Prepare for the emergence of negative market feedback cycles as global monetary stimulus is removed …
As the good relaxation the global monetary stimulus is gaining ground, markets are at increased risk of experiencing catastrophic loops. Investors must be prepared for this downward spiral, where shocks trigger a series of self-sustaining disturbances.
There are five loops that feed each other in the event of a financial crisis.
The collateral warranty loop.
Declines in the value of equities, bonds, real estate or derivatives linked to them trigger margin calls. These guarantee requests absorb cash or require the liquidation of assets, transmitting pressure even to previously unallocated securities. Constraints are magnified when liquidity is constrained, causing further falls. This results in losses, a reduction in capital reserves and a tightening of liquidity. The cycle is repeated until a price equilibrium is reached.
The cover loop.
Declining asset values cause investors to hedge by selling short or buying put options for insurance purposes. When market conditions are volatile or when operators can not buy or sell the underlying asset, they use agents such as different securities, currencies or commodities. This creates contagion. The cuts force banks to sell more to cover their exposure to the options they sold. For example, the recent drop in oil prices has been exacerbated by intermediaries covering put options purchased by American shale oil producers. This intensifies price pressures and absorbs the capacity of the commercial market.
The sovereign loop.
Changes in sovereign risk led to a negative price spiral because of the links between governments, central banks and commercial lenders, which accelerated the crisis.
Since 2007, purchases of government securities by banks have increased. This reflects the regulatory requirements for larger cash reserves. Banks have strengthened their holdings to provide a guarantee for their exposure to derivatives transactions. At the same time, quantitative easing programs have encouraged institutions to borrow cheaply from central banks and to invest in higher-yielding government bonds. Banking regulations treat public debt in a substantially risk-free manner and do not require capital held for assets, which increases the return on equity. The disadvantage is that when rates rise and debt prices fall, banks suffer losses. Government support may be required to maintain solvency and operational viability, placing greater pressure on the sovereign.
This problem is particularly important in Europe. Italian banks hold almost 400 billion euros (457 billion USD) of domestic sovereign debt (10% of their total assets). Potential exposures are larger than the equity of some Italian lenders. Recent increases in the yield on Italian government bonds – reflecting larger-than-expected budget deficits, the end of the European Central Bank's quantitative easing program and domestic political instability – have compounded the problems of financial institutions already heavily debt.
The sovereign loop also affects central banks holding large holdings of government bonds purchased as part of quantitative easing programs. When US Treasury rates rose sharply in 2013 during the so-called crisis period, the Federal Reserve, then presided over by its chairman Ben Bernanke, had recorded market value losses of more than $ 50 billion. on his securities portfolio. The stress tests applied to banks have suggested that the Fed could face estimated losses of between $ 200 and $ 400 billion. Although central banks can not technically go bankrupt, losses that reduce or cancel capital reduce confidence in the currency and increase sovereign risk. This can make it difficult for a central bank to perform its functions and support the financial system.
The intermediate loop.
Banks help spread feedback loops. Disturbances absorb liquidity and reduce available credit. The weakness of a bank raises the concerns of other national and foreign institutions exposed to the entity. Sovereign risk increases as markets assume the underwriting of the financial system by governments. This initiates a continuous cycle of increasing banking risk, fueling the increase in sovereign risk.
Decreases in loans and interbank transactions limit liquidity. The instability of the financial system increases as traders reduce their relationships, saving capital and liquidity. Banks use cautious market prices, exacerbating price declines and causing margin calls. More rigorous counterparty risk management reduces credit limits and requires additional security, thereby fueling the guarantee loop. Counterparty risk hedging exacerbates tensions on liquidity and prices. Losses increase and liquidity contracts.
The need for yield and the recovery of stock prices have attracted a new generation of investors in the actions of banks that ignore the lessons of 2008. The losses could force banks to reduce their dividends. This reduces investor income and can lead to massive sales, hampering banks' ability to raise new capital and worsening the crisis. Such dynamics also feed sovereign, collateral and hedging sovereign loops.
The loop of the real economy.
Limiting bank lending creates tighter credit conditions and higher costs, affecting businesses and households that are in debt or whose cash flow is limited. The pressure on the balance sheet leads to insolvencies and bankruptcies as well as asset sales to repay maturing debt or to meet obligations. Cash flow pressures reduce consumption and investment, forcing deleveraging and slowing economic activity, further weakening conditions. There are successive cycles of losses, credit crunch and cash crunch. Concerns about the need for government support for the banking system fuel the increasing sovereign risk.
Given the reduction in the arsenal of available policy tools, growing market skepticism with respect to economic policy and a dysfunctional policy environment, the authorities could have a hard time breaking these feedback cycles. In 2019, the preservation of capital will force investors to anticipate and navigate these catastrophic loops.