After last summer's turmoil in financial markets, an uneasy calm has reigned but this behaviour belies weak underlying economic conditions and at some point this tension will have to be resolved, cautions Claudio Borio of the Swiss-based Bank for International Settlements (BIS).
"Markets can remain calm for much longer than we think. Until they no longer can," said Borio, head of BIS' Monetary and Economic Department in a briefing to media in connection with the publication of the institution's latest quarterly review.
During the recent calm in financial markets ahead of an expected shift in U.S. monetary policy, stock markets have rallied, commodity prices have bounced back before weakening again, emerging market currencies have stabilized, credit spreads have narrowed and volatilities have declined.
But Borio warned that underlying conditions have not changed: The short-term outlook for emerging market economies remains weak and financial vulnerabilities have not gone away. The stock of U.S. dollar-denominated of over $3 trillion remains and has grown in domestic currency terms in line with the appreciation of the dollar, weighting on financial conditions and balance sheets.
In addition, there is a large stock of domestic debt, especially corporate but also household, that has surged while credit and property price booms appear to be losing steam.
Meanwhile, U.S. swap rates are low despite growing credit risks and overall interest rates remain exceptionally low as the Federal Reserve appears to be nearing lift-off, with one-third of euro area sovereign paper trading at negative yields, a new peak.
"Monetary policy divergence loomed ahead, with potentially significant implications for exchange rates and market adjustments," said Borio, noting it is hardly a surprise that financial markets remain unusually sensitive to central banks' every word and deed under such extraordinary conditions.
Click here for the BIS Quarterly Review for December 2015.
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