The Financial Express

Global financial conditions spark fear of market clean out

| Updated: March 14, 2021 20:51:20

--Representational image --Representational image

Global stock markets especially in the US, the UK  and other major industrialised economies have been surging upwards for some time. There are growing concerns that the US market has lost touch with market fundamentals, especially those related to the pandemic reality. Market observers point out to massive support from the Federal Reserve, rolling out of Codid-19 vaccines and injecting more stimulus into the economy as contributing to the upward surge.

As money continues to flow into the Wall street propelling all major market indexes upwards, it is causing serious debates whether the market is facing a dangerous bubble. A bubble is a sharp rise in prices fueled by market behaviour but the momentum is not supported by underlying market fundamentals. Eventually, market fundamentals catch up with the momentum, the bubble bursts, the stock sinks, and prices drop back to pre-bubble levels.

Speculative bubbles have a long history in global markets. In fact, there  have been  regular occurrences through out history, going back to tulips in the 17th century. In the recent past, one such was the 2000 tech bubble  spurred by technological advances, and then the 2008 housing and mortgage crisis widely known as the Global Financial Crisis (GFC). Now it appears  another one is looming.

Each speculative bubble has its own driving forces but most involve a combination of market fundamentals and psychological responses to those fundamentals. It starts with very favourable market fundamentals such as strong profit growth and expectations of future market power. People rush to invest so as not to miss out on higher returns gained by others causing demand for stocks outstripping supply leading to price spike.  Now massive support from the Federal Reserve means a lot of money sloshing around  and markets looking for investment sending the three Wall Street market indexes -- Dow Jones, S&P 500 and Nasdaq -- to new highs. This is causing serious concerns that the speculative bubble may soon burst with serious consequences.

Market analysts warn that red lights are flashing due to the endless pumping of money by the US Federal Reserve, the European Central Bank (ECB) other central banks into  the financial markets. Countries that are closely integrated with  global financial markets are also impacted by developments in those markets.

But countries that follow flexible exchange rate regime can partially insulate their economies from global financial conditions because exchange rate flexibility helps these countries not to move in lock step with the major central banks. But over the longer span of time all central banks are affected by developments in the global financial markets because of  downward pressure on interest rates. International investors' willingness to take risk also has an important bearing on domestic financial conditions.

Monetary policy in developing countries such as Bangladesh or India can not influence the factors that affect global savings and investment behaviour.  But   in a period of interest rates hovering around zero, policy rates are far above that in most developing countries and that  should cause an appreciation of the exchange rate in those countries impacting on growth and inflation unless those countries also ease their monetary policy in response to almost persistent declines in global interest rates. Furthermore, there is a range of headwinds to growth and inflation facing countries around the world; and central banks need to respond to them well ahead in time. Stuck in the middle of a viral pandemic, the world's largest economy, the US economy, shrank by 3.5 per cent in 2020-- the lowest in 74 years and the UK economy experienced a fall of 9.9 per cent during the same year, the lowest annual decline in 300 years in the country's history. These declines far surpassed the damage caused by the Global Financial Crisis (GFC) of 2008.  The picture is not different in most other countries around the world. The pandemic induced recession in most countries around the world rendered tens of millions of people jobless.

In an IMFBlog, Kristalina Georgieva, the Head of International Monetary Fund (IMF) has pointed out many of those challenges facing the global economy. While the global growth forecasts for this and the next year remain  positive, that growth prospects would be diverging dangerously across countries and regions. In fact, she emphasised that the convergence between countries could no longer  be taken for granted.  Therefore, policy actions are needed to prevent this great divergence.

She   further added that by the end of 2022, cumulative per capita income would be 13 per cent below pre-crisis projections for advanced economies  compared to 18 per cent for low income countries and 22 per cent for emerging and developing countries excluding China.

She then went on to say that in 2020, advanced economies on an average deployed 24 per cent of GDP in fiscal measures compared with 6 per cent in emerging markets and less than 2 per cent in low-income countries. These fiscal measures amounted to US$14 trillion. These have been accompanied by  considerable monetary easing by major central banks like the US Fed, the ECB and the Bank of England and others which enabled a kind of borrowing frenzy at record low interest rates. Ostensibly this easy money policy was intended to support the flow of credit to firms and households.

Many market analysts are also concerned that with interest rates hovering around zero, the conventional monetary policy may not be able to prevent another deep recession. With the significant fiscal stimulus announced by President Biden to supplement the current ultra-loose monetary policy and financial conditions prevailing now will negatively impact on financial stability.

Even China's financial regulator is worried about the potential impact of stimulus measures undertaken in the US and other developed countries on the Chinese economy.  There is a growing concern that such stimulus measures have pushed asset prices at a level  that can not be supported by market fundamentals and risk a run in the opposite direction i.e., bubble bursting. The side effect of it is inflation.

Yi Gang, the Governor of the People's Bank of China ( China's central bank) also expressed concern that the US stimulus package would pump extra money into the global economy which was already awash with extra money and then that money would end up in China. And that would result in imported inflation into China. Now China's policy makers are taking measures to control the speed and scale of capital inflows into the country to avoid any financial turbulence as the Chines economy is slowly opening up in the wake of the pandemic.  

The Biden administration's proposed US$1.9 trillion stimulus package will be entirely financed by government borrowing which will lead to a rapid increase in bond supply and that  will lower the price of bonds and push up  interest rates ( it is to be noted that bond prices and interest are inversely related). Now fiscal stimulus has taken the central stage in the US due to  monetary policy with its credit and quantitative easing  has mostly reached its limits with almost zero interest rate. 

According to a Financial Times commentator, Biden's proposed stimulus package could possibly overheat the economy. Lawrence Summers, former US Treasury Secretary and an Economic Adviser to former US President Barak Obama also expressed his concern over the consequences of the Biden stimulus package. He warned that this stimulus package could set off inflationary pressure that the US had not seen in a generation with consequences for the US dollar and financial stability.

The Fed has already clearly indicated that the current policy of ultra-low interest rates along with bond purchases will continue at least until the end of 2022.That means almost free money will stay for a long time without any idea how to bring this policy to an end without precipitating a market clean out. A financial commentator opined that such so called "forward guidance"  by the Fed could cause market complacency with unintended consequences.

The response to such concerns appears to double down further  as reflected in the Fed Chairman's declaration that the central bank will continue to maintain low interest rates into the indefinite future and continue to carry on asset purchases. This signals that there is an implicit guarantee of further stimulus in the event of market turbulence. Also, the Fed is mindful of the fact that  past bubbles popped after the Fed started raising interest rates in the hope of cooling off the overheated economy or markets. Now the Fed is  saying that it will keep the interest rates low until inflation tops its 2 per cent target.

Despite such assurances, there has been continuing sell off  of government bonds, thus lowering their prices leading to a significant rise in their yield i.e. interest rate. Such a rise in interest rates could jeopardise the current phase of economic recovery. To counteract rises in interest rates most central banks in advanced economies have intervened in the market by further accelerating asset purchases.

But there are growing concerns that asset purchases may not be able to stem the rise in the inflation rate as asset prices are increasingly becoming unsustainable. Now the fear is when market correction comes which essentially means  asset prices will fall, the central banks will be left with no  monetary policy options to counter the situation.

It is suggested that for some time it has become quite  clear that monetary policy has been fueling speculation rather than helping to support economic growth. The continuous inflow of cheap money  now has led to the disconnect between the financial system and the real economy which threatens both the stability of financial markets and economic growth. It is now generally suggested that time has come for central banks to put a brake, if not a complete halt, to their easy money  policy.

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