ECB warns markets are “susceptible to correction”

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Stretched valuations in property and equity markets, elevated levels of public and private debt, and increased risk-taking by non-banks pose a threat to eurozone’s stability, the European Central Bank (ECB) warned on Thursday (Nov. 17).

While the economic recovery from the Covid-19 crisis means short-term risks to the financial system have dissipated, longer term risks are accumulating with potentially grave consequences, the Frankfurt-based institution said in its November 2021 Financial Stability
Review (FSR).

“Concerns particularly relate to pockets of exuberance in credit, asset and housing markets, as well as higher debt levels in the corporate and public sectors as a legacy of the pandemic,” it said.

Eurozone’s financial markets have joined the world markets push higher, as investors piled into riskier assets in their search for yield, taking advantage of rising inflation and record low interest rates.

“The markets for equity and risky assets have maintained their striking buoyancy, making them more susceptible to corrections,” ECB Vice President Luis de Guindos said in the report.

“There have been examples of established market players exploring more novel and more exotic investments. In parallel, euro-area housing markets have expanded rapidly, with little indication that lending standards are tightening in response” he added.

eurozone inflation
(Source: Eurostat)

The 19-member common currency bloc’s annual inflation rate increased to 4.1% in October from 3.4% in September. It was the highest reading since July of 2008 and more than twice the ECB’s 2% target as the bloc continues to battle surging energy costs while supply chain bottlenecks persist.

The central bank’s President Christine Lagarde noted on Monday (Nov. 15) that inflation will take longer than expected to subside.

Meanwhile, house prices went up by 6.8 % in the euro area and by 7.3 % in the European Union in the second quarter of 2021, compared with the same quarter of 2020, Eurostat data showed.

“Vulnerabilities in residential real estate markets have grown, especially in countries with valuations that were already elevated prior to the pandemic” the report said.

“Tighter macroprudential policies can help address growing vulnerabilities, notably for housing markets in some countries” the ECB elaborated.

When it comes to the non-bank financial sector, which includes investment funds, insurers and pension funds, the ECB warned it “could face substantial credit losses if conditions in the corporate sector were to worsen” owing to increased investments in lower-rated corporate debt. “Investment funds also remain highly exposed to liquidity risk.”

Looking ahead, strains in global supply chains, a surge in commodity prices and the specter of new lockdowns could pose fresh challenges to the economic recovery and the outlook for inflation.

“If persistent bottlenecks feed through into higher-than-anticipated wage rises or the economy returns more quickly to full capacity, price pressures could become stronger,” the Bank said. “A more-persistent high-inflation scenario could translate into an untimely tightening of financial conditions, weighing on the economic recovery.”

The central bank said its own ultra-loose monetary policies including negative interest rates and large-scale asset purchases (trillions of euros of bonds) had increased “incentives to engage in more risk-taking which could become excessive and lead to the build-up of systemic risk”.

The ECB’s pandemic bond-buying program began in March 2020 and was meant to buy €1.85 trillion in bonds and run until at least March 2022.

While Lagarde has signaled pandemic asset purchases will end as planned in March, there’s no consensus on what will happen to the bank’s conventional bond-buying plan aka APP — currently running at 20 billion euros ($23.1 billion) a month.

ECB Governing Council member Robert Holzmann told an event in London last week that the central bank could stop buying bonds as early as next September if inflation looks to have sustainably returned to the official target.