Oct 12 (Reuters) – Signs of stress are growing in the global financial system, raising concerns about everything from cross-market contagion to breakdowns in financial products.
The concerns come as central banks around the world furiously tighten monetary policy as they struggle to control inflation, creating an environment that investors and policymakers say is fertile ground for bouts of financial instability.
Investors got a taste of the staggering volatility these episodes can bring last month, when an explosion in UK debt reverberated around the world. Although the Bank of England stepped in to stabilize markets, a number of closely watched indicators, such as global demand for dollars and risk aversion in credit markets, still show growing financial stress.
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Meanwhile, warnings of more riots ahead are mounting. Just this week, a gloomy report from the International Monetary Fund pointed to the risks of “disorderly asset appreciation” and “financial market contagion”, while JPMorgan (JPM.N) chief Jamie Dimon predicted an impending recession. Ray Dalio, founder of Bridgewater, the world’s largest hedge fund, said Tuesday that a “perfect storm” was brewing for the US economy.
Global financial conditions, which reflect the availability of financing, hit their tightest level since 2009 at the end of September, an index compiled by Goldman Sachs (GS.N) showed, driven by rising interest rates, falling of stocks and the rise of the dollar.
Suzanne Hutchins, investment manager for 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 that the market is quite illiquid right now,” he said. “There is a huge amount of leverage in the financial system and rates are much higher now, so there will certainly be some casualties.”
SEEING THE DASHBOARD
Among the indicators to gauge stress in the global economy is global demand for dollars, which has soared as investors seek refuge in the US currency from volatile asset markets.
Three-month euro/dollar cross-currency swap spreads, which measure demand for dollars in the currency derivatives market, widened this month to their highest level since March 2020 as volatility in gilts UK rocked asset prices. They have remained at elevated levels since the end of September.
A similar dynamic occurred in dollar/yen swap spreads, indicating that non-US borrowers are prepared to pay a premium for dollar funds.
“The magnitude of the (moves) is quite unusual,” said Tobias Adrian, director of the IMF’s Monetary and Capital Markets Department. “There is a shortage of funds in dollars.”
The IMF’s Global Financial Stability Report, released on Tuesday, also highlighted specific risks in open-end mutual funds and the leveraged loan market.
Meanwhile, the corporate debt market is showing the highest levels of risk aversion in years. The ICE BofA US Corporate Index (.MERC0A0) yield spread, which indicates the premium investors demand to hold corporate bonds over Treasuries, rose to its highest level since June 2020 last month and has narrowed only marginally.
The UK-led spike in global volatility last month showed how easily risks can spill over into markets when monetary policy tightens around the world, said Ed Perks, CIO of Franklin Income Investors.
“I think what really stands out to me is that when you do tightening cycles, let alone of this magnitude… tensions are felt,” he said.
Of course, a systemic crisis is by no means assured. US Treasury Secretary Janet Yellen said Tuesday that she has seen no signs of financial instability in US financial markets despite high volatility.
“We are far from people being in a mode where they say this is a distressed scenario,” said Michel Vernier, head of fixed income strategy at Barclays Private Bank. “We have excessive inflation, but we have been given time to prepare on the domestic, corporate and government side.”
Still, few believe the gyrations in global markets will subside any time soon. Bank of England Governor Andrew Bailey threw the markets another curveball on Tuesday when he said British pension funds hit by a drop in bond prices had just three days to fix their problems before the bank center will withdraw support.
At the same time, volatility in US equities and Treasuries rose ahead of Thursday’s inflation data, corresponding to levels associated with “very stressful events,” the IMF’s Adrian said.
Financial stability is “another type of risk that clients are now more attuned to,” Vasiliki Pachatouridi, head of EMEA iShares fixed income strategy at BlackRock (BLK.N), told Reuters, citing recent meetings with clients. . “I would say classical inflation is at the top of the list, then geopolitics and financial stability.”
Axel Weber, president of the Institute of International Finance, told attendees at 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 this in the last 50 years,” said Weber, who previously served as chairman of UBS AG and president of the German Bundesbank.
“The impact on the markets will be more brutal, more anticipated and much more massive,” he said.
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Information from Davide Barbuscia and Lewis Krauskopf; Additional reporting by Tommy Reggiori Wilkes, Dhara Ranasinghe, Yoruk Bahceli, David Randall, and Lananh Nguyen; Written by Ira Iosebashvili and Megan Davies; Edited by Nick Zieminski and Chris Reese
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