Draghi’s Calm Markets Sparking Concern of German RisksEshe Nelson, Neal Armstrong and John Glover
The European Central Bank’s unprecedented effort to fend off the threat of deflation has brought volatility in financial markets to a standstill. Policy makers aren’t so serene.
Price swings in euro-area bonds and equities have collapsed, borrowing costs for the riskiest issuers reached record lows and Cyprus accessed funding markets just a year after receiving a bailout. Rather than congratulate ECB President Mario Draghi, officials from Britain to the Bundesbank say persisting with the easing policy for too long may store up trouble.
“There’s a general discussion of whether investors are getting too complacent about risks,” said Allan von Mehren, chief analyst at Danske Bank A/S in Copenhagen. “At some point we are likely to reach levels that could not give proper compensation for the risk people are taking. This is similar to what happened ahead of the financial crisis.”
The unease underscores the challenge for Draghi as he and fellow policy makers attempt to revive lending in the economy without unduly inflating asset prices or enabling governments to ease up on plans to cut their deficits. A monetary policy just for Germany would set interest rates at 4.65 percent, according to a Taylor Rule model compiled by Bloomberg, versus minus 10.75 percent for Spain or minus 19.25 percent for Greece.
The ECB cut its benchmark interest rate to a record 0.15 percent at this month’s meeting and became the first major central bank to charge for overnight deposits. That sent the one-week Eonia swap rate to a record-low 0.003 percent on June 16, according to ICAP Plc data, signaling banks were willing to make loans at almost no cost for the borrower, rather than pay the ECB’s penalty charge. The overnight index fell to a record-low 0.01 percent yesterday.
Instead, cash is pouring into fixed-income markets. The average yield on euro-area government bonds fell to an all-time low of 1.3392 percent on June 9, from as high as 4.28 percent in November 2011, according to Bank of America Merrill Lynch’s Euro Government Index. Yields on bonds from Europe’s riskiest borrowers matched a record-low 3.46 percent on June 10, according to its Euro High Yield Constrained Index.
“This low-interest-rate environment, as much as it’s appropriate at this point in time, over a medium and longer period of time is kind of worrisome, especially in a German environment,” Bundesbank board member Andreas Dombret said in a Bloomberg Television interview with Haslinda Amin in Singapore yesterday. “We’ve seen in other countries this has led to housing bubbles so this is something we have to watch closely.”
German home prices rose 4.2 percent in the first quarter from a year earlier, according to an index published last month by the VDP Association of German Pfandbrief Banks, extending the country’s housing boom into a fourth year. Consumer prices in the euro area rose an annualized 0.5 percent in May, matching the slowest pace in more than four years, according to the European Union’s statistics office in Luxembourg.
“Naturally in Germany, as a result of low interest rates and low inflation, there are signs especially in the real-estate market of price developments that are dangerous,” German Finance Minister Wolfgang Schaeuble said yesterday at a joint news conference with U.S. Treasury Secretary Jacob J. Lew in Berlin. At the same time, the euro “is no longer a source of anxiety for financial markets,” he said.
There’s too much liquidity in financial markets and any excess should be reduced, Schaeuble said in Luxembourg today.
Extraordinary stimulus measures from central banks around the world are helping deaden price swings across markets. JPMorgan Chase & Co.’s Global FX Volatility Index fell to 5.51 percent yesterday, the least on record. Implied volatility, a measure of future price swings, tumbled to 4.11 percent for German bund futures as of 2:07 p.m. London time, the lowest since at least 2011, according to data compiled by Bloomberg.
The VStoxx Index, a measure of euro-area stock-market volatility, fell to 12.71 percent yesterday, the lowest close since 2006. The Stoxx Europe 600 Index of equities closed on June 10 at the highest level since January 2008.
“Many investors are putting low volatility equal to low risk,” said Dombret, who is a member of the ECB supervisory board for the Single Supervisory Mechanism that oversees banking policy. “That just may not be the case and things may change. It’s quite important to be hedged and not assuming that this low volatility will stay forever.”
Average yields on the riskiest bank bonds are close to records, with additional Tier 1 debt yielding 5.95 percent, after falling to a record 5.80 percent also on June 10, Bank of America’s High Yield Contingent Capital Index shows. The securities, which have no final maturity, are designed to convert to equity or be written down in a crisis, while interest payments are optional.
Downturns in the credit cycle typically are preceded by investors demanding “extraordinarily narrow” premiums over government debt to hold high-yield bonds, John Lonski, Moody’s Capital Markets Research Group’s chief economist, wrote in a research report yesterday.
Spreads on junk bonds in euros are now 301 basis points, close to seven-year lows, Bank of America index data show. That compares with an average of 783 basis points for the past seven years, and with an average of 660 basis points for the seven years through June 19, 2007, the index shows.
With interest rates and inflation subdued, international investors are returning to the sovereign bonds they snubbed as the euro-area debt woes threatened to fracture the currency union in 2011 and 2012. The extra yield investors get for holding Spanish 10-year bonds instead of benchmark German bunds touched 1.16 percentage points on June 10, the lowest since May 2010. Spain’s yields are below those of similar-maturity U.K. gilts and last week reached parity with U.S. Treasuries.
“Something’s not quite right; some investors are too sanguine to think Spain is the same riskiness as the U.K.,” Kristin Forbes, a professor at the Massachusetts Institute of Technology, who will join the Bank of England’s Monetary Policy Committee next month, told lawmakers at her appointment hearing in London this week. Policy makers need to take to the “bully pulpit” to “remind investors there is going to be a change in interest rates at some point in the future,” she said.
For now, borrowers are taking advantage of the tumbling interest rates. Cyprus returned to international markets when it raised 750 million euros ($1.02 billion) in a sale of five-year notes two days ago. Greece’s Eurobank Ergasias SA raised 500 million euros in a sale of four-year bonds rated Caa2 by Moody’s Investors Service yesterday, paying a coupon of 4.25 percent.
The challenge for Draghi, whose policies helped conquer the debt crisis, will be in the timing of the eventual withdrawal of monetary stimulus.
“Stronger growth and very low rates creates a clear risk of asset bubbles, which needs to be addressed and monitored,” said Danske Bank’s von Mehren. “The thing is all investors end up being long these assets and when the tide turns we all have to get out the same assets at the same time. And then it gets crowded by the door.”