWII recession was caused by the Fed’s reaction to a spike in inflation (usually in the commodity sector), which itself may have been prompted by aggressively easy monetary conditions by central banks during the prior cycle. Separately, Citi discussed just how late stage the current cycle, showing that according to pair-wise correlations, a recession may be imminent.
As for the BIS, this is how it summarizes the overarching threats:
[P]olicy tightening to contain an inflation spurt could trigger, or amplify, a financial bust in the more vulnerable countries. This would be especially true if higher policy rates coincided with a snapback in bond yields and US dollar appreciation: the strong post-crisis expansion of dollar-denominated debt has raised vulnerabilities, particularly in some emerging market economies (EMEs).
On the topic of surging rates, one has to keep in mind the amount of dollar-denominated EM credit: from 2009 to end-2016, US dollar credit to non-banks located outside the United States – a bellwether BIS indicator of global liquidity – soared by around 50% to some $10.5 trillion; for those in EMEs alone, it more than doubled, to $3.6 trillion.
But an even greater problem than an “inflationary spurt” facing the Fed, is the record global debt overhang: should Yellen et al hike rates too fast, the debt pyramid could implode under its own weight as debt service costs explode.
An overarching issue is the global economy’s sensitivity to higher interest rates given the continued accumulation of debt in relation to GDP, complicating the policy normalisation process (Graph I.1). As another example, a withdrawal into trade protectionism could spark financial strains and make higher inflation more likely. And the emergence of systemic financial strains yet again, or simply much slower growth, could heighten the protectionist threat beyond critical levels.
Charted, global debt has continued to climb to new all time highs…
While predictably rates and yields have declined to never before seen levels:
And yet, despite these great, latent risks, mostly due to high debt levels, low productivity growth and dwindling policy firepower, according to Reuters the BIS said central banks should take advantage of the improving economic outlook and its surprisingly negligible effect on inflation to accelerate the “great unwinding” of quantitative easing programs and record low interest rates. Of course, if the “improving conditions” are a result of central bank policies, this intervention will be very brief.
New technologies and working practices are likely to be playing a roll in suppressing inflation, it said, though normal impulses should kick in if unemployment continues to drop. “Since we are now emerging from a very long period of very accommodative monetary policy, whatever we do, we will have to do it in a very careful way,” BIS’s head of research, Hyun Song Shin, told Reuters.
Shin, one of the more rational voices within the BIS, said that “if we leave it too late, it is going to be much more difficult to accomplish that unwinding. Even if there are some short-term bumps in the road it would be much more advisable to stay the course and begin that process of normalization.“
It may be too late: as Citi’s Matt King warned, the moment normalization officially begins – and is no longer just a bluff – markets will flounder. Which is why Shin added that it will be “very difficult, if not impossible” to remove all the central bank “bumps.”
Ironically, the biggest question in the report was one that was not explicitly stated: how long can the Fed tighten before the next recessions sends rates crashing back to zero if not negative, and unleashes even more QE. or as Reuters puts it, the BIS report added that the lack of clarity over inflation also makes it far harder to judge how far rates could go up before they start coming down again.
“In practice, therefore, central banks have little alternative but to move without a firm end-point in mind,” the report said, another way of saying they are flying blind.
Finally, the report discussed the growing threat of protectionism, perhaps the most dangerous of the four main risks it identified. In a sidebar to the main report, the BIS said estimated that if 10% tariffs were put on imports from Mexico or China, U.S. labor costs would have to drop by about 6% to compensate for the higher costs of “imported inputs.” Translated: crashing wages, and political upheaval once globalization goes into reverse in earnest.
the BIS simulation “reveals a comparatively large sensitivity of US production costs to tariffs on imports from Mexico or China. To put the resulting cost shocks in context, the centre panel of Graph III.B displays the reduction in US wages that would be required to fully compensate for the increasing costs of imported inputs. For example, such tariffs would lead to a 0.86% cost increase in the US transportation industry. To fully offset this increase, US labour costs would have to decrease by around 6%, satisfying 0.86% – 6% * 0.14 ? 0, where 0.14 is the labour cost share in the US transportation equipment industry.”
For some of the largest emerging markets there were also concerns about dollar debt and protracted credit expansion, often alongside rising property prices, storing up risks. Low interest rates, though, have generally kept debt-service ratios below critical thresholds.
“The policy challenge is to take advantage of the current tailwinds to put the expansion on a sounder footing,” said Claudio Borio, head of the BIS monetary and economic department. “First and foremost, that requires building resilience, domestically and globally.”
One piece of advice: record high stock prices and record low volatility as a result of what Citi called “forced buying”, which is also known as “buying without conviction”…
… is exactly the wrong way to go about “building resilience.”
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