It might appear perverse but the relatively positive news coming out on the state of the US economy represents a new threat to the stability of the financial system.
Last week’s encouraging US employment data has triggered another bout of volatility in global currency and bond markets as a conviction grows that the US Federal Reserve’s vague commentary about a "tapering" of its quantitative easing program is likely to translate into action sooner rather than later.
While a gradual "normalisation" of US monetary policy in line with a continuing US economic recovery – which could take several years – is good news for the global economy it isn’t necessarily such good news for financial market participants who had been operating on the basis that global monetary policies would remain extraordinarily loose for the foreseeable future.
As soon as the Fed starting musing about a tapering of its $US85 billion a month QE III program of bond and mortgage purchases in May there was a sharp increase in the level of volatility across financial markets as myriad trades predicated on long-term cheap funding started to be unwound.
Bond yields in the US, Europe and emerging markets spiked quite markedly and close to $US50 billion flowed out of US exchanged-traded and mutual bond funds in June.
The potentially destabilising impact of the rise in market interest rates in the US and elsewhere was seen in data issued by the Federal Reserve board on Friday which showed that, where US banks had started the year with more than $US40 billion of unrealised gains on their bond holdings, about $US34 billion of those paper profits have now evaporated.
Given that there have been 50-plus basis point rises in US five and 10-year bond yields over the past month (more than 100 basis points compared with a year ago) that isn’t surprising. The US has done a good job of recapitalising its banking system and returning it to profitability, however, its banks ought to be able to absorb mark-to-market losses on their bond portfolios.
That may not be quite the case for banks elsewhere.
Earlier this year the Bank for International Settlements provided an illustration of what could happen if bond yields really spiked, saying that a 3 per cent rise in US treasury yields would cost holders of those securities more than $US1 trillion. Losses for holders of debt issues by France, Italy, Japan and the UK would range from about 15-35 per cent of the GDP of those countries, it said.
The impact of the turmoil generated by the prospect of a withdrawal of the QE III program over the next year or so has generally been slightly more subdued in Europe than in the US and emerging markets, probably because the European authorities have vowed to maintain their own expansive monetary policies.
In two of the weaker economies, Portugal and Greece, however, bond yields have jumped over the past month by about 100 basis points and 185 basis points respectively. Greece, of course, is in the final throes of thrashing out an agreement which would see it receive the next tranche of its bailout funding.
There is a broad risk within Europe that if market rates are forced up its under-capitalised banks could come under new pressure. Unlike the US the European authorities have allowed some of their banks to remain under-capitalised, presumably in the hope that time and some return to growth would reduce their vulnerability.
European banks were also encouraged, or not discouraged, from buying sovereign bonds in the early years of the financial crisis using the relatively cheap funding to create, not just a profitable spread but support for their generally over-stretched governments’ finances by keeping yields on sovereign bonds lower than they might otherwise have been.
QE III’s impact on global interest rates and the European Central Bank’s promise to do "whatever it takes" has had a significant impact on yields on European sovereign debt over the past year or so – or at least had a positive impact until the speculation of a tapering of the QE III program began in May.
With the public finances of southern Europe still extremely fragile the last thing the Europeans would want is for its banks to have to raise capital or be bailed out because of losses on their bond portfolios.
When the European Banking Authority has conducted "stress tests" of its banks in the past it has effectively allowed the banks to ignore unrealised losses on their sovereign debt holdings in assessing their capital adequacy.
The ECB will take over supervision of Europe’s banks in the middle of next year and has begun its own review of their asset quality which is expected to be rather more rigorous than those earlier tests. It is expected to force the banks to disclose their unrealised losses on government debt.
If global rates were to continue to rise the European sovereign debt crisis, dormant for the past year, might once again be back in the headlines because of the nexus between the balance sheets of some of the region’s big banks and those of their governments.