There is a maxim that states financial markets are always right. It is true that this rule is subject to investors having reliable information regarding the economic and financial landscape. However, we have already made significant progress in behavioral economics applied to markets to conclude that individuals and groups do not always act rationally, but rather according to their own biases. Loss aversion is one such bias when high price levels have been reached in certain financial assets. This is confirmed by various financial stability reports from official bodies.
The sharp rise in medium- and long-term debt interest rates over the last month, doubling initial yields in some cases, has generated losses for many investors and confusion among authorities. These are increases of just over half a point in the worst-case scenario, which puts their importance in terms of impact into perspective and reflects the underlying exceptionality of the current scenario of low or near-zero interest rates. The main central banks have been quick to reaffirm that financial conditions remain very favorable for the post-COVID economic recovery. Although, on the other hand, they are closely monitoring developments, as is only to be expected.
Official financial stability reports have been warning for many months about the vulnerability of wholesale markets as a potential risk to be monitored. On more than one occasion, there have even been calls for the strict supervision and regulation that exists for banks to be extended in some way to markets whose importance as ‘shadow financiers’ has grown strongly since the financial crisis. The extreme monetary measures taken—undoubtedly essential in the face of a crisis like the current one—such as the purchase of debt by central banks in the markets, have contributed to this. As a consequence, warnings about the financial repression of savings and the undervaluation of risk in portfolios have become common; always subject to the imbalance existing for authorities between the high cost of not taking action and the acceptable cost of taking it.
The European Central Bank (ECB) reiterates that financial conditions must remain favorable to close growth and inflation gaps. Although recovering pre-crisis growth levels is an important objective, increasing the potential growth rate is also vital, an area where monetary policy is less efficient. Furthermore, the exceptional nature of the measures taken is not without risks to financial stability. Financial asset inflation is one of these risks, due to greater market instability reflecting potential excesses. Another risk is the potential damage to bank balance sheets from maintaining overly loose financial conditions for too long.
But what if the markets were simply anticipating an improvement in economic prospects? We are faced with the increasingly real possibility that vaccines will lead us to an economic recovery scenario where monetary policy must pass the baton to fiscal policy and supply-side measures. Official interest rates are set by authorities, but medium- and long-term interest rates are determined by investors based on their expectations. The fundamental question is whether they have enough information to justify a short-term return to normality for the interest rate curve and a medium-term return for zero or negative official interest rates. Let us hope this is the case.
José Luis Martínez Campuzano, spokesperson for the Spanish Banking Association
