Be prepared for the appearance of negative feedback cycles in markets as global monetary stimulus is withdrawn.
By Satyajit Das and cross-posted from Bloomberg.com
As the great unwind of global monetary stimulus gains momentum, markets are at increased risk of experiencing doom loops. Investors need to be prepared for these downward spirals, where shocks set off a self-perpetuating sequence of disruptions.
There are five doom loops that feed each other in a financial crisis.
The Collateral Doom Loop.
Declines in the value of stocks, bonds, property or derivatives tied to them trigger margin calls. These demands for collateral absorb cash or necessitate liquidation of assets, transmitting the pressure even to previously unaffected securities. Stresses are magnified where liquidity is constrained, causing further falls. Losses, reduced capital buffers and tightened liquidity results. The cycle repeats until a price equilibrium is reached.
The Hedging Doom Loop.
Sliding asset values cause investors to hedge by short-selling or buying put options as insurance. When market conditions are volatile or where traders cannot buy or sell the underlying asset, they resort to proxies such as different securities, currencies or commodities. This creates contagion. Declines force additional selling by banks seeking to hedge their exposure to options they have sold. For example, recent falls in oil prices were exacerbated by intermediaries covering put options purchased by U.S. shale oil producers. This intensifies price pressures and absorbs trading market capacity.
The Sovereign Doom Loop.
Changes in sovereign risk set in train negative price spirals because of the linkages between governments, central banks and commercial lenders, accelerating the crisis.
Since 2007, bank purchases of government securities have increased. This reflects regulatory requirements for higher liquidity reserves. Banks boosted holdings to post as collateral for their exposure to derivative transactions. Meanwhile, quantitative easing programs encouraged institutions to borrow cheaply from central banks and invest in government bonds with higher returns. Bank regulations treat government debt as substantially risk free and don’t require capital to be held against holdings, increasing returns on equity. The downside is that when rates increase, and debt prices fall, banks suffer losses. Government support may be needed to safeguard solvency and ensure operating viability, increasing stresses on the sovereign…