The global financial system is showing growing signs of strain, raising concerns about market contagion from financial product breaks.
The worries come as central banks around the world rush to tighten monetary policy in a bid to tame inflation, which analysts and policymakers say amplifies the risk of financial instability.
Investors got a taste of the eye-popping volatility last month when an explosion in UK debt reverberated around the world. The The Bank of England intervened to stabilize the marketsbut a number of closely watched indicators such as global demand for dollars and risk aversion in credit markets still show growing tension.
Meanwhile, warnings of further ructions to come are mounting. Just this week, a grim report from the Risks reported by the International Monetary Fund “disorderly revaluations of assets” and “financial market contagions”.
Meanwhile, Jamie Dimon, CEO of JPMorgan predicts an impending recession. And Ray Daliofounder of Bridgewater, the world’s largest hedge fund, said a “perfect storm” was brewing for the US economy.
Global financial conditions, which reflect the availability of funding, reached their tightest level since 2009 in late September, according to an index compiled by Goldman Sachs, supported by soaring interest rates, falling equities and soaring dollar.
Suzanne Hutchins, investment manager of global funds at Newton Investment Management, said the current environment increases the risk of so-called black swan events, or unforeseen events that usually have extreme consequences.
“We know the market is pretty illiquid at the moment,” she said. “There is huge leverage in the financial system and rates are now much higher, so there will definitely be casualties there.”
Rise in demand for dollars
Among the indicators to gauge tensions in the global economy is global demand for dollars, which has soared as investors seek protection from asset market volatility in the US currency.
Three-month euro/dollar currency swap spreads, which measure demand for dollars in the foreign exchange derivatives market, widened this month to their highest level since March 2020 as volatility in UK gilts took a hit. shaken asset prices. They have remained at high levels since late September.
A similar dynamic played out in dollar/yen swap spreads, indicating that non-US borrowers are willing to pay a premium for dollar funds.
“The scale of the (movements) is quite unusual,” said Tobias Adrian, director of the IMF’s Monetary and Capital Markets Department. “There are dollar funding shortages.”
Meanwhile, the corporate debt market is showing the highest levels of risk aversion in years. The yield spread on the ICE BofA US Corporate Index, which indicates investors’ premium demand for holding corporate bonds relative to Treasuries, hit its highest level since June 2020 last month and will not narrow. is only slightly attenuated.
The spike in global volatility caused by the UK last month showed how easily risks can ripple through markets when monetary policy tightens around the world, said Ed Perks, CIO at Franklin Income Investors.
“I think what it really highlights for me is that when you do tightening cycles, let alone of this magnitude… there is tension,” he said.
Of course, a systemic crisis is by no means assured. US Treasury Secretary Janet Yellen said on Tuesday she had seen no signs of financial instability in US financial markets despite high volatility.
“We’re a long way from people being in a mode where they’re saying this is a troubled scenario,” said Michel Vernier, head of fixed income strategy at Barclays Private Bank. “We have excessive inflation, but we have had time to prepare on the household side, on the business side and on the government side.”
Yet few people believe that the fluctuations in global markets will soon subside. Bank of England Governor Andrew Bailey threw a fresh curveball at markets on Tuesday when he said UK pension funds hit by a slump in bond prices had just three days to sort out their problems before that the central bank withdraws its support.
Meanwhile, volatility in stocks and U.S. Treasuries rose ahead of Thursday’s inflation data, matching levels associated with “highly stressed events,” the IMF’s Adrian said.
Financial stability is “another type of risk that clients are now more in tune with,” said Vasiliki Pachatouridi, head of BlackRock’s iShares Fixed Income strategy, based on recent client meetings. “I would say classic inflation is at the top of the list, then geopolitics and financial stability.”
Axel Weber, president of the Institute of International Finance, told attendees of the group’s annual meeting on Tuesday that he expects more volatility as central banks rush to raise rates in the face of persistent inflation. .
“I haven’t seen anything like it in the last 50 years,” said Weber, who was previously chairman of UBS AG and president of Germany’s Bundesbank.
“The impact on the markets will be more brutal, it will be more significant and it will be much more massive,” he said.
- Reuters with additional editing by Jim Pollard