Financial markets are sleepwalking towards a crisis

“The most notable thing in the financial markets today is the absence of anything notable,” says Economist.com’s Free Exchange blog. There have been very few sudden or significant moves for a long time now.

The S&P 500 has gone 468 days without a correction, defined as a drop of 10%. That, notes Société Générale, is the fourth-longest period since 1970. Since 1969, the S&P 500 has dropped by 1% or more 27 days a year on average. In the past year, there have only been 19 such days.

“The market’s been lulled to sleep,” says JJ Kinahan of TD Ameritrade. Volatility has practically disappeared. The most widely monitored gauge of equity market gyrations is the Chicago Board Options Exchange Volatility Index, or VIX.

It reflects the price people are paying to insure their equity portfolios against sudden swings, so it acts as a guide to expected volatility. The VIX has drifted down to around 11.5, close to the historic lows seen in 2007. In the past ten years, it has averaged 20, including a spike to 80 triggered by the financial crisis.

It’s not just stocks. Volatility in bond and foreign exchange markets has also slid to multi-year lows, with gyrations in bond markets almost back to the near-record lows of 2013, just before the taper tantrum.

Some commodity markets are also practically hypnotised. Oil has been remarkably steady for three years. Its trading range over the past year has been the narrowest 12-month movement since 1988. Global markets haven’t been this calm since before the crisis.

Stability begets instability

Market history shows that stable markets are often a sign of complacency and that situation always ends in tears. The FT’s James Mackintosh notes that only twice since 1990 has volatility in US bonds and equities been so low at the same time: in 1998 and 2006-2007. Both times culminated in disasters.

Hedge fund LTCM threatened the financial system in 1998 after stable bonds prompted it to take on too much debt. Almost a decade later, the global financial crisis hit.

The basic problem is that long periods of stability are ultimately destabilising. As economist Hyman Minsky pointed out, stability begets complacency, which begets instability as relaxed investors take on more and more risk.

When assets are stable, borrowing money to buy them, taking on more leverage, or seeking out exotic debt instruments such as collateralised debt obligations (CDOs) all seem safer. It’s only when the music stops that investors rediscover what taking on more risk actually means.

Are we heading for another crash?

There are now some worrying signs of the kind of complacency and risk-taking seen in the run-up to the global crisis, as Finanz und Wirtschaft points out. Junk bond issuance in Europe and America has soared to record levels. Yields on junk bonds have slid below pre-2007 levels.

Margin debt on the US stock exchange – reflecting investors buying stocks with borrowed money – is back to 2.5% of GDP, a level last seen in 2000 and 2006. The volume of collateralised loan obligations – bundled corporate loans – is set to eclipse 2006 levels this year, “as if the crisis had never happened”.

None of this means a systemic crisis is on the horizon, notes Free Exchange. New regulations have made it harder for banks and investors to indebt themselves, and the financial system now relies less on short-term wholesale funding, which is vulnerable to runs.

But Minsky warned that long periods of calm encourage financial innovation, which has a way of getting around regulatory limits. The debt instrument that will be associated with the next crisis – like mortgage-backed securities were with the last one – may not yet have risen to prominence.

But, as Goldman Sachs’ Charlie Himmelberg puts it, “eventually, this will lead to no good. If leverage wants to come back to the system, it just does”.

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