During this eventful month, the Australian and US stock markets experienced significant fluctuations. Although they have largely regained lost ground, the IMF warned that the events of August should be seen as a warning of potential chaos to come if volatility continues to rise alongside uncertainty.
In early August, there was a sharp decline in global stock prices, triggered by the unwinding of carry trades that borrowed yen to fund long positions in risky assets. These sales intensified after the Bank of Japan’s monetary policy decision in late July and a weaker-than-expected U.S. labor market report for July.
The resulting stock volatility surged from previously compressed levels, exacerbating the selloff before stabilizing in the days that followed.
Although the volatility was short-lived, the latest IMF report Global Financial Stability Report pointed out that this episode offered insight into the turbulent market reactions that can occur when spikes in volatility intersect with leveraged positions held by financial institutions, leading to non-linear market responses and accelerated selling.
“A further rise in economic uncertainty could increase downside risks to future growth, asset prices and bank lending growth,” the IMF said.
The fund explains: “For example, assuming that global real economic uncertainty increases by an amount equivalent to its increase during the global financial crisis, the negative outcome of global real GDP growth one year from now will worsen by 1.2 percentage points. This effect is stronger when macrofinancial vulnerabilities are higher or when market volatility is more disconnected from uncertainty. Uncertainty can also trigger cross-border spillovers through trade and financial ties.
Drawing a parallel between the August unrest and the role of non-bank financial intermediaries (NBFIs) in transmitting financial stress, the IMF noted that the rapid unwinding of leveraged positions can create liquidity imbalances, thus increasing market volatility.
“With the growth of open-end bond funds, hedge funds and private credit, the use of leverage among several segments of NBFIs is increasing,” he said.
“Even in the absence of defaults, which could give rise to counterparty risk and lead to contagion between financial institutions, rapid unwinding of leveraged positions can generate liquidity imbalances that amplify market disruptions. ”
He also highlighted that the lack of adequate data poses a significant challenge for authorities, hampering their ability to assess vulnerabilities linked to non-bank debt and identify large and concentrated positions.
The IMF’s concerns extend to global financial stability, with the fund identifying three key imbalances that could exacerbate risks and amplify shocks.
First, it highlights “high” asset valuations in the equity and corporate credit markets, driven by “optimistic investor sentiment, apparently undeterred by slowing corporate earnings growth and continued deterioration of the most fragile segments of the corporate and commercial real estate sectors. .
Rising public debt represents another critical imbalance, while increased indebtedness of financial institutions – particularly NBFIs such as hedge funds and private credit funds – constitutes the third.
“These imbalances could worsen future risks to financial stability by amplifying negative shocks, which have become more likely due to elevated economic and geopolitical uncertainty,” the IMF said.
Much of this uncertainty comes from the fact that half the world’s population has or will elect new governments this year, making it difficult to predict future policies – from tax to trade to geopolitics. Ongoing military conflicts, notably in the Middle East and Ukraine, further contribute to this unpredictability.
The IMF warned that adverse shocks are “not only likely”, but that the growing mismatch between uncertainty and relatively low volatility in financial markets suggests that a spike in volatility could soon bring them into line with prevailing uncertainties.
