By www.CentralBankNews.info
A return to normal economic conditions after years of quantitative easing is likely to be volatile for financial markets as investors adapt to rising interest rates, according to Stephen Cecchetti, senior economic adviser at the Bank of International Settlements (BIS).
After disappointing U.S. economic data between mid-March and mid-April, signs of economic growth have improved since early May and sentiment among investors has become more optimistic, Cecchetti told journalists in connection with the release of the latest BIS quarterly review.
While volatility in financial markets is normal and part of the adjustment to new information, Cecchetti warned that it also carries risks due to the large amount of bonds that are now owned by financial institutions, households and firms.
“The ride to normality will almost surely be bumpy, with yields going trough calm and volatile periods as market participants digest sometimes conflicting news about the recovery,” Cecchetti said.
Last week the yield on the benchmark U.S. 10-year Treasuries rose to over 2.2 percent from 1.6 percent in early May, a move that is hardly a surprise as interest rates rise as the economy recovers.
But financial institutions and other investors now hold large amounts of interest-sensitive assets on their balance sheets and they are facing potential losses.
“With the outstanding volume of government bonds greater than ever, interest rate risk – expressed as potential losses in relation to GDP – is at a record high in most advanced economies,” Cecchetti said.
Economists have estimated that total outstanding debt has exploded by some $34 trillion since the eruption of the global financial crises in 2007 as authorities have fought to stimulate economic growth. It is estimated that central banks have taken about $10 billion of debt onto their balance sheets, leaving some $25 trillion in newly-issued debt that is held by financial institutions, households and firms.
While sophisticated hedging strategies may shift this interest-rate risk from some banks to other institutions, it won’t completely eliminate the risk and there will be widespread losses, he warned.
The best way to guard against the possible disruptions to financial markets and economic growth is high capital buffers and robust balance sheets, Cecchetti added.
