ECB warns of financial stability risks amid market exuberance

Bloomberg

The euro-area faces elevated risks to financial stability as it emerges from the pandemic with high debt burdens and
“remarkable exuberance” in markets as bond yields rise, according to the European Central Bank (ECB).
The language, echoing former Federal Reserve Chairman Alan Greenspan’s description of the dot-com bubble in the 1990s as “irrational exuberance,” highlights mounting concerns that the flood of fiscal and monetary stimulus needed to fight the crisis is also building up dangerous imbalances.
If more upward surprises in US inflation prompts investors bet on earlier monetary tightening, driving up bond yields without an accompanying improvement in economic growth, “spillovers from US equity market repricing could be substantial,” ECB said in its Financial Stability Review on Wednesday.
The euro zone is vulnerable to such spillovers because, like most countries, it has built up significantly higher debt during the crisis. Rising yields would depress bond prices and weaken balance sheets at the region’s banks — which have long suffered from feeble
profitability. The ECB also said the uneven economic impact of the pandemic means financial stability risks are likely to materialise in sectors and countries with higher pre-existing vulnerabilities.
The central bank already stepped in earlier this year when rising US bond yields drove up borrowing costs across the globe. Officials ramped up the pace of asset purchases, arguing that the region wasn’t yet ready for higher borrowing costs as its recovery has been hindered by a slower start to vaccinations.
The ECB highlighted other risks facing the bloc’s economy, including slack in the labour market and subdued investment which could lead to a
sluggish recovery.
While the Fed has also rebuffed suggestions of imminent tightening, some investors are betting that the central bank will need to scale back its support sooner rather than later. US consumer prices rose in April by the most since 2009, prompting officials to drive home the message that current spikes are likely to be transitory.
The ECB report also noted “exuberance” in crypto-assets, stating that “the surge in Bitcoin prices has eclipsed previous financial bubbles like the ‘tulip mania’ and the South Sea Bubble in the 1600s and 1700s.”
Still, it concluded that with such assets not widely used for payment, and with banks having limited exposure, the financial stability risks “appear limited at present.”
The ECB highlighted other risks facing the bloc’s economy, including slack in the labor market and subdued investment which could lead to a sluggish recovery. It also included a new analysis of climate-related risks, which affect a “significant share” of bank loans to companies, it said.
“We are optimistic that financial and economic conditions will bounce back,” ECB Vice President Luis de Guindos said in the report. “There is, however, a reality that the pandemic will leave a legacy of higher debt and weaker balance sheets, which — if unaddressed — could prompt sharp market corrections and financial stress or lead to a prolonged period of weak economic recovery.”