Once again, the financial market scene was far from uneventful during recent months. Volatility spiked in mid-October. Stock prices fell sharply and credit spreads soared. US Treasuries were exceptionally volatile, at least intra-day – even more than at the height of the Lehman crisis. And yet, just a few days later, the previous apparent calm had returned. Volatility in most asset classes had sunk back down to the depths of the previous two years. And as benchmark sovereign yields sagged once more, the valuation of riskier assets recovered at least part of the lost ground. So, what is going on?
It is too early to say what exactly triggered these sharp, if brief, price swings. As we speak, researchers and market regulators in the United States and elsewhere are sifting through tons of data to understand every market heartbeat during those turbulent hours on October the 15th. That said, some preliminary reflections are in order. No doubt, one-sided market positioning played a role, as participants were wrong-footed. But is there more to it?
It is, of course, possible to draw comfort from recent events. Those who do so stress the speed of the rebound. At the same time, a more sobering interpretation is also possible. To my mind, these events underline the fragility – dare I say growing fragility? – hidden beneath the markets’ buoyancy. Small pieces of news can generate outsize effects. This, in turn, can amplify mood swings. And it would be imprudent to ignore that markets did not fully stabilise by themselves. Once again, on the heels of the turbulence, major central banks made soothing statements, suggesting that they might delay normalisation in light of evolving macroeconomic conditions. Recent events, if anything, have highlighted once more the degree to which markets are relying on central banks: the markets’ buoyancy hinges on central banks’ every word and deed.
The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows – unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth – in inflation-adjusted terms – is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine.
Looking ahead, two major developments in the period under review are likely to leave a profound imprint on the financial and macroeconomic scene.
The first concerns exchange rates. As macroeconomic conditions have diverged across the key currency areas, so have the actual and expected monetary policy stance. The ECB and the Bank of Japan have loosened policy and indicated that more easing may well be in the offing; by contrast, the Federal Reserve has stopped purchasing assets and has been hinting at an interest rate hike at some point in 2015. This has already triggered sizeable exchange rate shifts. The US dollar has appreciated relative to the euro and the yen as well as more generally.
The second concerns the sharp drop in the oil price, alongside a milder one in that of other commodities. In fact, the 40 per cent fall since June 2014 is the third largest in the last fifty years, exceeded only by that following the Lehmann default and the breakdown of the OPEC cartel in 1985. Part of the drop reflects demand factors, not least softening growth in China. But much of it reflects unexpected increases in supply. This is surely good news for the global economy. That said, there are bound to be winners and losers, and the drop may disproportionately affect some regions of the world, possibly compounding domestic vulnerabilities.
These developments will be especially important for emerging market economies. The spike in market volatility in October did not centre on these countries, unlike at the time of the taper tantrum in May last year and the subsequent market tensions in January. But the outsize role that commodities and international currencies play there makes them particularly sensitive to the shifting conditions. Commodity exporters could face tough challenges, especially those at the later stages of strong credit and property price booms and those that have eagerly tapped equally eager foreign bond investors for foreign currency financing. Should the US dollar – the dominant international currency – continue its ascent, this could expose currency and funding mismatches, by raising debt burdens. The corresponding tightening of financial conditions could only worsen once interest rates in the United States normalise.
Unfortunately, there are few hard numbers about the size and location of currency mismatches. What we do know is that these mismatches can be substantial and that incentives have been in place for quite some time to incur them. For instance, post-crisis, international banks have continued to increase their cross-border loans to emerging market economies, which amounted to $3.1 trillion in mid-2014, mainly in US dollars. And total international debt securities issued by nationals from these economies stood at $2.6 trillion, of which three quarters was in dollars. A box in the Highlights chapter of the Quarterly Review seeks to cast further light on this question, by considering the securities issuance activities of foreign subsidiaries of non-financial corporations from emerging markets.
Against this backdrop, the post-crisis surge in cross-border bank lending to China has been extraordinary. Since end-2012, the amount outstanding, mostly loans, has more than doubled, to $1.1 trillion at end-June this year, making China the seventh largest borrower worldwide. And Chinese nationals have borrowed more than $360 billion through international debt securities, from both bank and non-bank sources. Contrary to prevailing wisdom, any vulnerabilities in China could have significant effects abroad, also through purely financial channels.