BIS Warns OF Bouts Of Extreme Volatility, As Market Undergoes “Paradigm Shift”
The Bank of International Settlements is particularly good at two things in its periodic quarterly review update: i) stating the obvious, especially when it comes to summarizing the trader and market participants concerns at any given moment, and ii) having its constituent central bank members – after all the BIS is the “central banks’ central bank” – ignore all of its warnings.
In its just released, latest report, the BIS continues to excel in both, when it lays out what it dubs a “paradigm shift in markets” and points out that unlike previous VaR shock episodes, most notably the 2013 Taper Tantrum, financial markets have been remarkably resilient to rising bond yields and sudden shift in outlook following last month’s shock U.S. election result.
However, the BIS warns that the sheer scale of uncertainties ahead means the adjustment will be “bumpy”, the BIS said on Sunday. In its quarterly report, the BIS said that while the resilience to recent market swings following the U.S. election and Brexit vote have been welcome, investors should be braced for further bouts of extreme volatilty and “flash crash” episodes like the one that hit sterling in October.
One of the gloomier of BIS forecasters, Claudio Borio who is head of the monetary and economic departmet at the organization, said that “we do not quite fully understand the cause of such unusual price moves … but as long as such moves remain self-contained and do not threaten market functioning or the soundness of financial institutions, they are not a source of much concern: we may need to get used to them.” Well, as we said, the BIS has a particular flair for pointing out the obvious..
Borio added that “it is as if market participants, for once, had taken the lead in anticipating and charting the future, breaking free from their dependence on central banks’ every word and deed.” Or, perhaps, market participants simply respond with the expectation that central banks will never again left markets drop, in response to warnings such as that from the ECB ahead of the Italian referendum, which allowed global asset prices to recoup all losses from last Sunday’s vote in just a few hours.
Indeed, as Borio admits, “the jury is still out, and caution is in order. And make no mistake: bond yields are still unusually low from a long-term perspective,” Borio said. As we showed last week when refering to SocGen’s scariest “credit” chart, corporte yields are near all time lows, even as net leverage is the highest it has been in this cycle.
However, while corporate yields are “irrationally” low, government bond yields have risen sharply since the middle of the year. The benchmark 10-year U.S. Treasury yield has jumped 100 basis points since July’s multi-decade low, with a growing number of investors saying the 35-year bull run in bonds is now over. Worse, it has led to nearly $2 trillion in global fixed income losses, which surprisingly, has not led to a major shake up across markets. Why is this? The BIS provides one explanation – the bulk of the losses are concentrated in the hands of central banks who – luckily – do not have to mark to market:
The limited market impact of higher yields may in part have reflected the capacity of major holders of government bonds to bear mark-to-market losses (Graph 5, right-hand panel) as well as limited evidence of negative feedback loops through hedging activities.
For instance, around 40% of US Treasuries are owned by the Federal Reserve and the foreign official sector. Pension funds (the third largest holders of Treasuries) and insurance companies may even benefit from rising rates in the medium term, as a normalised yield environment would allow them to more easily meet promised returns. However, valuation losses in the short run may affect profits and capital depending on accounting standards. In addition, the hedging activities of the US government-sponsored enterprises (GSEs), which contributed to the bond market turbulence of 1994, are much lower now. This is because, as part of quantitative easing policies, GSEs sold a large share of their portfolios to the Federal Reserve, which does not hedge its securities.
“Credit and equity market reactions in [emerging-market economies] were more muted than in 2013, possibly reflecting a different economic and financial backdrop,” the BIS observed. “A prospective boom in the U.S. may also have been seen to benefit” emerging-market economies, it said. “Yet risks remain,” the BIS said, citing political uncertainty in some areas and that 10% of dollar-denominated corporate debt in emerging markets is set to mature next year. A strong dollar makes it more expensive for emerging markets to service debt with their local currencies.
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Meanwhile, as central banks – and everyone else – pretends to ignore the rising bond losses, U.S. stocks are chalking up record highs, market volatility is anchored at historic lows and corporate spreads have remained relatively tight. Liquidity has been “adequate”, according to the BIS.
This all points to investors anticipating stronger growth resulting from easier U.S. fiscal policy, lower taxes and looser regulation, particularly in the financial sector, the BIS said. Banks will generally benefit from higher rates and a steeper yield curve, and the recent surge in U.S. bank stocks is “a telling sign of a brighter perceived outlook,” the BIS said.
At this point, the BIS repeats what every other market participants already knows and has expressed concern about, namely that higher yields and a stronger dollar pose risks, especially to emerging markets, even though some EM equity and credit markets held up better than they did at the time of the taper tantrum in 2013.
That said, the BIS believes that is a silver lining: the starting point for emerging markets wasn’t so severe as investors had already withdrawn “massive” amounts from EM funds between 2013 and 2015, while loans in recent years had generally been taken out over long maturities and at fixed rates. Still, nearly 10% of dollar-denominated corporate debt in EM comes due next year, meaning firms must either pay back $120 billion or refinance it at a higher and rising cost, according to the BIS. To wit:
Despite relatively limited asset market reactions in November, uncertainties facing EMEs loom large. Vulnerabilities are both external and domestic in nature. On the external side, in the aftermath of the US election, EME assets repriced the changing prospects of a boom in the United States, higher global yields, a rising dollar and the potential for a backlash against free trade. The trade-offs between these different channels may change quickly, in particular given high political uncertainty. Market dynamics could also be influenced by continued large historical exposures of EME funds. Moreover, nearly 10% of EME dollar-denominated corporate debt is scheduled to mature in 2017. Thus, close to $120 billion will need to be either rolled over or paid back, which could put further pressure on EMEs. Domestically, a umber of EMEs still face imbalances related to recent periods of rapid credit growth.
Another potential risk: dollar funding costs and money market spreads rose sharply in the latest quarter as investors adjusted to new U.S. money market rules that took effect in October. Short-term dollar funding from money market funds shrank by some 70%.
The BIS writes that these portfolio shifts have driven short-term dollar funding costs notably higher, in particular for relatively longer-term liabilities (Graph 9, third panel). On average, the one-month US dollar Libor-OIS spread was 5 basis points wider in November of this year than in October 2015, while the average three-month and six-month US dollar Libor-OIS spreads widened by 20 and 36 basis points, respectively. The costs of alternative dollar funding sources, such as cross-currency basis swap spreads (which add to the costs of issuing in a non-dollar currency and swapping the proceeds into dollars), have also turned higher, pointing to ongoing anomalies in this market, a topic extensively discussed on Zero Hedge previously.
But unlike 2008 when widening spreads tightened financial conditions and torpedoed banks’ creditworthiness, this was a regulation-driven move that had “limited” spillover effects on broader financial markets. Borrowers simply raised cash elsewhere, the BIS said.
What happens next? Borio has a section dedicated to that as well:
And so we come to the “what next?”. Are we facing a market overreaction or a paradigm shift? Hard to tell at this stage: the uncertainties involved are too large. What is surprising is that it took just one political event to seemingly dispel, in one fell swoop, the market’s belief in a future of persistently ultra-low interest rates, secularly low growth and disinflationary pressures. These events could finally represent the long-awaited beginning of a welcome normalisation process from the extraordinary post-crisis conditions. But the jury is still out, and caution is in order. And make no mistake: bond yields are still unusually low from a long-term perspective.
In the meantime, it is possible to identify some of the possible implications, should the shifts towards higher interest rates, a steeper yield curve and a stronger dollar persist and intensify. The road is bound to be bumpy. It could not be otherwise, given the point of departure. Banks and the financial sector would generally benefit from higher rates and a steeper yield curve, although there would be capital losses in the near term. This would be a welcome boost to the banking industry in many advanced economies, which is still struggling to overcome market scepticism, produce sustainable profits and leave the crisis fully behind. The surge in US bank stocks is a telling sign of a brighter perceived outlook, even if it also reflects expectations of laxer regulation in the sector. At the same time, non-US financial institutions that are heavily reliant on dollar funding may have to adjust. And emerging market economies are likely to come under further pressure. Especially vulnerable would be those where the domestic financial imbalances accumulated over the previous prolonged financial booms coincide with the higher foreign currency debt burden induced by dollar appreciation and higher rates. None of this need happen tomorrow; events unfold slowly but at an uneven pace. And it is uncertain how intense the strains might turn out to be. But all this bears close watching.
Perhaps the lack of a notable market response to recent events is why to Borio the biggest concern was not equities, but rather that mounting public and political skepticism toward free trade poses a major threat to economic growth.
“Looking further ahead, the most worrying signs relate to the risk of greater protectionism. Those signs have been multiplying in recent years, and prospects have darkened considerably with the most recent political events,” said Claudio Borio, concluding that “there would be no winners, only losers. Lower global growth, and possibly higher inflation, would benefit no one.”