Washington, D.C., April 30, 2015 - Driven by zero rates, plentiful liquidity and the expectation that this stimulus will ultimately fuel stronger global growth, financial markets have been buoyant, but this suggests that distortions may be building up, according to the latest Capital Markets Monitor from the Institute of International Finance.
"Depending on how long the "Goldilocks" economy can be sustained, market participants may be faced with a binary set of challenges - a potential disorderly adjustment if U.S. tightening is more aggressive than currently expected, or a potential "decade of zero rates" - which could have a range of negative consequences," said Hung Tran, executive managing director at the IIF.
The IIF said that a "Goldilocks" scenario for markets could well persist for a considerable period of time. Recent data suggests that economic activity is weak enough in the Euro Area, Japan and even China to warrant further QE and monetary accommodation, while the recovery in countries such as the U.S. and UK is still tentative enough to delay the first liftoff date for monetary tightening. As a result, central bank liquidity remains plentiful and both short and long-term interest rates are set to stay low. This could further accentuate the financial distortions and worse, penalize savers, including long-term investors such as pension funds and life insurance companies.
The IIF noted that the Fed's intention to eventually raise the Fed funds rate has been well communicated, and that it is reasonable to assume that higher U.S. rates have been largely discounted by markets. Only surprises relative to current market expectations-for example, an earlier liftoff date, a quicker/steeper trajectory of subsequent tightening, and/or higher end rates-would be likely to trigger a significant market reaction at this point.
The IIF noted that while banks have reduced their market-making activity, there is still a debate about whether this will result in any radical change in the availability of secondary market liquidity during a major market correction, compared to pre-crisis precedents. However, there is certainly a risk that reduced market-making capacity could increase the chances of divergence between liquidity demanders and suppliers in capital markets; this risk should be addressed for prudential reasons.
The IIF also drew attention to rising emerging market corporate sector indebtedness and questioned how much the risk of these debts is actually being hedged. ' Although debt levels in many emerging markets countries are still low by international standards, the threshold for debt sustainability in emerging markets may be lower. Moreover, the ability of EM firms to hedge effectively may be more limited, particularly given the decline in commodity prices and associated drop in foreign exchange revenues. The rapid increase in EM debt levels remains a cause for concern.
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The Institute of International Finance is the global association of the financial industry, with close to 500 members from 70 countries. Its mission is to support the financial industry in the prudent management of risks; to develop sound industry practices; and to advocate for regulatory, financial and economic policies that are in the broad interests of its members and foster global financial stability and sustainable economic growth. Within its membership the IIF counts commercial and investment banks, asset managers, insurance companies, sovereign wealth funds, hedge funds, central banks and development banks. For more information visit www.iif.com.