The economic impact of US tariffs and other trade measures have hogged headlines since last year. But the story of what’s happening in the global financial system as a direct and indirect result of these measures has remained largely untold.
Some indications of potentially systemic financial sector problems began to emerge during the recent spring meetings of the International Monetary Fund and World Bank. These issues are highlighted in the IMF’s latest Global Financial Stability Report and in the US Federal Reserve’s April Financial Stability Report.
“Financial stability risks have grown significantly, driven by tighter financial conditions and heightened trade and geopolitical uncertainty,” Tobias Adrian, an economic counsellor at the IMF wrote in a blog post. “Valuations of some [financial] assets remain stretched despite recent sell-offs. Further asset price corrections suggest the need for close attention, given the highly uncertain economic backdrop.”
According to the IMF report, the ratio of equity prices to earnings was near the high end of its historical range even before the market volatility in early April, and has since stayed high relative to analysts’ forecasts. US Treasury yields across maturities have also remained at the higher end of their levels since the 2008 global financial crisis.
Liquidity across many financial markets has, meanwhile, remained low.
The IMF report notes that the most dramatic corrections in asset prices so far have been in US markets and that capital markets have become increasingly concentrated. For instance, the US accounts for nearly 55% of the global equity market, up from 30% two decades ago.
As the IMF points out, capital markets are key to driving economic activity. The stability of these markets and the financial institutions that intermediate them are “macro-critical, especially when market volatility and economic uncertainty are high, as they are now”.
Meanwhile, the report cautions that sovereign debt levels continue to rise, seemingly outpacing growth in the market infrastructure tasked with ensuring smooth market functioning. “Core government bond markets may see elevated volatility, especially those in countries with high debt levels.”
Sovereign debt now accounts for 93% of global economic output, up from 78% a decade ago, and financing costs have increased. “Because government bonds are cornerstone instruments in capital markets, disruptions in this market could pose a threat to financial stability,” the IMF warns.
It notes that non-bank financial institutions have become more active in channelling savings into investment since 2008, and that their nexus with traditional banks has continued to grow, warning that “further sell-offs could strain some financial institutions, and the ensuing deleveraging in the sector could exacerbate market turmoil”.
With global growth forecast to slow, the repayment ability of borrowers could deteriorate, leading to losses to both private credit funds and partner banks.
Although expanded financial intermediation by non-banks positively affects the economy, the IMF says excessive growth predicated on borrowing from traditional banks may make both types of lenders more susceptible to potential contagion risks.
Global systemically important banks and other leverage providers, such as clearing houses for derivatives, use various tools to protect themselves against the risk of failure of non-bank financial institutions. But, as the IMF report notes, they cannot control how much a client borrows elsewhere.
The report warns that the highly leveraged trading strategies of some hedge funds could backfire in volatile markets. This could lead to a deleveraging in which they sell assets into a falling market, in turn causing losses for banks that provided their leverage.
