‘Someone will get hurt’: Investors and analysts warn on rising market stress

Investors and Wall Street analysts are sounding the alarm about a possible “market crash” as back-to-back tumult in US stocks and bonds and a rising dollar raise tensions in the financial system.

A stress gauge for US markets — produced by the Treasury Department’s Office of Financial Research — has risen to its highest level since the coronavirus pandemic in May 2020.

Even as Wall Street stocks start the new quarter with gains, the OFR’s Financial Stress Index is near a two-year high at 3.1, with zero indicating a normal functioning of the market. This has contributed to a growing list of benchmarks suggesting trading conditions for US Treasuries, corporate bonds and cash markets are becoming increasingly tight.

“The speed at which things are collapsing around the world . . . is obviously a ‘neon swan’ telling us that we are now clearly in the market crash phase,” said Charlie McElligott, strategist at Nomura.

Line chart of the Office of Financial Research's Financial Stress Index and sub-components, showing that stress is evident in US financial markets

Mounting concerns were fueled by a series of large rate hikes by the Federal Reserve to curb inflation. Higher borrowing costs and fears of an economic slowdown have prompted a sharp sell-off in public markets, while the US currency strengthened to the detriment of its global peers.

Rate hikes by the European Central Bank and Bank of England — and scrapped tax plans by the UK government — have also added to market volatility this year as global policymakers seek to rein in price growth.

“When financial conditions tighten so much, everyone is looking to see who or what is going to make central banks blink,” said Michael Edwards, deputy chief investment officer at hedge fund Weiss Multi-Strategy Advisers. “She [the Fed] are determined to tighten financial conditions, and [because] The economy is very strong. . . they must use the financing markets as a transmission mechanism. So someone will get hurt.”

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McElligott pointed to the 20 percent fall in the Japanese yen this year, a sell-off in UK sovereign debt in recent weeks and some loans that are stuck on banks’ balance sheets and lenders are unable to sell to investors, even at deep discounts, as signs the tension in the markets.

He added that the dollar’s strength is “causing enormous economic strains. . . and increasing metastasis in markets”.

The stresses are causing markets not to work as they should: companies find it harder to finance themselves, securities are harder to buy and sell, prices are volatile and investors are less willing to take risk.

Conditions have deteriorated throughout the year, but late this was particularly evident in equity markets, where valuations have fallen precipitously as borrowing costs have risen and growth prospects have plummeted.

Private companies have been unable to list their shares publicly, and banks have had to pull out of debt financing they planned to provide to their customers after investors refused to open their checkbooks.

Last month, banks were forced to hold $6.5 billion in debt to fund the acquisition of software maker Citrix on their own balance sheets after failing to find willing buyers for all of the debt financing.

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“This is a story about boiling lobsters. They put them in cold water and slowly turn up the heat,” said George Goncalves, head of US macro strategy at MUFG. “That’s what’s happening in the markets. The Fed is turning up the heat. However, since the market is still liquid, it is not yet clear where the weakness lies.”

Line chart of ICE BofA US Corporate High Yield Index return (%), showing that the cost of borrowing for risky US companies has risen sharply

JPMorgan Chase economist Bruce Kasman said Friday that the relative health of the banking system and low funding needs for much of the corporate world meant the financial system’s vulnerability remained low. However, the US bank warned that the rise in the OFR index is evidence of the broader spread of stress in financial markets – and reduced risk appetite – being caused by the strong dollar and higher US interest rates.

“Risks to global financial stability are an increasingly well-known unknown to the outlook,” Kasman said.

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

Fridson noted that premium investors looking to hold risky, junk-rated corporate bonds versus safe government bonds rose significantly over the past month. By his calculations, the junk bond market now reflects a 22 percent chance of a recession, up from just 2 percent in mid-September.

According to the rating agency Moody’s, corporate defaults more than doubled between July and August. Bank of America strategists warned on Friday that their gauge measuring credit market stress is at “borderline critical levels” and that “market dysfunction will begin” if it rises much further.

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Separately, a Goldman Sachs index that measures market disruption and dislocation is being propelled higher by stress in funding markets and heightened volatility in the $24 trillion US Treasury market.

The 10-year Treasury yield, which is used as a benchmark for the cost of borrowing around the world, has risen from about 1.5 percent to 3.6 percent this year — and last week it briefly hit the 4 percent for the first time in 12 years mark exceeded.

According to the Ice BofA Move index, volatility in this market has also reached its highest level since the coronavirus-induced turmoil in 2020.

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

The volatility can also be seen on a day-to-day basis: the biggest move in the 10-year Treasury bond for 2021 was a 0.16 percentage point decline on November 26. So far this year there have been seven days of major movement.

As Fed policymakers steadfastly hike rates, they too are on the lookout for potential dangers from the market slump.

“As monetary policy tightens around the world to combat high inflation, it’s important to consider how cross-border spillovers and spillbacks might interact with financial vulnerabilities,” Lael Brainard, the Fed’s vice chairman, said on Friday. “We are alert to financial vulnerabilities that could be exacerbated by the emergence of additional adverse shocks.”

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