Thursday, July 07, 2016

Fed Falters as Threat of Brexit Contagion Looms
11:47AM JULY 7, 2016
Stephen Bartholomeusz
Business Spectator columnist

The US Federal Reserve Board could be seen as dithering on US rate rises, looking for excuses not to raise rather than reasons to pursue the glide path to normalising them it was outlining late last year.

The board minutes for its June meeting were released overnight and, in citing the Brexit vote which occurred more than a week after that meeting, the board members may have been prescient.

While there was, and is, a view that the vote — which turned out to be a shock vote in favour of the UK exiting the European Union — has no meaningful implications for the US or the rest of the world, the reality of the immediate aftermath of the vote might suggest otherwise.

The repercussions within the UK itself are obvious. It is heading into a nasty recession. In echoes of the 1990s commercial property market collapse and the related banking crisis and “recession we had to have” in this economy, there’s already an accelerating run on UK property trusts, an immediate drying up of foreign investment and emergency measures announced by the Bank of England.

If that were all that were happening, the view that the UK isn’t significant enough for an implosion there to matter within the global economy and financial system might be correct.

Brexit has, however, immediately brought forward a crisis in Italy’s banking system that is spilling over into the Italian political system and that illustrates and underscores the vulnerabilities and potential fissures within a eurozone constructed on jerry-built foundations.

More significantly and disturbingly, its aftershocks have flowed directly and very significantly into global currency and bond markets.

Before Brexit there were an estimated $US7.5 trillion to $US8.5 trillion of government bonds trading at negative yields. Two weeks later, according to Bloomberg, the amount of government bonds with negative yields has soared to just under $US10 trillion.

Around the world yield curves have flattened, historically pointing to bleak outlooks for economies. That is despite, or perhaps because of, the key central banks unleashing an estimated $US12 trillion or more in quantitative easing measures since the financial crisis.

Brexit may or may not be the “black swan” event that precipitates another crisis but it has raised a massive question mark over the future shape and stability of the eurozone, which has much greater significance for the global economy and financial system than the UK.

At a more micro level, it does have implications for the financial system. London is the headquarters for a number of banking and insurance groups that are of global systemic importance and there are other large European institutions heavily exposed to the UK economy and financial system.

If the UK were to plunge into a deep recession, there would be some substantial losses for its banks (which are well capitalised) to absorb and the potential for contagion to reach the eurozone banks, which generally aren’t anywhere near as well-capitalised. With European central bank stress test results due within weeks, there is another potential flashpoint for the eurozone looming.

It is, however, those post-Brexit shifts in currencies and bonds that, when coupled with the Fed’s prolonged “frozen in the moment” stance this year, points to the complexities of the post-crisis settings.

The increasing proportion of government bonds with negative yields is the driver of the lowering and flattening of yield curves in those few economies that are growing at respectable rates, like the US or Australia.

Funds are flowing out of the UK, the eurozone, Japan and emerging market economies towards the US and Australia, pushing the value of the US and Australian dollar up and bond yields down.

The negative yields are also sucking the profitability out of banks, insurers and pension funds — and households with net savings — around the world and undermining their balance sheets.

The rising levels of global weakness and uncertainty — and the increased sensitivity of financial markets to even the suggestion of any US rate rises — have pushed the Fed into an ever more delicate position.

The post-crisis unconventional monetary policies have encouraged/forced investors to take on ever-increasing levels of risks for ever-decreasing returns and the historically unprecedented risk-free rates in the developed world — rates that Brexit has forced down even further — continue to do so.

That, however, is making the Fed ultra-cautious. While there was a divergence of views within the Open Market Committee exposed by the latest minutes, the committee members would be acutely aware that even just a strengthening of the prospect of a US rate rise has the potential to trigger a panicked rush out of risk positions around the world.

Apart from the financial instability that this might ignite, the US dollar would inevitably spike and threaten to choke off what has been a relatively modest US economic recovery. It could also plunge the emerging market economies that have previously gorged on US dollar-denominated debt into crisis.

With the dominoes teetering in Europe, China’s growth rate spluttering, Japan still trapped in its decades-long economic winter and markets extremely leveraged to the slightest shift in expectations of the timing of any movement in US rates, the Fed is trapped within one of those “damned if we do, damned if we don’t” dilemmas.

While it might well have been the major player in constructing the settings that have created the predicament it now finds itself in, it isn’t clear how it escapes them without risking something quite unpleasant and destructive.

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