It’s been well telegraphed by the US Federal Reserve that they are looking to normalize monetary policy at some point this year.
The question is, could it spark a renewed bout of market volatility, despite the best efforts of Fed officials?
The IMF looked into this in their latest Global Financial Stability Report, in which they warn “markets could be increasingly susceptible to episodes in which liquidity suddenly vanishes and volatility spikes”.
Using the example of the US treasury “flash crash” of October 2014 and Swiss Franc peg removal in January this year – two events that created significant market volatility – they suggest that the moves seen across markets were “likely amplified by market makers’ withdrawal of liquidity support”.
Digging deeper, they also suggest that “many of the factors responsible for lower market liquidity also appear to be exacerbating risk-on/risk-off market dynamics and increasing cross asset correlations during times of market stress”.
That is, as market liquidity dries up during times of volatility, the scale and breadth of market moves are becoming more amplified in nature.
The IMF suggests automation and the rise of high-frequency trading, reduced market making by traditional dealers, inadequate market safeguards, the emergence of less-regulated non-bank market intermediaries, market benchmarking and the use of derivatives and exchange-traded funds are all contributing to reduced market liquidity, increased volatility and higher levels of correlation across asset classes.
The analysts at Societe Generale describes this chapter on the potential for liquidity problems as “not for the faint-hearted”.
“The IMF is not alone in issuing these warnings and it is no surprise that the IMF’s Global Financial Stability Map showed an increase in risks,” Soc Gen’s global head of economics, Michala Marcussen, wrote.
As the chart below shows, post the financial crisis of 2008/09, correlations across financial markets have increased substantially. Higher correlations mean assets are more likely to move up and down together.
In response to this increase in cross-asset correlations post crisis the fund warns that there are now “greater risks of contagion across asset classes or borders”.
While the fund offers a variety of suggestions to help reduce the risks of this occurring before the Fed begins to normalize policy almost all of them are dependent on near-term actions being taken by policymakers around the globe.
With the Fed likely to begin raising rates at some point later this year one has to be sceptical whether these safeguards will indeed be in place.
If they’re not, even despite the best efforts of the Fed to communicate this move, expect market volatility to increase as we head towards year end.
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