Divergences Widen in Markets
16 Pages Posted: 30 Nov 2018
Date Written: September 1, 2018
Sentiment turned sharply in financial markets as 2018 moved into its second half. A renewed US dollar rally and escalating trade tensions resulted in an uneven tightening of global financial conditions. The Federal Reserve continued the gradual and predictable removal of monetary accommodation as the US economy gathered speed again, in part boosted by last year’s fiscal stimulus. Yet financial conditions in the United States, if anything, eased further. Conditions tightened somewhat in the credit markets of some advanced economies (AEs). In contrast, financing tightened sharply in emerging market economies (EMEs), which saw their currencies depreciate and their access to borrowing wane, amid signs of market disarray in the most vulnerable economies.
US financial markets diverged from their peers. The US stock market sprinted ahead of those in both advanced and emerging economies, and its volatility edged lower. The steady accommodation provided by the ECB and the Bank of Japan (BoJ), together with a flight to safety from stressed EMEs, helped to keep a lid on long-term US government yields despite looming Treasury debt issuance. As a result, the US yield curve flattened further, nearing inversion. Overall, US financial conditions stayed looser than in the other main AEs. For instance, while credit spreads of US corporate borrowers stayed relatively flat between June and mid-September, European corporates saw moderately wider spreads that built upon a previous round of widening in May. These wider spreads were in part attributable to the higher borrowing costs faced by some European financial institutions, which reflected intraeuro area sovereign stress and the exposures of some banks to vulnerable EMEs.
The tighter financial conditions in EMEs built upon the pressure seen earlier in the year. Against the backdrop of a stronger US dollar, escalating trade tensions, and further signs of a slowdown in China, portfolio inflows remained limited. Compounded by domestic vulnerabilities, some countries experienced portfolio outflows, with policy or political uncertainty contributing to market stress in a few jurisdictions. Currency depreciation coincided with higher sovereign spreads, both for instruments denominated in US dollars and for those in local currency. The cumulative damage to EME assets since global trade tensions escalated in late March was in some respects greater than that resulting from the fallout of the 2013 taper tantrum, or the devaluation of the renminbi in August 2015. But sovereign spread levels at the current juncture stayed, by and large, below those of previous episodes and contagion from the most affected countries was limited. Nevertheless, as of mid-September, investors 2 BIS Quarterly Review, September 2018 remained uneasy about whether the financial stress in EMEs would increase and spread further.
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