November 30, 2022

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Concerns that an increase in interest rates may lead to a new 'black swan': - It is very usual that the risk of a financial crisis arises in a situation like the one we are in now

Concerns that an increase in interest rates may lead to a new ‘black swan’: – It is very usual that the risk of a financial crisis arises in a situation like the one we are in now

In recent months, central banks around the world have raised interest rates rapidly and sharply. The aim is to reduce spiraling inflation, but it is being debated whether this has created the risk of a new financial crisis.

Autumn was marked by the world’s central banks raising interest rates very aggressively and simultaneously, prompting economic researchers from several academic circles to warn of the danger of a global recession.

But the fact that interest rates have risen so much in such a short time, in an economy that, among other things, historically low interest rates has sent the debt ratio of countries and companies to new heights, also raised questions about whether higher interest rates could lead to a financial crisis.

Bjorn Roger Wilhelmsen, partner and chief economist at Nordkinn Asset Management, says the risk of some kind of financial crisis from sharply rising interest rates – a kind of “black swan” – is certainly a hot topic.

It is, of course, difficult to determine what will be and where it will happen. But he says it is very common for the risk of a financial crisis to arise in a situation like the one we are in right now.

– Suddenly you see someone with payment problems, and then things can get worse – and cause a financial crisis, he adds.

Concerned about the national debt

He believes that a recurrence of the financial crisis is unlikely, while the debt ratio among households in the United States is lower now than it was at the time. In addition, US banks have been much stricter in regulation, so the new Lehman case is less likely.

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— but there are other debts than households, says Wilhelmsen.

It highlights the level of debt between companies, especially in those cases where companies have low profits, as an example that can lead to potential financial stress.

– And we’re a little concerned about that with the national debt. There is a risk, says Wilhelmsen, that we will have a new version of the euro crisis in 2011-2012 – if inflation spikes, which means central banks can’t remedy that by cutting interest rates.

– In addition, families in Europe are more vulnerable, and here the debt ratio has increased, he adds.

Lots of debt in both the private and public sectors

Christian Lee, chief strategist at management firm Formue, highlights an example of the risks of financial stress:

The systemic stress index in the euro-based financial system and the US financial system, prepared by the European Central Bank, excluding the pandemic, remains close to the highest since the 2012 debt crisis and financial crisis, respectively, says Christian Lee, chief strategist at Formue Management. .

There is a lot of debt in both the private and public sectors, and if interest rates continue to rise, a negative spiral could occur, he adds.

external shock

This has not happened yet, despite the decline in value in both the stock and bond markets that was greater than during the financial crisis at the end of the 2000s.

Lee points to strong labor markets, private sector savings surpluses, and a lack of major imbalances, such as before the IT bubble burst at the turn of the millennium, or in the US housing sector before the financial crisis, as important explanations behind the fact that we “avoid even systemic events.” right Now”.

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It is also clear that “a new external shock may still have to occur”, for something similar to happen. Some external influence with severe consequences for the rest of the economy, such as the collapse of an efficient finance company, can be such a shock.

Christian Lee, chief strategist at Formue, says strong labor markets and surpluses in the private sector are among the factors that have prevented financial strains after the sharp rise in interest rates in the past six months.

Christian Lee, chief strategist at Formue, says strong labor markets and surpluses in the private sector are among the factors that have prevented financial strains after the sharp rise in interest rates in the past six months. (Photo: Dedrick Linerod Arnesen)

“But, as long as inflation is too high, key interest rates go up and liquidity is squeezed, we run a huge risk that the seams will eventually fray in one or more corners of the financial system,” Lee says.

It is constantly being tightened. This week, the US central bank raised its interest rate for the fourth time in a row, while the Bank of England brought in its first triple increase in more than 30 years. At the same time, the Norges Bank raised its key interest rate by 0.25 percentage points.

By the end of the year, most central banks, which had bought privately backed bonds during the pandemic, began dumping those bonds again — by selling bonds on a massive scale.

This pushes bond prices down, bond yields – and reduces liquidity in the financial system.

A ‘high probability’ of a much worse economic situation

Christian Lee notes that a possible new period of significant price declines in the stock and bond markets, and perhaps also in “increasingly large non-listed markets” will increase the risk of “one or more adverse events.”

“In my view, neither the stock or credit markets are priced in a recession where unemployment is high, earnings growth becomes negative or there is a large default, Lee says.

He therefore believes that there is still a risk that markets are not pricing in that inflation will not fall linearly toward the 2 to 3 per cent target – nor that key interest rates may continue to rise more than expected.

– If we assume that monetary policy affects the real economy with a delay of 12-24 months, there is a good chance that the economic situation will be much worse than it is today, says Lee.

He adds that “the combination of any new, larger price fall in the markets”, along with a global recession, could “crack both large corporate or government finances”.

For example, government bonds issued by many emerging and developing economies are priced at levels that indicate a high risk of default, Lee says.

New Inflation Updates

Next week, Norway, the United States and China will be among the many countries with inflation numbers for October.

The big question is whether these will contain surprises, and whether they will cause central banks to change their expected interest rates.

Lee and Wilhelmsen both think that in Norway you’ll be able to see inflation has eased somewhat, partly as a result of lower electricity prices and lower commodity price hikes. Both say at the same time that it is not unreasonable that core inflation, which Norges Bank attaches to the greatest importance, will increase even more.

In the US, stocks are pointing both ways: the labor market remains very strong, boosting, among other things, wage growth – signaling the need for further tightening by the Federal Reserve. At the same time, factors such as lower freight rates, lower house prices and the easing of supply chain problems caused by the pandemic suggest that inflationary pressure is on the way to lowering.

That doesn’t make the job any easier for central banks, who are hitting the brakes without ending up in a recession.

In many ways, the global economy, not least the Federal Reserve, is in “Catch 22” mode, says Christian Lee.(Conditions)Copyright Dagens Næringsliv AS and/or our suppliers. We would like you to share our cases using links that lead directly to our pages. All or part of the Content may not be copied or otherwise used with written permission or as permitted by law. For additional terms look here.