Investors should prepare for “severe but plausible stresses” given the range of risks facing the global economy, the Bank of England warned today.
Officials at the Bank said that the “significant but short-lived spike in volatility and falls in equity indices” seen in early August demonstrated the risks facing global markets.
“Recent market moves illustrate the risk of sharp corrections, which can be amplified by non-bank risks. Firms need to be prepared for such risks,” members of the Bank’s Financial Policy Committee (FPC) cautioned.
The FPC, which monitors financial stability risks, identified a range of factors which had contributed to the stress. These included weak US economic data, the unwinding of the yen carry trade and poor results from US tech firms.
The Bank said a broader market downturn had been averted because economic data had subsequently turned more positive. Key market infrastructure had also been insulated from the shock.
Although the market volatility did not tip into a wider financial meltdown, FPC members stressed that traders still needed to be cautious.
Since the sell-off, US equity markets have scaled new heights while estimates of risk premia remain close to their historic lows in the US, EU and UK, the FPC pointed out.
“Market contacts noted the apparent disconnect between stretched valuations and risks to global growth…Markets therefore remained susceptible to a sharp correction”.
The FPC drew attention to a range of risks that could impact market confidence, including heightened geopolitical tension and downside risks to the outlook for global growth.
“Global vulnerabilities remain material, as does uncertainty around the geopolitical environment and global outlook,” the FPC warned.
If any of these concerns were to materialise, the impact on the economy could be amplified through risky bets in financial markets.
In particular, the FPC highlighted concerns about the US Treasury market. Hedge funds have been making increasingly big bets on US Treasuries, which play a crucial role in anchoring prices for markets around the world.
According to the Bank, hedge fund’s net short position in the US Treasuries reached a peak of $1trn during the quarter compared to a previous peak of $875bn.
Major deleveraging in the US Treasury market could “amplify the transmission of future stress,” the FPC warned.