The return of some volatility to international stock markets should be welcomed as there are few things more insidious than the illusion of permanent calm because this can set the stage for some of the largest and most damaging losses, according to Claudio Borio, head of the Bank for International Settlements (BIS) monetary and economic department.
Like a bolt from the blue, U.S. stock markets went into a tailspin on Feb. 2 amid a surge of volatility, triggered by the release of a strong figure for wage growth, pushing up yields on U.S. Treasuries, Borio said in remarks in connection with the release of the March 2018 edition of BIS’ respected quarterly review.
A few days later, on Feb. 5, internal market dynamics took over – in a way that was reminiscent of the role of program trading and portfolio insurance in the 1987 stock market crash – as exchange-traded products that bet on volatility were wrong-footed and forced to sell to cover losses.
“But it is back, and some volatility is healthy,” Borio said.
Looking back at this burst of volatility, which was largely confined to equities, Borio said the wobble in financial markets hasn’t change the overall economic and financial picture, with financial conditions still unusually accommodative.
The U.S. dollar remains weak, a tell-tale sign of easy financial conditions, especially for emerging market economies.
While the depreciation of the U.S. dollar has surprised many economists given the combination of tighter U.S. monetary policy and fiscal expansion, BIS finds this is not unprecedented and the dollar also fell in the 1990s and 2000s when the Federal Reserve tightened.
The sudden shift in stock markets last month may also herald further wobbles, Borio said, as financial markets and the global economy are in unchartered waters. It was a reminder of how complicated the exit from years of accommodative monetary conditions could be.
“Finally, all this underscores how delicate task central banks are facing,” said Borio, adding treading this path will call for a great deal of skill, judgment and “a measure of good fortune.
“But policymakers need not fear volatility as such. Along the normalization path, some volatility can be their friend,” he said.
In its quarterly review, BIS looks at the role of exchange-traded products, such as those allowing investors to trade volatility (VIX) for hedging or speculative purposes, can create and amplify market jumps even if the core players are relatively small.
Drawing on BIS’ international banking statistics going back to the 1980s, two BIS economists look at how the global leadership of U.S. banks from the perspective of emerging Asia gave way to Japanese banks in the 1980s and then European banks in the 1990s and 2000s.
The banks became a conduit for the spread of financial distress, such as the Asian financial crises in 1997-1998, the Great Financial Crises of 2007-2009 and Europe’s sovereign debt crises of 2010-2011.
Today Japanese banks are once again the largest lenders to emerging Asia but Chinese banks now have a sizable and growing global footprint and likely to take their turn as important lenders.
Included in BIS’s quarterly review are six special features, with one showing that demand for cash has risen in many advanced countries despite the more frequent use of cards and contactless payments. This resurgence appears to be driven by the lower opportunity cost of holding cash at a time of very low interest rates.
A second feature argues that the current low valuations of banks by financial markets are not out of line with historical patterns, casting some doubt on explanations that see regulation as a major source of the low valuations and suggesting that banks could improve the valuations through traditional drivers of profitability, such as tackling bad loans and controlling expenses.
The third feature examines the risks posed by the rapid rise in debt issued by large property developers in several Asian economies as firms have shifted away from traditional bank loans toward issuing debt securities. Low profitability is has left them vulnerable to higher interest rates, falling property prices or local currency depreciations.
The fourth feature argues that the shift toward passive investing through index mutual funds or exchange-traded-funds (ETFs) could lead to a higher correlation of returns and less security-specific price information. In recent episodes of stress in financial markets, passive mutual fund lows were fairly stable while active mutual funds showed persistent outflows and ETFs flows were volatile.
A fifth feature finds a growing tension between traditional national account statistics and the global nature of today’s economy in which companies and their ownership are global and their and activity is geographically dispersed and not limited by borders. Policymakers need to take a broader view when assessing risks to the financial system.
The sixth feature expands BIS’ well-established work on early warning indicators (EWIs) of systemic banking crises and concludes that household debt and international debt are useful in this regard, especially when combined with property prices.
Within the indicators of household debt, household debt service ratio stands out and within international debt indicators, cross-border claims perform better than foreign currency debt.
The feature finds that early warning indicators of stress in the banking systems of Canada, China, Hong Kong, Switzerland are blinking red, closely following by Russia and Turkey.
Click to read BIS March 2018 Quarterly Review.
Some financial market volatility is healthy, says BIS