- Equity markets rallied as markets shrugged off trade tensions and policy uncertainty and focused on robust corporate earnings, while credit spreads compressed further.
- Short-term bonds priced in greater policy easing, but long-term yields stayed high and yield curves steepened at the very long end on fiscal and inflation concerns.
- Emerging market assets saw gains, benefiting from the risk-on environment and the weakening of the US dollar.
Global financial markets maintained a risk-on tone during the review period, shrugging off concerns over mounting tariff and policy uncertainty, wrote the Bank for International Settlements (BIS) in its latest quarterly review covering June to September.
Despite short-lived bouts of volatility triggered by incoming data and political developments, market sentiment remained upbeat, defying mounting challenges, including unease over the longer-run fiscal outlook in several key jurisdictions.
The prevailing risk-on sentiment was a key ingredient of generally easing financial conditions. Conditions relaxed significantly in the US, as well as in the United Kingdom. Those in the euro area remained broadly unchanged, with more lackluster equity performance.
Narrower credit spreads and buoyant corporate bond markets were the key drivers of the easing in the “risk factor” underlying the BIS measure of financial conditions. In the US, corporate yields and spreads led the risk factor to ease further, despite the relatively high level of government bond yields. In France, an increase in credit and sovereign spreads, not only vis-à-vis German bunds but also Italian treasuries, contributed to a steady tightening of the risk factor.
The US dollar, noted the BIS, behaved “unusually” for a risk-on phase, appreciating while equity markets posted strong gains and depreciating into higher interest rate differentials.
“Overall, global financial conditions eased significantly, driven by equity gains and compressing credit spreads in the United States and benign conditions in emerging market assets. Conditions in Europe remained more subdued following a strong half-year,” according to the review.
Credit spreads
As is typical during risk-on phases, the rally was accompanied by subdued volatility, with the VIX receding. Credit spreads remained compressed and declined to lows not seen in a decade in spite of default rates ticking up. During a media briefing, it was noted that leverage and repo markets continue to be key channels to monitor for signals of systemic risk.
US assets stable
The BIS scrutinized the rapid rebound from US tariffs policy uncertainty and safe haven properties of US Treasuries and portfolio flows of global investors.
During the review period, there were elevated policy uncertainties in the United States, prompting broader questions about a potential structural repositioning by global investors away from US assets, for both bonds and equities. Also, discussions intensified on which other countries and assets might benefit from any rotations in portfolio flows.
However, the evidence available – at least so far – does not show signs of a material portfolio reallocation away from US assets. While some non-US investors sold significant volumes of US assets in April, most of these flows reversed in May and June. Strong underlying fundamentals continue to anchor global demand for US assets, providing additional support for their momentum.
The favorable sentiment towards US assets aligns with the resilience of US corporate earnings and the unmatched depth of US financial markets. It may have also been bolstered by diminishing concerns about the long-term effects of trade conflicts. The outsize holdings of US assets by global investors, coupled with the slow pace of strategic asset allocation decisions and mandates, indicate that any significant portfolio shift away from US assets is likely to be gradual.
However, global investors have been showing signs of adjusting their geographical exposures.
Central bank taxonomies
In a special chapter, BIS researchers prompted central banks to reconsider how operational frameworks relate to bank incentives and market outcomes.
They proposed a new taxonomy with two key dimensions: first is the marginal opportunity cost of holding reserves, which influences banks’ incentives to trade reserves in the money market; second is the quantity of reserves, which affects how banks manage liquidity risks and comply with regulatory and supervisory requirements.
“The continuous nature of these dimensions allows for a granular classification of operational frameworks. Applying the taxonomy to real-world operational frameworks uncovers unexpected similarities between distinct frameworks and highlights how similar designs can lead to differing outcomes,” the researchers wrote.