Low interest rates and little volatility: a double-edged sword

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July 4th, 2014

On the whole, the trend for international financial markets has been very positive over the first half of the year. In fact, perhaps too positive in some areas, insofar as the right conditions could be brewing for subsequent episodes of instability.

Signs of escalation can initially be seen in the drop in risk-free interest rates and in risk premia and, consequently, in rising share prices. But the incredibly low level of volatility in derivatives, both recorded and implicit, is even more striking. Trading is also vigorous and fluid in both primary and secondary markets. As a result, the indices measuring the degree of market stress have returned to the all-time low levels of 2007. The main reasons for this situation are well-known: less likelihood of extreme risks (such as the breaking up of the euro, etc.), moderate but resilient growth, low inflation and expansionary monetary policies, with this last factor being particularly important. One of the medium-term goals of current monetary policy in developed countries is precisely to achieve buoyant financial markets. But it is advisable to avoid excesses which, should they go too far, would have a boomerang effect. The guardians of financial stability are vigilant, as well they might be. Several warnings can be deduced from reports published on this area over the last three months by organisations such as the IMF, ESRB, ECB and FSOC, but none is as categorical as that of the Bank for International Settlements (BIS) which, in its recent annual report, classifies the climate in financial markets as euphoric and detached from economic reality.

The BIS attributes a dominant and almost exclusive role in this financial scenario to central bank policies. Firstly, causing a two-fold effect on the sovereign debt markets of advanced countries: very low and very stable yields, with hardly any volatility. These two effects combine and reinforce each other to produce a third: more risk-taking and more leveraging by investors in their search for yield. It is easy to spot examples of this phenomenon; for example, and with particular relevance, the boom in junk bonds, a market that is currently in vogue among investors and has an increasing number of issuing companies. By way of anecdote, of note is the rise in issuances and narrowing of spreads of so-called cat bonds, instruments that transfer the risk of natural catastrophes such as hurricanes and earthquakes to
the bond holder. Also revealing is the proliferation of carry trade strategies in foreign exchange markets.

Should low interest rates and imperceptible volatility go on for too long, this might encourage a false sense of security or excessive complacency among investors, leading them to increase their debt burden in order to invest in risk assets. This would make the system vulnerable to any upset likely to increase volatility, insofar as it might (through the same channel as risk-taking) reverse the direction of the market spiral from upward to downward.

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