A toxic mix of complacency, excessive risk-taking and market exuberance in financial markets is raising risks of a market correction, the International Monetary Fund has said. Underlying their risky bets, investors seem uniform in their belief that interest rates are going to be low as far as the eye can see. “A sense of complacency appears to be permeating markets,” said Tobias Adrian, the director of the IMF’s Monetary and Capital Markets Department, in a blog post accompanying the international agency’s latest Global Financial Stability report.
Financial markets have shrugged off the most recent softening of economic activity, the IMF report noted. At the same time, asset valuations appear to be stretched in several sectors. “For example, in the tech sector, we’re detecting some frothiness,” Adrian said during a question-and-answer session following the publication of the report. Under these conditions, a sudden asset-price correction — from a persistent increase in interest rates for example — would cause a tightening of financial conditions, he said. Investors already seem to have looked past a recent tick-up in long-term yields with the U.S. 10-year Treasury note TUMBMUSD10Y, 1.016 up to 1.19% on January 12, before retreating to 1.04%.
Asked about trading in GameStop Corp. and stocks that have surged in price driven by message boards such as Reddit’s Wall Street Bets forum, Adrian said there is a move into day-trading reminiscent of the 1990s-dot-com boom. “Quite a lot of volatility is possible – of course when this might occur is uncertain,” Adrian said. ”At the moment, these are pockets and overall valuations are not driven by them at the moment,” he added.
This exuberance and nonchalance creates a “difficult dilemma” for central bankers, Adrian said. They need to keep financial conditions easy to provide a bridge to the economic recovery, but they also need to safeguard the financial system against “unintended consequences” of their policies.
Financial stability risks have been held in check so far, but action is needed to address vulnerabilities exposed by the pandemic, he said.
The list of what financial regulators should focus on is a long one, according to the IMF, and includes: rising corporate debt, fragilities in the nonbank financial institutions sector, increasing sovereign debt, market access to concerns for some developing developing economies and declining profitability in some banking systems. “Tackling vulnerabilities through these policies is crucial to avoid putting medium-term economic growth at risk and to prevent adverse feedback loops between the financial sector and the real economy,” Adrian said. The IMF report warned that delayed comprehensive health care solutions could endanger the global financial system.
Risks in the non-financial corporate sector remain too. The number of potential “fallen angels” firms with a BBB-minus credit rating and negative outlook has tripled globally since the beginning of the coronavirus pandemic and in the U.S. and euro-zone the potential for further downgrades is elevated. In China, concerns about financial vulnerabilities remain given the defaults by state-owned enterprises in the last three months of 2020.
