"Historically low levels of interest rates globally and the current backdrop of low volatility across financial markets may encourage market participants to underestimate the likelihood and severity of tail risks. There are increasing signs that investors, in searching for yield, may be increasing the vulnerability of the financial system to shocks. This vulnerability is amplified by structural changes in markets potentially reducing the availability of market liquidity at times of stress." - Financial Stability Report, June 2014 | Issue No. 35, The Bank of England
It took me a few weeks to get around to listening to the press conference for the Bank of England's (BOE) latest Financial Stability report, but it proved to be well worth the time and effort. Most of it was about the UK housing market and the efforts of the BoE's Financial Policy Committee (FPC) to prevent the United Kingdom's market from getting over-leveraged and over-heated. The FPC's bottom-line on its regulatory measures is that the housing market is healthy now, but the FPC is looking down the road to prevent risks to financial stability:
"The recovery in the UK housing market has been associated with a marked rise in the share of mortgages extended at high loan to income multiples. At higher levels of indebtedness, households are more likely to encounter payment difficulties in the face of shocks to income and interest rates. This could pose direct risks to the resilience of the UK banking system, and indirect risks via its impact on economic stability…
….The FPC does not believe that household indebtedness poses an imminent threat to stability. But it has agreed that it is prudent to insure against the risk of a marked loosening in underwriting standards and a further significant rise in the number of highly indebted households."
The FPC is particularly worried about a growing imbalance between supply and demand that is driving prices upward. For example, "in a survey by the Home Builders Federation, the balance of house price expectations over the next twelve months at the end of 2013 reached its highest level since early 2004 and remained at this level in 2014 Q1." Prices rose faster than average wages in the past year, causing a notable decline in affordability: "the UK house price to average earnings ratio - a crude measure of affordability - has risen to more than six times annual earnings in the past few months. That is still lower than the 2007 peak of more than seven times earnings, but higher than the average in the decade before 2007, of around five times earnings."
The following charts demonstrate how far UK buyers continue to stretch to buy homes:
New mortgages advanced for house purchase by loan-to-income ratio
New mortgages advanced for house purchase at loan to income ratios at or above 4.5
Source: Bank of England Financial Stability Report for June, 2014
Reporters attending the press conference were right to question the efficacy of financial measures which will supposedly not impact the health of the housing recovery. The FPC claims its "…actions in respect of the mortgage market should have little macroeconomic impact if house price inflation moderates in the way assumed in the central case of the MPC's May 2014 Inflation Report. But the FPC's actions should prevent a build-up of excessive household indebtedness in the event that house price inflation does not moderate." Reporters were also right to question whether restricting lending will further widen the gulf between the housing-haves and have-nots.
The BoE cannot respond directly to housing imbalances with a campaign of monetary tightening because the market is still not ready for such a shift. A sudden drop in prices will certainly discourage builders from bringing supply to the market and sellers waiting for higher prices will definitely stay out the market. Most importantly, financial markets appear particularly unprepared for such a normalization in rates.
Indeed, the FPC is VERY clear that it thinks the market is not ready for a normalization in monetary policy.
The discussion about liquidity risks starkly revealed the FPC's assessment of market vulnerabilities. The FPC has spent more and more time discussing this topic as it is clearly worried the market is under-pricing these risks. My interpretation of the main concern is that a move to normalization of interest rates will cause a rush to the exits from financial instruments primed for low interest rates. This rush could start a negative feedback loop if market participants are not able to sell due to a lack of liquidity in certain markets. One could imagine these markets suffering from a lack of buyers as no one wants to get caught holding rate-sensitive financial instruments when the outlook for rates goes decidedly higher. The dilemma of course is how to push rates higher in an "orderly" way that does not, in a sense, scare the skittish squirrels away all at once. One potential method consists of steady "encouragement" to slowly get the process started ahead of time.
The FPC provides three different charts that tell a similar story: the spike in risk premia from the financial crisis is long behind us and now back down to pre-crisis levels. I will not go into the explanation of the various models (interested readers should definitely check it out - p13) except to say that one is empirically based on cash-CDS (credit default swaps) on North American and European corporate bonds, another is a model based on deviations of estimated corporate bond liquidity risk premia from historical averages, and the last is a calculation of a kind of spread measuring the willingness to hold illiquid 10-year U.S. government bonds. Of all the measures only the last is actually BELOW pre-crisis levels.
The FPC's ultimate conclusion is important:
"Liquidity risk premia vary significantly throughout the economic cycle, rising sharply during periods of stress. That was demonstrated during the financial crisis, with indicators of liquidity risk premia rising abruptly in 2008-09. Since then, they have fallen close to their pre-crisis levels and, amid increasing signs of investors searching for yield, appear slightly below average in some fixed-income markets.
But this is not necessarily a benign signal. There is a risk that current valuations are masking an underlying fragility, particularly in the light of a post-crisis reduction in banks' market-making and proprietary trading activity. As discussed in Section 2, this fragility could be exposed if investors simultaneously sought to unwind their fixed-income positions in response to a common interest rate or volatility shock, causing secondary market liquidity to dry up in pockets of the financial system. Such a sell-off could result in wider financial market disruption." (Section 2 is a discussion of short-term risks to financial stability).
MY conclusion from this statement is that the FPC is announcing that the market IS under-pricing very real fragilities in the financial system. The FPC does not believe the message in the markets; it is opening the hood and trying to encourage market participants to join the review. I think the press conference underlined the FPC's seriousness on this point. From BoE Governor Mark Carney (emphasis mine):
"…when we think about the medium term, we're very conscious that we've pushed liquidity risk into the private sector. We pushed higher capital standards there as well. And as a consequence, liquidity premia should be higher than historic averages rather than lower than historic averages.
Now the confluence of the stance of global monetary policy, other factors, low volatility breeding low volatility, is meaning that liquidity premium actually is detailed in the report or actually well below - that's going to change at some point.
You can call that - I think it's a statement of the obvious. We can couch that as a warning, but it will adjust and we'll try to refrain from saying - we told you so."
Jon Cunliffe followed up Carney with more explicit details:
"I'd say there are different aspects to this risk. I mean, there are clearly risks about whether market participants have kind of properly internalised the normalisation of monetary policy, but also there are risks around that normalisation from unexpected, for example, geopolitical events, and whether they're actually looking at the range of probabilities there.
But even if they are correctly - or have internalised that in looking at the risks they're taking - there's then the question of whether, it's a particular point the Governor raised, whether they're properly pricing the liquidity risk in today's conditions. So whether in the event that there's a change in conditions, they can move in and out of markets with the ease that they're predicting, and how much compensation they're asking in the pricing for taking that liquidity risk…
…But we also want to make the market aware of the possibilities here, so that people start to price and charge for the risks they're taking."
As I stated earlier, it seems the FPC is placing a lot of hope on its ability to communicate clearly and convincingly enough to motivate market participants to do the repricing work themselves…in an orderly fashion of course. After a Financial Times reporter tried to get Cunliffe to state explicitly whether or not the FPC believes risks are being mispriced, Cunliffe responded in repetition, making it clear again that the FPC expects the market to do the heavy lifting on its own:
"At the moment I think, if you look at the liquidity premium and if you look at other areas, there is a risk that they're not doing that. It's for them to do it, but it's for us to remind them of where the risks are in this area."
It is not easy to process the overall implications for trading the British pound (NYSEARCA:FXB). It appears to me that to the extent the BoE is successful in getting the market to do the heavy-lifting of repricing, it can maintain the "luxury" of ultra-low interest rates. At the same time, it seems the BoE will have to use interest rates to convince the market that it really does need to reprice risks. On balance, it seems the British pound will maintain its existing strength for quite some time to come even if the bulk of the recent run-up is reaching a conclusion (essentially I am arguing for a trading range with a SLIGHT upward bias).
The current UK experience should also pave the way for the US when it finally gets to the point its own housing market becomes over-heated. However, outside of a few markets with strong job growth, the U.S. housing market is nowhere near as extended as that in the UK. In fact, the US is still in the early stages of a recovery, one that has appeared to stall without any further action from the U.S. Federal Reserve. Indeed, in its July Monetary Policy Report to Congress Fed Chair Yellen called housing market conditions "disappointing."
In the meantime, be careful out there!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In forex, I am net long the British pound