Financial markets are "sailing into uncharted waters" that could ignite a new round volatility as central banks slowly reverse years of stimulus program and government officials squabble over global trade rules, a weekend report has warned.
The Bank for International Settlements, a collective of the world's central banks and a key voice in future monetary policy thinking, said Sunday in its regular quarterly update that February's market upheaval may not be isolated and noted that much of the market's current perception of risk is linked to a "benign" outlook for inflation. Global central banks shouldn't be deterred, however, by sharper market volatility, the Switzerland-based BIS said, and should continue their path of policy tightening even as they balance the risks between controlling inflation and supporting the global economic recovery.
"The market wobble may well not be the last. Financial markets and the global economy are sailing in uncharted waters. And after an unusually long period of unusually low interest rates and accommodating monetary conditions, it would be unrealistic to expect no further market ructions.," said the BIS's Claudio Borio. "The most recent protectionist rhetoric complicates matters further. Treading the path will call for a great deal of skill, judgment and, yes, also a measure of good fortune."
The BIS noted that the 10% market correction recorded in early February was linked to a 20 point spike in the CBOE Volatility Index, known as the VIX, that was "way out of proportion to the equity market drop". Nonetheless, the increase in market volatility is probably a welcome development, the report noted, "as there are "few things more insidious in markets than the illusion of permanent calm."
"As experience indicates, that illusion can set the stage for some of the largest and most damaging losses," Borio said. "And after an unusually long period of unusually low interest rates and accommodating monetary conditions, it would be unrealistic to expect no further market ructions."
That warning is worth heeding when central banks still hold a staggering $20 trillion in government, agency and corporate bonds as part of their post financial crisis efforts to stablize markets and stoke inflation. That asset pile, according to some estimates, is worth around 44% of a global GDP, the highest on record.
"What we saw this quarter is simply the latest reminder of how such a period complicates exit, by inducing market participants' risk- and position-taking," the BIS said. "In addition, it has highlighted just how much prevailing market trends depend on a benign inflation outlook.
"No doubt, the wobble has shaken off some positions - the equivalent of pressing a "reset" button. But the overall picture has not fundamentally changed," Borio noted.