High debt levels, Fed tightening may trigger another crisis

January 11, 2019 10:21
Even if the Federal Reserve stops hiking rates, the liquidity drain will continue as long as the quantitative tightening goes on. Photo: Reuters

Global stock markets have rebounded substantially amid signs that US-China trade talks are turning more positive.

Does that mean the stock market has already moved out of the shadows of 2018? I don’t think so. The financial market still faces many uncertainties, such as the credit crunch. The bursting of the credit bubble is one potential source of trouble. 

The credit market might be the most vulnerable link this year, which could give rise to something like the European debt crisis in 2011. 

The St. Louis Fed Financial Stress Index, an indicator that tracks numerous credit-sensitive assets, including corporate and Treasury yields as well as Ted Spread and VIX, has started to edge up since the fourth quarter of last year. That suggests market liquidity is tightening. 

Also, investment-grade and high-yield corporate bonds have registered over US$65 billion net outflow in the 10 weeks to Dec. 31. That marks a record high. In other words, investors are dumping corporate bonds.  

Many countries, especially emerging markets, have posted staggering credit expansion after the 2008 financial crisis. 

The credit to private non-financial sectors in developed and developing markets surged above US$160 trillion in the first quarter of last year. It accounts for 244.9 percent of GDP. Both figures hit a record high. That shows private non-financial sectors are having extremely high leverage, and the bubble is building up. 

It remains unclear whether the United States and China will reach a deal in their trade talks, though the possibility is rising. But I believe the US-China rivalry won’t end even if this round of their trade dispute is settled. That means financial market volatility will remain high. 

More importantly, global economic growth is running out of steam. Europe, Japan and emerging markets have been struggling with moderating growth since early 2018. 

Meanwhile, the Federal Reserve has begun to shrink its balance sheet since the fourth quarter of 2017, and the amount of its debt purchase program increased from US$10 billion to US$50 billion in the last quarter of 2018. The tightening effect has started to set in.  

The liquidity drain will continue as long as the quantitative tightening goes on, even if the Fed stops hiking rates. 

Given the high leverage built up, the Fed’s balance sheet normalization plan could be a trigger for another financial market turmoil. 

This article appeared in the Hong Kong Economic Journal on Jan 10

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist