The recent failure of U.S.-based Archegos Capital Management, a family office that made large, risky bets on a handful of stocks, could be a sign of how more investors might get tripped up by overreacting to inflationary risks, the global club of central banks warned on Tuesday.
Shocks to financial markets from higher inflation could result from enormous government spending plans and a rapid release of household savings built up during the Covid-19 pandemic, said the Bank for International Settlements, often called the central bankers’ central bank.
A string of banks, led by Credit Suisse Group AG, lost billions of dollars on loans to Archegos when it collapsed in April. The BIS said prolonged, aggressive risk-taking in markets had increased the probability of investors being wrong-footed.
Agustín Carstens, head of the BIS, said its central prediction was for a smooth recovery with only temporary rises in inflation above central bank targets in the U.S. and other advanced economies. But uncertainties remained, particularly if the pandemic was quickly overcome and households began to splurge the cash they had saved during lockdowns.
“How fast will households reduce those savings?” he said, adding that if government spending continues at a rapid pace, “then that could cause higher inflation.”
Consumers in advanced economies have been forced to save rather than spend a lot of their income during lockdowns, and that has led to a big buildup of spare cash. U.S. households have excess savings equivalent to more than 5% of GDP, a level beaten only by the U.K., Canada and Australia, according to the BIS in its annual economic report.
U.S. inflation already hit an annual rate of 5% in May and the Federal Reserve significantly increased its forecast for inflation this year at its June meeting. The Fed is convinced elevated inflation will be temporary and fall back quickly toward the central bank’s long-term 2% target next year, but some investors are already concerned it will prove more sustained.
Salman Ahmed, global head of macro at Fidelity International, said that monthly inflation readings would need to drop back below annualized rates of 2% in the final few months of this year—otherwise the Fed’s forecast would turn out too low.
The BIS said the inflation-damping influences of cheap technology and global trade would likely continue to weaken the pricing power of both workers and companies. However, even if high inflation ultimately proves temporary, financial market participants could overreact, anticipating more sustained inflation, the BIS said.
“Participants could be caught wrong-footed and be forced to unwind their positions,” it said. “Recent localized stress, such as the Archegos failure and the losses it has inflicted on banks, could turn out to be the proverbial canary in the coal mine.”
The BIS added, “Especially in the United States, which would be critical in this scenario, a tug of war between financial markets and the central bank would probably ensue.”
A key question would be about the resilience of investment funds and other nonbank financial intermediaries. There could be hidden leverage, through borrowing or derivatives, and mismatches between illiquid assets and the ease with which investors can demand their money back.
Mr. Carstens added that a focus on the regulation of market-based finance meant many of the worst sources of financial instability were being taken care of.
Another potential longer-term problem is the level of government debt globally and how much it would cost to pay the interest on it if rates rise. High debt-service costs would mean governments have to slash spending or raise taxes.
Despite very high government debt, average servicing costs as a share of GDP are currently at record lows. However, if interest rates rose to the levels of the mid-1990s, average service costs would be at a record and exceed previous wartime peaks, the BIS said.
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