The next financial crisis may be triggered by central banks

Debt is used to finance the purchase of assets, and the greater availability of credit pushes asset prices higher. From time to time, however, lenders lose faith in borrowers’ ability to repay and stop lending; a fire sale of assets can follow, further weakening the belief in the creditworthiness of borrowers.

Central banks then step in to cut interest rates or (since 2008) to buy assets directly. This brings the crisis to a temporary halt but each cycle seems to result in higher debt levels and asset prices. The chart shows that the combined valuation of bonds and equities in the developed world is higher than ever before.

All this suggests that the financial system could be due another crisis. Deutsche makes several suggestions at to what might cause one, from a debt-related crash in China, through the rise of populist political parties to the problem of illiquidity in bond markets.

The most likely trigger for a sell-off is the withdrawal of support by central banks; after all, the monetary authorities are generally credited with having saved the global economy and markets in 2009. In America the Federal Reserve is pushing up interest rates and reducing the size of its balance-sheet; the European Central Bank seems likely to cut the scale of its asset purchases next year; the Bank of England might even increase rates for the first time in more than a decade.

Central banks are well aware of the dangers, of course; that is why interest rates are still so low, even though developed economies have been growing for several years. But the process of withdrawing stimulus is tricky. A big sell-off in the government-bond markets in 1994 started when the Fed tightened policy after a period when rates were kept low during the savings-and-loan crisis.

The high level of asset prices means that any kind of return to “normal” valuation levels would constitute a crisis, on Deutsche’s definition. That might mean that central banks are forced to change course and loosen policy again. But the process would take a little time; central banks will not want to appear too enslaved to the markets.

Many investors will want to ride out the volatility; that has been a winning strategy in the past. The problems will emerge among those investors who have borrowed money to buy assets—in America the volume of such debt exceeds the level reached in 2008. The big question is which is the most vulnerable asset class. American mortgage-backed securities were the killers in 2008; it is bound to be something different this time round.

https://www.economist.com/news/finance-and-economics/21729750-process-withdrawing-monetary-stimulus-fraught-danger-next