Abstract: In this article, the authors argue that the extreme global asset price vola-tility is sending shockwaves through the financial system. Given the high leverage ratio of global financial institutions, hidden risk exposures, complex counterparty relationships, and the policy constraints on central banks, the damage might fur-ther increase and even trigger systemic risks. Against this backdrop, Chinese en-terprises, financial institutions, investors, regulatory authorities should be on high alert for the spillover effects of the extreme volatility in asset prices, watch closely the market risks, liquidity risks, counterparty risks, and customer default risks, and prepare in advance all kinds of contingency plans in order to minimize the shocks of relevant risks to Chinese enterprises and financial institutions.
Since the start of 2022, the global financial market has experienced greater volatil-ity, with extreme price movement in all kinds of assets.
Commodity prices including copper, aluminum, natural gas, and wheat have hit record highs. Among them, European natural gas has surged 17 times over the past year; the forward discount of 12-month crude oil was once more than 6 standard deviations above the historical level; the US dollar index has soared to a 20-year high while the yen, once a haven currency, has plummeted by over 10% to the US dollar in the past two months, a record low over the past 2 decades; emerging market currencies like Turkish lira, Russian ruble, Indian rupee, Brazilian real, Chilean peso, and Argentine peso have dipped to historical lows to the US dollar; the US 10-year Treasury yield has jumped to a 4-year high, German 10-year bond yield to a 7-year high, and the UK 2-year bond yield to a ten-year high……
The extreme volatility of asset prices will cause losses of some institutions. But the implication is more than that.
In the current market environment, risky assets rise and fall in line with safe-haven assets, which breaks the long-term correlation between different assets. This might turn risk-avoiding hedging into a much more risky practice, leading to unexpected losses. Given the high leverage ratio of global financial institutions, hidden risk exposures, and complex counterparty relationships, these losses might further expand and even trigger systemic risks.
But unlike the 2008 global financial crisis, the 2011 European sovereign debt cri-sis, the 2020 Covid-19 shock, and other periods of market turbulence, as inflation in Europe and the US has hit a 30-40 year high, the central banks in these coun-tries cannot inject huge liquidity through policies such as “quantitative easing” or “unlimited quantitative easing” to help financial institutions ease their liquidity strain; instead, they need to speed up increasing rates and removing liquidity, pos-ing threats to the stability of the financial market.
Against this backdrop, Chinese enterprises, financial institutions, investors, and regulatory authorities should be on high alert for the spillover effects of the ex-treme volatility in asset prices. They should watch closely the market risks, liquid-ity risks, counterparty risks, and customer default risks, and prepare in advance all kinds of contingency plans in order to minimize the shocks of relevant risks to Chinese enterprises and financial institutions.
I. EXTREME VOLATILITY OF ASSET PRICES
The commodity market is the source of this round of asset price swings.
Over the past two years, various global commodity prices have surged, pushing up the US Commodity Research Bureau (CRB) Index and many of its sub-indices to record highs (Figure 1).
Since the beginning of 2022, the escalating Russia-Ukraine conflict has further disrupted the global supply chain of commodities, leading to extreme movement of many commodity prices.
For example, Dutch natural gas prices has soared since March, with the highest yearly increase of more than 17 times (Figure 2). Nickel price fluctuated a lot. On March 7, it skyrocketed by 85% within a day, making the exchange suspend the trading. But after the trading was resumed, the price kept falling for several days, with the largest drop of 44%.
The extreme movement of prices is not a rare case for a few categories of commodi-ties. Multiple commodity prices including energy, metal, and agricultural products have all hit record highs or year’s highs (Table 1); the price swing in some commodi-ties is more than 3 standard deviations above the historical average. Certain com-modities have abnormal pricing, which is extremely rare. For example, the 12-month discount on crude oil forward price was once more than 6 standard deviations above the historical level, and the price difference at its highest between Russian crude oil and European as well as the US crude oil even exceeded 30 US dollars.
In addition to the commodity market, the bond and foreign exchange markets have also witnessed great volatility.
The soaring commodity prices have driven inflation up in Europe and the US, forcing central banks to speed up the exit from the accommodative monetary poli-cy that has been adopted for more than a decade. As a result, Treasury yields have soared while the bond prices have plummeted (Figure 3, Table 2). So far, the US 2-year and 10-year Treasury yields have risen to a 4-year high, while the US long-term Treasury index (with a maturity of over 20 years) has fallen to a 3-year low, down by more than 20% from its highest level at the end of last year; the weighted index of US Treasuries over the whole maturity spectrum dropped by around 10% from its highest level at the end of last year.
As for risk-free interest rates, Treasury yields are the benchmark for pricing all types of assets. The rapid increase of Treasury yields weighs on the valuation of risky assets, affecting investors’ risk appetite and asset allocation decisions. As a result, US high-yield bond spreads have widened significantly (Figure 4). The increase in Treasury yields, coupled with the widened credit spreads, has added to in-vestors’ losses in the credit market, the implication of which should not be un-derestimated.
Given different stages of economic development and growth patterns among coun-tries, the surge of commodity prices has had different impacts on each coun-try/region’s economic growth and inflation and prompted different levels of fiscal and monetary policy response, thus leading to divergent trends in each country’s exchange rate movement.
In the US, high inflation, strong domestic demand, and an extremely hawkish Fed have pushed the US dollar index up to a 20-year high. In Japan, as the inflationary pressure is rather low, the Bank of Japan is relatively dovish, which has driven the dollar/yen exchange rate up to over 130, hitting a 20-year high (Figure 5). As for emerging markets with generally weak economic fundamentals, high inflation, and large current account deficits, in the context of surging US interest rates, many of these economies face great pressure in terms of capital outflows and exchange rate depreciation, and the exchange rate of some currencies have dipped to a his-torical low (Table 3). The substantial exchange rate depreciation has increased emerging economies’ burden of servicing foreign currency debt, adding to the risk of foreign debt crisis in these markets.
Under the multiple pressures of increasing capital outflows and local currency de-preciation, investors have started to adjust their exposure to emerging markets, leading to poor performance of emerging market stocks. Stock markets in Eu-rope, the US, and other developed economies have also experienced a correc-tion yet with a relatively milder magnitude.
High inflation will erode consumers’ confidence and real purchasing power, thus affecting domestic demand. It will also drive up enterprises’ production and oper-ating costs as well as labor costs, and undermine the profitability of listed compa-nies, which might cause the Davis double-killing effect in which stock valuation and corporate earnings are both revised downward and thus exacerbate the vola-tility of the stock market.
All in all, from 2022 onwards, the global commodity market, government bond market, and forex market have all experienced extreme volatility, whereas the stock and credit markets have had relatively moderate movement.
Based on the deviation of global asset prices from historical trends, the “Haitong International Global Major Asset Class Price Deviation Index” is created. The in-dex shows that currently the price deviation has reached the highest level since the 2009 global financial tsunami (Figure 6). The extreme volatility of asset pric-es will cause damage to some institutions. Given the high leverage ratio of global financial institutions, hidden risk exposures, and complex counterparty relation-ships, the damage might further increase and even trigger systemic risks.
II. THE SPILLOVER EFFECT OF EXTREME ASSET PRICE VOLATILI-TY ON FINANCIAL INSTITUTIONS
The extreme volatility in asset prices will pose four potential risks to financial in-stitutions: 1) direct losses because of holding or trading assets with price fluctua-tion; 2) huge losses caused by highly leveraged transactions that amplify the mar-ket volatility; 3) losses caused by pricing, hedging, and trading model failure; 4) collateral damage and risks of bad loans due to counterparty or customer defaults.
1. Direct losses caused by asset price fluctuation
It is obvious that the extreme movements in asset prices will cause direct losses of those asset-holders and traders. As mentioned earlier, the US Treasury (across the maturity spectrum) index has dipped by around 10% from its recent high level in last December (Figure 3). Based on a rough estimate of the current stock of US Treasury (at around 23 trillion US dollars), holders of US Treasuries have suf-fered paper losses of some 2.3 trillion US dollars in the past 5 months. This is only the mark to market losses in the cash bond market. Given the considerable transactions and positions of Treasury futures and other financial derivatives on US Treasuries, related losses will be more substantial.
In addition, the S&P 500 has fallen about 15% from its highest level since the start of this year, and the Nasdaq has even tumbled 22%. As a result, over the past 4 months, investors of US stocks have suffered mark-to-market losses of more than $9 trillion. Considering the use of leverage and the transactions and positions of financial derivatives on US stocks, relevant losses would be even greater. These losses will ultimately be the paper losses of some institutions or individuals.
Indeed, many financial transactions (especially derivative trading) are “zero-sum games” with losers and winners. But the distribution of gains and losses might be extremely uneven, and it is hard to predict which institutions will suffer losses to what extent, and whether systematically important institutions will have huge losses. When asset prices are extremely volatile, massive losses might be unavoid-able. If huge losses occur in systemically important financial institutions, the con-sequence will be unimaginable.
2. Risks of widened losses caused by highly-leveraged transactions
As leveraged trading is a common practice in the global financial market, the shocks due to the extreme swing in asset prices might be amplified by leverage.
Countries around the world have strengthened regulation of the financial industry since the financial crisis in 2009, and the overall leverage ratio of financial institu-tions such as international investment banks has dropped significantly. However, the leverage ratio of financial institutions in transactions such as bonds and foreign ex-change can reach more than 50 times.
Recently, the US treasury volatility index (MOVE) has approached the level of March 2020 when the Coronavirus Stock Market Crash occurred, and the implied volatility of JPMorgan Emerging Market Currency Index (EMCI) has once risen to the level of April 2020 (Figure 7). In a highly volatile market environment, highly leveraged transactions will magnify the losses of financial institutions, and may even lead to risks of bankruptcy and default in extreme cases.
II. THE SPILLOVER EFFECT OF EXTREME ASSET PRICE VOLATILI-TY ON FINANCIAL INSTITUTIONS
The extreme volatility in asset prices will pose four potential risks to financial in-stitutions: 1) direct losses because of holding or trading assets with price fluctua-tion; 2) huge losses caused by highly leveraged transactions that amplify the mar-ket volatility; 3) losses caused by pricing, hedging, and trading model failure; 4) collateral damage and risks of bad loans due to counterparty or customer defaults.
1. Direct losses caused by asset price fluctuation
It is obvious that the extreme movements in asset prices will cause direct losses of those asset-holders and traders. As mentioned earlier, the US Treasury (across the maturity spectrum) index has dipped by around 10% from its recent high level in last December (Figure 3). Based on a rough estimate of the current stock of US Treasury (at around 23 trillion US dollars), holders of US Treasuries have suf-fered paper losses of some 2.3 trillion US dollars in the past 5 months. This is only the mark to market losses in the cash bond market. Given the considerable transactions and positions of Treasury futures and other financial derivatives on US Treasuries, related losses will be more substantial.
In addition, the S&P 500 has fallen about 15% from its highest level since the start of this year, and the Nasdaq has even tumbled 22%. As a result, over the past 4 months, investors of US stocks have suffered mark-to-market losses of more than $9 trillion. Considering the use of leverage and the transactions and positions of financial derivatives on US stocks, relevant losses would be even greater. These losses will ultimately be the paper losses of some institutions or individuals.
Indeed, many financial transactions (especially derivative trading) are “zero-sum games” with losers and winners. But the distribution of gains and losses might be extremely uneven, and it is hard to predict which institutions will suffer losses to what extent, and whether systematically important institutions will have huge losses. When asset prices are extremely volatile, massive losses might be unavoid-able. If huge losses occur in systemically important financial institutions, the con-sequence will be unimaginable.
2. Risks of widened losses caused by highly-leveraged transactions
As leveraged trading is a common practice in the global financial market, the shocks due to the extreme swing in asset prices might be amplified by leverage.
Countries around the world have strengthened regulation of the financial industry since the financial crisis in 2009, and the overall leverage ratio of financial institu-tions such as international investment banks has dropped significantly. However, the leverage ratio of financial institutions in transactions such as bonds and foreign ex-change can reach more than 50 times.
Recently, the US treasury volatility index (MOVE) has approached the level of March 2020 when the Coronavirus Stock Market Crash occurred, and the implied volatility of JPMorgan Emerging Market Currency Index (EMCI) has once risen to the level of April 2020 (Figure 7). In a highly volatile market environment, highly leveraged transactions will magnify the losses of financial institutions, and may even lead to risks of bankruptcy and default in extreme cases.
Due to the rising inflation, central banks in the United States, the United Kingdom and Australia have all started a cycle of interest rate hikes. Market expectations for interest rate increases have also strengthened. Currently, the market expects the Fed to raise interest rates a total of 11 times in 2022, with a total rate hike of 275 basis points (Figure 11). In addition to the 75 basis points that have already put in place, it is estimated that the Fed will raise interest rates by another 200 basis points during the year.
With this expectation, offshore and onshore dollar liquidity has begun to tighten, and financing costs have risen significantly (Figure 12). Although the current offshore and onshore dollar liquidity premiums and risk premiums have not reached the levels at the time of the outbreak of the pandemic in early 2020, if a systemic risk or a li-quidity crisis breaks out, European and American central banks will find it hard to reimplement unlimited QE and relieve market pressure through large-scale liquidity injection. It is unclear how the market risk can be resolved by then.
IV. POLICY RECOMMENDATIONS
Based on the above analysis, we believe that the impact of extreme fluctuations in global asset prices on the financial system may still be in the process of transmis-sion. The ultimate impact of these shocks cannot be underestimated due to the com-plex relationship among financial institutions, the invisibility of financial derivatives and leveraged transactions, and policy constraints faced by central banks.
In this context, Chinese enterprises, financial institutions, investors and government regulators should be highly vigilant against the spillover effects of extreme fluctua-tions in asset prices, pay close attention to market risks, liquidity risks, counterparty risks and default risks, and take precautions in advance. Various risk management plans should be well prepared to minimize the impact of related risks on domestic enterprises and financial institutions.
First, it is recommended that Chinese companies with overseas business or assets adjust their asset allocation as soon as possible and increase the proportion of high-liquidity assets to prevent liquidity risks; increase the number of custodian institu-tions, diversify counterparties, and prevent asset losses due to extreme fluctuations in asset prices and failure or default of overseas financial institutions. It is recom-mended that enterprises with debts denominated in foreign currencies make li-quidity arrangements and foreign exchange purchase plans for repayment of princi-pal and interest in advance to prevent repayment difficulties or defaults due to tight liquidity in overseas markets. At the same time it is necessary to manage exchange rate risks to prevent serious maturity mismatches and currency mismatches.
Second, domestic financial institutions are recommended to conduct risk assess-ment on their overseas assets and liabilities, especially on relevant financial deriv-atives and leveraged transactions, and conduct stress tests. It is suggested to strengthen liquidity management of foreign currency assets and liabilities to pre-vent serious maturity mismatches and currency mismatches. Financial institutions should review their products and services related to overseas markets, especially structured products and various financial derivatives, to prevent risk events like BoC’s Yuanyou Bao, a move that can help protect the interests of financial institu-tions and customers, and reduce the risk of customer default. More recommenda-tions include strengthening communication with overseas counterparties, en-hance due diligence and risk monitoring of counterparties, and take measures to in-crease asset preservation tools and strategies as much as possible to reduce counter-party risks.
Third, it is suggested that regulatory authorities strengthen the statistics and monitoring of overseas risk exposure of financial institutions, especially those with systemic importance. It is necessary to conduct stress tests at the state level, and make risk management plans for potential risks. A sound plan can be used to quickly tackle the risk, and to prevent the spillover effects of extreme price fluctua-tions in overseas markets from affecting domestic financial markets and the financial system as much as possible.
Finally, investors are advised to reduce the risk exposure of overseas assets and increase the proportion of liquid assets. Gentlemen don't stand un-der the wall of danger. It can take a rather long time to see the outbreak of the risk of overseas markets. Investors should pay close attention to the evolution of global eco-nomic fundamentals, changes in the geopolitical situation and developments of over-seas financial markets, and be especially cautious with operation. Now it is the time to fight for survival before seeking growth.
This article was published on CF40 WeChat blog on May 7, 2022. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
