It is too soon to know for sure whether the recent bank failures in the United States and the merger of Credit Suisse with UBS were isolated events or a harbinger of future troubles, the International Monetary Fund said Tuesday.
While market anxiety has been reduced in recent days, market sentiment remains “fragile” and strains are still evident, the international financial institution said, in its latest report on global financial conditions.
“Concerns remain about vulnerabilities that may be hidden,” not just at banks, but in the shadow banking sector, the report said.
“The impact of tighter monetary and financial conditions could be amplified because of financial leverage, mismatches in asset and liability liquidity, and a high degree of interconnectedness within the nonbank financial intermediation sector and with the traditional banking institutions. This raises the specter of stress in some sectors—such as venture capital, technology, and commercial real estate sectors—that have been particularly hit by the removal of ample liquidity spilling over to the rest of the financial system,” the IMF said.
At the same time, more traditional concerns remain.
Large emerging market countries, which have avoided adverse spillovers from tightening advanced economies, could see capital outflows, the IMF said.
There is a possible rosy scenario in which inflation cools rapidly, which will keep financial markets contained.
But, on the other hand, if inflation surprises to the upside and stays sticky, financial stress could well emerge.
“The most obvious trigger is inflation being higher than expected,” said Tobias Adrian, the director of the IMF’s monetary and capital markets department, which produces the IMF stability report.
But financial markets face unpredictable times.
“For several years, investors have used investment strategies predicated on low volatility—reaching for yield and using of leverage—and some of them appear to be unprepared for a world of higher realized volatility, rising defaults, and falling asset prices,” the IMF said.
If the troubled risk management at Silicon Valley Bank is found to be more widespread, that would be a source of concern.
Lurking in the background is poor liquidity in the U.S. bond market that could amplify price moves and the lack of a bipartisan plan to raise the U.S. debt limit.
Federal Reserve officials have stressed they have tools to address financial stability risks that are separate from interest rates. The IMF said that if financial strains intensify, trade-offs between fighting inflation and maintaining financial stability may emerge.
“Policymakers should act swiftly to prevent any systemic events that may adversely affect market confidence in the resilience of the global financial system. Maintaining confidence is paramount for the functioning of the global financial system,” the IMF said.
At the same time, central banks can communicate that they have a continued resolve to bring inflation back to target as soon as possible once the financial stress has lessened.
This post was originally published on Market Watch
