ECB Says Low Interest Rates Aid Debt Resilience But Risks Remain

Updated on
  • Central bank publishes twice-yearly Financial Stability Review
  • Low volatility, high asset prices at risk of abrupt reversal
Constancio about the euro-area economy, cryptocurrencies, asset values and Brexit.

The euro area’s strengthening recovery and monetary stimulus are making national debt burdens more sustainable, though the risk remains that political uncertainty could cause yields to spike abruptly, the European Central Bank said.

The Frankfurt-based institution said in its twice-yearly Financial Stability Review that stress in euro-area sovereign-bond markets has declined to levels seen before the financial crisis. The favorable developments were likely underpinned by reduced economic policy concerns in Europe following national elections in major countries, and a continuation of the ECB’s monetary support.

Read more: Draghi’s Right, Rich and Poor Euro Nations Getting More in Sync

Even so, it said that “higher interest rates may trigger concerns about sovereigns’ debt-servicing capacity,” and noted that “distrust in mainstream political parties continues to rise, leading to fragmentation of the political landscape away from the established consensus.”

The ECB’s cautiously optimistic outlook comes against the background of the fastest economic growth in a decade for the euro area, bolstered by the prospect of continued monetary support. At the same time, it’s a reminder that the central bank’s recent decision to slow its bond-buying may be the beginning of the end for ultra-loose monetary policy.

Market Vulnerability

“It is much more unlikely that sources of financial instability would come from the euro area itself,” ECB Vice President Vitor Constancio told Bloomberg Television’s Matt Miller in an interview. “We don’t have in the euro area a generalized situation of overstretched valuations in asset markets. It’s not to be expected, that with things going as they are, that this would be then the part of the world where instability could come.”

The stance compares with concerns about investor complacency raised by Germany and Sweden in their own reports on financial stability earlier on Wednesday.

“Market participants have become more vulnerable to unexpected developments,” Bundesbank Vice President Claudia Buch said. “Risks stemming from revaluations, changes in interest rates and credit losses could materialize simultaneously and reinforce each other.”

Sweden’s Financial Supervisory Authority remarked that a strong economy and low interest rates create the conditions for an “abrupt” increase of yields of over-valued assets, especially in the real-estate sector.

The ECB also noted that a sudden repricing in global markets remains one of the three key “medium-level systemic risks,” together with the low profitability of euro-area banks, and public and private debt sustainability in some countries. None of these risks has increased since the last report in May.

Source: ECB

The Organization for Economic Cooperation and Development said on Tuesday that markets are vulnerable to a sudden increase in volatility and the risk of a repricing of global assets remain “significant,” especially as monetary stimulus is withdrawn.

Divergence among global central banks could be a source of tension in financial markets in the coming months. While the Fed is expected to raise interest rates four times by the end of next year and has started shrinking its balance sheet, the ECB has committed to keep rates unchanged and to reinvest maturing bonds well into 2019.

“While the economic expansion is expected to sustain momentum at both the euro area and global levels, the cyclical upswing may be put to the test by the potential adverse ramifications of increasingly divergent monetary policies across major advanced economies,” the ECB said.

The ECB’s report comes as other central banks across Europe home in on the threats hiding behind the scenario of solid recovery and subdued volatility.

The Bank of England, which published its own Financial Stability Report on Tuesday, warned that a messy divorce with the European Union would disrupt the financial system and the economy.

Yet Brexit was given only a passing mention in both the ECB and the Bundesbank reports.

“The U.K.’s decision to withdraw from the EU could have adverse financial stability implications for the euro area, but the risk that access to wholesale and retail financial services would be materially restricted for the euro area economy appears limited,” the ECB said.

In Denmark, which published the results of bank stress tests, the central bank said lenders’ capital buffers would be too thin in case of a severe recession.

At the ECB, the banking sector also continues to be a key concern.

“Profitability challenges remain,” it said. “In some regions, profitability prospects are still dampened by large stocks of non-performing loans.”

— With assistance by Boris Groendahl, Nicholas Comfort, and Piotr Skolimowski

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