“Beyond its impact on bank profitability, a prolonged period of low interest rates may also induce investors in search of yield to take on undue risks that could sow the seeds of financial imbalances. Eventually, this could undercut the central bank’s ability to maintain price stability.” A similar point was made in the ECB monetary policy meeting account: “It was noted, however, that the financial stability implications needed to be monitored closely as declining bank lending rates could squeeze banks’ margins beyond adequate risk coverage. Moreover, the point was made that more attention needed to be paid to the non-bank financial sectors, where looser market-based financing conditions and the search for yield also posed risks.” Nevertheless, “there was broad agreement that monetary policy had to remain highly accommodative for an extended period of time in the face of a protracted weakness in the economy and subdued inflation developments.”
It illustrates to what extent the ECB is between a rock (risk of unanchoring of inflation expectations) and a hard place (risks to financial stability). Concerning the latter, the latest ECB’s Financial Stability Review, also published last week, makes for sobering reading. Focussing on the specific area of financial markets, the Review offers a long list of attention points[1]. These can be summarised into one sentence: a prolonged period of very expansionary monetary policy increases the procyclicality of the economy because investors are pushed into taking more risk when chasing returns whereas debt issuers are seizing the opportunity of declining borrowing costs to increase leverage and return on equity, which in turn supports equity valuations. A subdued inflation outlook means that these mutually reinforcing dynamics will not come to an end because of increases in official interest rates but rather by worries about the earnings growth outlook.
Investment portfolios are also subject to procyclicality as a consequence of quantitative easing. Remember that an intermediate objective of this policy is to lower government bond yields by driving down the term premium. As an example, when the ECB buys bonds from an insurance company, the duration of the latter’s assets drops. This is called ‘duration extraction’. It implies that a source of return (the extra yield over and above the short term interest rate) has gone. This obviously forces the insurer to increase exposure to other sources of risk. In doing so, it seeks to maintain the expected return of its portfolio. This is called the ‘portfolio rebalancing channel’, which is another key transmission mechanism of QE. Examples of other sources of risk are credit risk (by investing in corporate bonds) or equity risk[2]. At first glance, it looks as if credit or equity risks are simple substitutes for duration risk. However, they behave very differently depending on the phase of the business cycle. When growth is accelerating and expectations of monetary policy tightening are increasing, government bonds suffer far more than corporate bonds (the corporate bond spread narrows) whereas equities thrive due to an improved outlook for corporate earnings. At present, we should however be more interested in what would happen should growth severely slow down. In that case, government bond yields decline and government bond prices rise significantly, but asset owners who have sold part of their holdings to the ECB benefit less than before. On the other hand, they suffer more than before from the decline in corporate bonds (due to spread widening) and equity prices considering the purchases they had made after having sold their government bonds to the ECB.
To conclude, duration extraction, which results from central bank asset purchases, causes a substitution of duration risk with other sources of risk. Investment portfolios become less diversified, due to reduced exposure to government bonds, and the procyclicality of portfolio returns increases. In case of a severe growth slowdown, this implies increased downside risk, which investors may seek to pre-empt by reducing positions in risky assets, thereby accelerating their decline.
