The tensions in financial markets in the last quarter of 2018 are the first of several "bumps in the road" expected as central banks move toward their pre-crisis monetary policy settings, the Bank for International Settlements said in its quarterly review.
Claudio Borio, head of the bank’s monetary and economic department, said market disruption was likely to recur.
"Faced with unprecedented initial conditions — extraordinarily low interest rates, bloated central bank balance sheets and high global indebtedness, both private and public — monetary policy normalization was bound to be challenging, especially in light of trade tensions and political uncertainty. The recent bump is likely to be just one in a series," he said.
During the quarter, prices fell for many asset classes as central banks raised interest rates and slimmed balance sheets.
"Two factors appear to have been at the root of the financial market repricing: Despite strong earnings announcements, mixed signals from the economy and changes in the perception of the Federal Reserve's stance. Until then, investors had seen a gradual, yet steady, tightening ahead. But as December began, they revised downwards their expectations of its pace," said Borio.
Flight to safety
U.S. government bond yields rose in October but went into reverse as the selloff of risk assets spread, said the bank. Then a further round of turbulence resulting in still lower yields hit markets in December.
"The tremors in October had all the hallmarks of a snapback in bond yields, albeit a comparatively mild one. Amid the usual accompanying volatility spike, equity prices erased all the gains accumulated since the beginning of the year as term premia decompressed and both nominal and real interest rates increased. The tremors in early December had more of a flight-to-safety character." said Borio.
The bank said political uncertainties were very much in evidence during the quarter as worries about a hard Brexit shook markets in the U.K., with sterling taking a knock. In the euro area, Borio said the source of tension was, once again, the darkening outlook around Italy’s already delicate fiscal condition.
The European banking sector, in particular, showed continuing weakness.
"Bank shares plunged further than those in other advanced economies. Ostensibly, investors remained nervous about the sector, which is struggling to improve its lackluster profitability, in some cases is still burdened by nonperforming loans, and is highly exposed to the sovereign’s fortunes," said Borio.
The bank said the stock market rout was global, with the Chinese stock market being especially weak, but emerging market economies "plodded on." However, Borio also said from a longer-term perspective U.S. financial conditions are still "comparatively easy" and valuations remain "rather elevated."
The bank's quarterly review also looked at where non-U.S. banks raise their U.S. dollar funding, which now stands at $12.8 trillion — as large a sum as at the peak of the financial crisis.
Before the crisis, the bank said, European lenders in particular used their branches in the U.S. to borrow in dollars in financing their purchase of mortgage-backed securities and the rapid growth of this business was associated with the build-up in overall risks before the crisis.
Since the crisis, European banks have shrunk their dollar businesses and the role of their U.S. affiliates while non-European banks expanded their dollar borrowing quite rapidly. Now, non-U.S. banks rely less on their U.S. branches and increasingly raise dollars in their home markets with a larger share provided by U.S. residents in cross-border transactions.
This could have implications for the availability of dollar funding times of market stress.
"Non-U.S. creditors may be pressured to withdraw funding as they might face a dollar funding squeeze themselves. The fact that a large share of dollars is provided by US residents, who are less likely to face dollar liquidity problems, may therefore alleviate potential funding risks to some extent," said the bank.
However, it also said cross-border funding may be fickle in a crisis and concluded it is not clear what the risks are associated with the change to the way banks gain access to dollars.
The report also looked at ways to predict recessions based on the premise that once financial cycles peak the real economy typically suffers. The bank said this is most evident around financial crises which tend to usher in deep recessions as falling asset prices and high debt burdens act as a drag on growth.
It found that different financial cycle proxies, including debt servicing ratios or the deviation of the credit-to-GDP ratio from its long-term trend, provide valuable information for up to three years ahead, outperforming traditional yield curve-based interest rate spreads.