Gala BURSA 2018

Financial crisis yellow code warning in the United States

Călin Rechea (Translated by Cosmin Ghidoveanu)
Ziarul BURSA #English Section /

Financial crisis yellow code warning in the United States
Călin Rechea (Translated by Cosmin Ghidoveanu)

"The markets are turning into the markets' greatest enemy", wrote an analyst of Goldman Sachs in a note addressed to its customers, according to an article by Bloomberg, and the jump in the VIX volatility index last month "is a symptom of the financial fragility".

But where is the financial fragility coming from, when the developed economies, especially that of the United States, seem to have entered a sustainable growth trajectory?

Could it be just a mirage, which is " melting" amid the small steps that the Federal Reserve is taking towards the normalizing of financial conditions?

It could be, because the growth forecasts for Q1 2018, posted by the Federal Reserve Bank of Atlanta, have seen a significant "slide" in just a few weeks. On the first day of February 2018, the division of the Atlanta Fed showed that the US economy would see a 5.4% growth in annualized terms. Since then, the forecasts have been revised downwards, and the estimate at the end of last week showed a growth 1.8%.

In this context, an indicator of the "stress" on the financial market reached a level comparable to that of 2009. We are talking about the spread between the 3-month LIBOR and the OIS (Overnight Indexed Swap) rate , which recently passed the level of 55 basis points, as it was about 28 basis points at the end of last year.

The LIBOR-OIS is considered "a key indicator of the credit risk in the banking system", as the LIBOR rate represents the cost of unsecured short term financing on the interbank market, and the value of the OIS rate is tightly related to the actual policy rate in the US and is a borrowing cost in the absence of credit risk.

According to data from the ICE (Intercontinental Exchange), the new manager of the LIBOR interest rate starting with February 2014, the 3-month LIBOR rate for the American dollar has risen significantly in the last months and has exceeded 2.2%, the highest level since December 2008.

Bhanu Baweja, deputy strategy director at UBS Investment Bank, thinks that the rise of financing costs in the US is not a reason to worry, but merely a "diversion", as stated in an article in Financial Times.

In the opinion of Baweja, the rise of the LIBOR is caused by the increase in the yields on short term bonds issued by the American government and does not indicate an increase in the credit risk.

Citigroup analysts see things differently. Even though they feel that the advance of the LIBOR and of the LIBOR-OIS is the result of technical factors, Matt King and Steve Kang warned their customers that "the spread of the negative effects is very likely", according to Bloomberg, especially since "the LIBOR rates represent a benchmark for loans, interest rate swaps and some mortgage loans".

In the opinion of Matt King, "the rise of the LIBOR-OIS spread reflects the tightening of borrowing in dollars beyond the level intended by the Federal Reserve", according to a report posted on Zerohedge, and "in the coming months we are expecting increased pressure".

The conclusion of Citigroup analysts is that "the tightening of lending terms can exceed the expectations of the central banks", and the effects on the stock markets will be extremely negative.

The Bloomberg estimates show that the financial instruments evaluated at about 350 trillion dollars depend on the evolution of the LIBOR rates.

To Jerome Schneider, head of investment firm Pacific Investment Management Co. (PIMCO), the recent evolution of the interest rates represents "the beginning of a new paradigm", according to its statements made given to Bloomberg.

The rise of the borrowing costs in dollars comes at an unfortunate time. The interest rates which have been at all-time lows for years have led to an accelerated increase of debts denominated in dollars, especially in emerging economies.

"The unprecedented level of dollar denominated debt makes the global financial system more sensitive than ever to the evolution of the dollar and of borrowing costs", Ambrose Evans-Pritchard writes in British daily The Telegraph.

In an analysis from the FxWire Pro it is written that "the advance of interest rates in a period of economic growth has always happened over centuries" and "there are no reasons for concern if you don't have excessive debt in dollars or if your business model isn't heavily dependent on low borrowing costs".

That is precisely what the problem is. Nobody knows how many companies can survive in the absence of low borrowing costs.

"We are expecting a major impact of the rise in borrowing costs for the dollar among emerging economies", FxWire Pro analysts further write.

As can be seen, we are even closer to the moment of truth. A robust economy should have no reasons to worry about the rise of the borrowing costs. Can the same thing be said about today's global economy?

"Economies would be stronger if they didn't have such a high degree of indebtedness", Martin Wolf, editorialist with Financial Times wrote recently. Wolf also says that "the analysis of macroeconomic theory indicates a high level of ignorance over the way economies work".

These statements, which are hard to contradict despite the numerous statements from the central banks, show that the lessons of the crisis have not been learned, with the only "solution" being the additional stimulation of the increase in debts, with the vain hope that, by a miracle, "the hangover" of overindebtedness can be resolved by feeding "fuel" with an octanic figure higher than the previous one, in other words through direct money printing.

Unfortunately, the wakeup call is increasingly closer and cannot be avoided.

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