Are We Sleep Walking Into Another Financial Crisis?

Referring to economics in the mid 1800’s as the “dismal science”, Scottish philosopher Thomas Carlyle coined the phrase in response to the economics profession’s lack of defence of slavery in the West Indies. According to Carlyle, the optimum level of labour in the economy should be a combination of market forces plus coercion. 
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Given the backdrop to the dismal science tag, therefore, the criticism of economics seems misplaced and harsh to say the least. 200 years later the tag remains, however, aimed mainly at economist's regular failure to predict market crashes and recessions.

Predicting such events with any level of accuracy is often challenging. There's a sense, nonetheless, that all is not right in financial markets despite recent optimism in the global economy.

The exiting of Ulster Bank and KBC from the Irish market earlier this year is a symptom of a larger issue. This isn’t unique to Ireland either. Over the last decade, approximately 2,000 banks in the eurozone have disappeared. 

Aside from tougher regulatory rules imposed by central banks since 2008, the prolonged period of low interest rates is likely the main reason. Lower rates are designed to make lending more affordable to stimulate consumption and investment and therefore boost economic growth.

When the central bank reduces rates, reserves held at the central bank by commercial banks earn less interest. So AIB or Bank of Ireland, for instance, have a choice. Leave their cash on deposit earning less interest or go out and lend to businesses and households at cheap rates.

Both scenarios reduce bank’s profitability. In some countries like Germany, interest rates have turned negative meaning borrowers don’t repay the full capital being borrowed. Since banks hold government bonds as assets on their balance sheets, lower yields affects their capital structures and thus their ability to create loans. 

Figures released by the European Central Bank in August 2021 show that private sector lending to SME’s in the Eurozone is at the same level as 2015. So at very low interest rates, banks have been reluctant to increase lending. Without lending, consumption and business investment falls. During the business cycle of 2010-2020, average GDP growth was just 2% in the US and Euro area.

While consumer demand has rebounded strongly since lockdowns this year, it is likely that demand will naturally fall away again in 2022. The next business cycle post-Covid could follow similar trends of low GDP growth unless interest rates rise and credit to the private sector increases for sustained periods of time.

The problem facing the global financial system, however, is that interest rates can’t rise without serious repercussions to financial markets. Globally, combined public and private debt levels since the banking crisis in 2008 and Covid-19 are now three times the size of national output. For every dollar earned, $3 are owed. Higher debt servicing for governments and corporations greatly increase the risk of defaults. As a consequence, central banks are artificially suppressing interest rates and buying more debt. How long can this continue?

Low interest rates have also caused large asset bubbles to form in financial markets. Instead of lending to the real economy, banks chase higher yields by purchasing riskier assets. The spread between safer government bonds and junk bond have thus narrowed.

Share buybacks by large corporations exacerbate the problem. As cheap money continues to flow into markets, banks and retail investors use leverage to speculate, driving up share prices further. Holders of these pricey assets, many heavily leveraged, are badly exposed to any corrections in the markets.

Acutely aware of this, central banks need to keep interest rates low to avoid a systematic collapse. Currently the Federal Reserve Bank of America (The Fed) is purchasing $120 billion of bonds and mortgage backed securities every month to keep long duration bonds from rising. Even if investors sell out of their assets and yields rise, the Fed and the ECB repurchase them on secondary markets. Bond prices go up and yields fall again.

How healthy are markets when assets are artificially supported like this? How can risky junk bonds trade at similar yields as investment-grade bonds? How is it that historically high unemployment rates are followed by record highs in equities? What’s causing currencies in emerging markets to strengthen during an economic crisis as large as the Covid pandemic? 

Many analysts worry that should this regime continue long term, the bond market could run out of willing buyers. Overpriced negative yielding bonds are a poor investment. So as governments and corporations issue more debt, demand for these low yielding bonds falls causing prices to collapse and the bubble to burst. Although reluctant to do so, the central banks may be forced to start tightening monetary conditions and allowing rates to rise in order to encourage investors back into the market. This wont come without the risk, however. 

While higher interest rates make newly issued bonds more attractive to investors, existing bond prices collapse in value. If inflation continues to rise, central banks may be forced to raise rates either way. Ironically, economic growth could crash the stock market.

So it seems that central banks are stuck between a rock and a hard place trying to avoid both inflation and higher rates. Investors will be watching very closely how the Fed and ECB taper monetary policy over the next few months, given how strongly economies have rebounded.

When the economy is growing and jobs are plentiful the risk of complacency grows and people get blind sided. The economic growth and housing bubble prior to the Great Financial Crisis in 2008 is a good example of this. Most people don’t follow markets or pay any attention to things like interest rates, bonds or central banks. Understandably, there’s now a great sense of optimism from consumers and business as the economy rebounds back to life - just as there was in 2008 prior to the crash. And as we know, that all changed overnight. 

While Irish banks are better capitalised and stress tested since the banking crisis, the global financial system is careening down another potential dead end and very few are talking about it.

​The markets have become addicted to low rates and debt - and cheap cash injections are only a quick fix. Sooner or later cold turkey becomes the only alternative as the patient either refuses another hit or the doctor refuses to administer the drug. It could be next month, it could be two years away, but a significant correction in the market seems inevitable.

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