Why financial market shocks will be the new normal as central banks tighten their liquidity belts

Nicholas Spiro says the volatility on Wall Street in February and the turbulence in Italy, China and Turkey are not isolated events but the outcome of quantitative tightening

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An investor looks at a board showing stock information at a brokerage office in Beijing on July 6. The Shanghai Composite Index entered a bear market in late July. Photo: Reuters

Published: 3:00pm, 16 Aug 2018Updated: 10:34pm, 16 Aug 2018

One of the buzzwords in financial markets this year has been “idiosyncratic”. A series of shocks that began in early February with a sudden eruption of volatility in US stock markets and have since put Italy, China and now Turkey under strain have been treated by international investors as disparate sell-offs, each with their own causes and catalysts.

At first glance, this appears to be the case. The turbulence in US equity markets – which stemmed mainly from an abrupt unwinding of the so-called “short volatility” trade in which investors bet heavily on continued calm in stock markets – had little to do with the escalation in political risk in Italy in May due to fears about the new populist government’s commitment to the rules underpinning the euro.

Even within emerging markets, the reasons behind the four-month-long period of turmoil differ, depending on the country. While the sharp falls in China’s currency and equity markets have been driven mainly by fears about the impact of the trade war on the country’s slowing economy, this month’s dramatic decline in Turkey’s currency is attributable to fears that the country will not be able to meet its large external financing requirements.

Yet, on closer inspection, a common thread runs through this year’s market blow-ups: the steady tightening of financial conditions which is making investors more sensitive to the plethora of vulnerabilities in both advanced and developing economies.

To be sure, benchmark interest rates remain near historic lows and there is little prospect of a severe credit crunch any time soon. Yet there has been a discernible shift in the financial landscape over the past year or so.

One of the clearest signs of this is the 60 basis point jump in the three-month London interbank offered rate (Libor), a benchmark for global borrowing costs, since January to its highest level since 2008. For the first time in a decade, cash is starting to become competitive, putting so-called “risk assets” under strain.

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