ECB warns of financial stability risks amid market 'exuberance'

Says flood of fiscal & monetary stimulus may build up dangerous imbalances

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 rose, 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,” the ECB said in its Financial Stability Review on Wednesday.

 

“A 10 per cent correction in US equity markets could therefore lead to a significant tightening of euro-area financial conditions, similar to around a third of the tightening witnessed after the coronavirus shock in March 2020,” it said.
 
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 materialize 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. It will review that decision next month. 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.

 
Bitcoin bubble
 
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.”          
 

ECB chief Guindos remains upbeat on economy despite risk

The ECB is relatively upbeat on the economic outlook as it prepares for a crucial monetary policy meeting next month, despite mounting risks to financial stability from overvalued asset prices.
 
The risks to the economic outlook “are much more balanced than in the past,” ECB Vice President Luis de Guindos said.