“Someone Will Get Hurt”: Investors and analysts warn of growing market stress

Wall Street investors and analysts are sounding the alarm of a possible “market crash,” as successive bouts of turmoil in US equities and bonds and the surge in the dollar cause increasing levels of stress in the financial system.

An indicator of tension in U.S. markets – produced by the Treasury’s Office of Financial Research – has risen to the highest level since the roar of the May 2020 coronavirus pandemic.

Even as Wall Street stocks start the new quarter with gains, the OFR Financial Stress Index is close to the two-year high of 3.1, where zero denotes normal market functioning. This has added to a growing list of benchmarks suggesting that trading conditions in US government debt, corporate bonds and money markets are increasingly strained.

“The speed of things breaking all over the world. . . it is obviously a “neon swan” telling us that we are now clearly in the market crash phase, “said Charlie McElligott, a strategist at Nomura.

Growing concerns were fueled by a series of sharp interest rate hikes by the Federal Reserve to curb inflation. Rising borrowing costs and fears of an economic slowdown have led to a large sell-off in public markets, while strengthening the US currency at the expense of its global counterparts.

Rate hikes by the European Central Bank and the Bank of England, as well as aborted fiscal plans by the UK government, have also amplified market swings this year as global policymakers attempt to curb the growth of debt. prices.

“When financial conditions tighten so much, everyone is looking for who or what will be causing central banks to blink,” said Michael Edwards, deputy director of investment at hedge fund Weiss Multi-Strategy Advisers. “They [the Fed] they are determined to obtain more restrictive financial conditions, e [because] the economy is very strong. . . they must use financial markets as a transmission mechanism. So someone will get hurt. ”

McElligott pointed to a 20% drop in the Japanese yen this year, a sell-off of UK sovereign debt in recent weeks and a smattering of blocked loans on banks’ balance sheets that lenders are unable to offload to investors even with hefty discounts. , as signs of market tensions.

He added that the dollar’s strength was “causing enormous economic strain. . . and, increasingly, metastasizing in the markets “.

Stress means markets are not functioning as they should: companies are not easily able to obtain financing, it is more difficult to buy and sell stocks, prices are volatile, and investors are less willing to take risks.

Conditions worsened throughout the year, but until later it was especially evident in the equity market, where valuations fell precipitously due to rising borrowing costs and cutting growth prospects.

Private companies were unable to publicly list their shares, and banks had to withdraw planned debt financing for their clients after investors refused to open their checkbooks.

Banks last month were forced to hold $ 6.5 billion in debt to finance the acquisition of software maker Citrix on their balance sheets after they failed to find willing buyers for the entire debt financing.

“This is a story about boiled lobsters. You put them in cold water and slowly turn on the heat, “said George Goncalves, head of US macro strategy at MUFG.” This is what is happening in the markets. The Fed is raising the temperature. But as the market is still full of liquidity, it is not yet clear where the weakness lies “.

ICE BofA US corporate high yield index (%) return line chart showing financial costs have increased for US risky assets

JPMorgan Chase economist Bruce Kasman said Friday that the relative health of the banking system and small funding needs for much of the corporate world mean that financial system vulnerabilities have remained low. However, the US bank warned that the rise in the OFR index is evidence of the wider spread of stress on financial markets – and decreasing risk appetite – driven by the strong dollar and higher US interest rates.

“The risks to global financial stability are increasingly unknown to the outlook,” said Kasman.

The corporate bond market is also showing increasing signs of tension, according to Marty Fridson, Lehmann’s chief investment officer, Livian, Fridson Advisors.

Fridson noted that the premium demanded by investors for holding risky, junk-rated corporate debt over safe-haven Treasuries has increased significantly over the past month. According to her calculations, the junk bond market now reflects a 22% probability of recession, up from just 2% in mid-September.

According to rating agency Moody’s, corporate insolvencies more than doubled from July to August. Bank of America strategists on Friday warned that their credit market stress gauge was at a “critical limit” and that “market dysfunction begins” if it rises much further.

Separately, a Goldman Sachs index that measures market devaluations and dislocations is driven up by stress in financing markets and increased volatility in the $ 24 trillion US government debt market.

The 10-year Treasury yield, which is a benchmark for borrowing costs around the world, increased this year from around 1.5% to 3.6% and last week briefly exceeded 4% for the first time in 12 years.

According to the Ice BofA Move Index, volatility in that market also reached its highest level from the coronavirus-induced swings of 2020.

Line chart of daily change in 10-year US Treasury yield (basis points) showing price swings in the $ 24 trillion Treasury market are becoming more intense

Volatility can also be seen on a daily basis: the biggest move in the 10-year Treasury in 2021 was a drop of 0.16 percentage points on November 26. There have been seven days so far this year with bigger moves.

While Fed policymakers remain steadfast in raising rates, they too are on the lookout for potential dangers from the downturn in the market.

“As monetary policy tightens globally to combat high inflation, it is important to consider how cross-border spillovers and spillbacks could interact with financial vulnerabilities,” Fed Vice President Lael Brainard said Friday. financial that could be exacerbated by the advent of further negative shocks “.

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