Markets precipitate tightening

Announcements in May that the Federal Reserve envisaged phasing out quantitative easing reverberated through global financial markets. They triggered a surge in benchmark bond yields that spilled over across asset classes and regions. Equity prices in both advanced and emerging market economies fell sharply, as did a number of emerging market currencies. The downward pressure on prices abated in early July when the Federal Reserve, the ECB and the Bank of England reassured markets that monetary policy would remain accommodative until the domestic recovery was on a solid footing. In advanced economies, equities quickly recovered and yields, despite their rise, remained low by historical standards. This led to a continuing squeeze of credit spreads and increased issuance of riskier bonds, a phenomenon reminiscent of the exuberance prior to the global financial crisis.

The market-led tightening of financial conditions generated serious tremors in emerging market economies. Together with the already deteriorating outlook for growth in these economies, this amplified pressures on local bond, equity and foreign exchange markets, all of which compounded vulnerabilities created by dependence on fickle foreign capital.