Janet Yellen must be glad that the week is over. The Federal Reserve Chair's semiannual testimonies to the House Financial Services Committee and Senate are grueling enough at the best of times, but last week she had to sit through them while markets were glowing red everywhere.
Over recent trading sessions, the market selloff since the start of the year has changed its emphasis, turning its sights from the energy sector to banks. By last week, shares in JPMorgan Chase had fallen by 19% year-to-date. Bank of America and Citigroup were both down more than 30%. In Europe on Thursday the composite spread measured by the iTRaxx Financials Subordinated Debt CDS index hit a three-and-a-half-year high of 331 basis points, having more than doubled since the beginning of December. The markets seemed to be suggesting that the risk of a major financial crisis was not immaterial.
This latest turn in market sentiment seems to have begun at the end of January, when the Bank of Japan announced a move to negative interest rates on deposits from its member banks, which takes effect on Tuesday. Far from stimulating the market, this surprise move further reduced faith in Abenomics and heightened fears of a global downward spiral in central bank rates. Last week saw Sweden's Riksbank-the first central bank ever to go negative with deposit rates, back in 2009-cut to -0.5%, despite reasonable growth in the Swedish economy. This similarly caused a rush out of anything to do with European banks and into safe havens. On Thursday, Yellen told the HFSC that, having dismissed the idea of negative rates in 2010, the Fed is "looking at them again" as a possibility should it need to "add accommodation."
Despite all the downward pressure on bank stocks, this does not feel like the existential or systemic threat to the banking system that we faced in 2008. Back then, we had a toxic combination of too much leverage in the system, a massive housing bubble bursting, and the huge policy mistake of letting Lehman Brothers fail. Today, banks have much healthier capital ratios, especially in the U.S. However, negative rates (and yield curves that are flatter than at any time since 2007) are clearly not good for banks' profit margins, and struggling banks could mean tightening financing conditions for the economy as a whole. That the Fed itself cannot seem to decide whether it wants to pull in the opposite direction or give in to the negative-rates tide merely sows more confusion.
That sums up the biggest issue creating disarray right now: the market's confidence in central bank policies is deteriorating. Over the past six or seven years, these policies have worked to mitigate the economic and financial risk posed by the systemic issues behind the crisis of 2008. But many now worry that the central banks are out of policy options to deal with current weak growth and the risk of deflation.
Central bankers are not magicians. They cannot unilaterally solve all of the economic challenges we face across the globe. Whether in the U.S., Europe, Japan or China, there need to be structural reforms and significant changes to government policy, often unique for each country or region, to restore growth to healthier levels. Examples include investment in infrastructure in the U.S., fiscal union in Europe, labor-market reform in Japan, and market-driven capital allocation in China. Even when these get on the agenda, these reforms will take time and effort to accomplish. If markets continue to have only the Fed and other central bankers to look to for policy guidance, with their increasingly limited tools for the unprecedented issues we face, it should come as no surprise if it turns out that volatility is here to stay.
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