Markets swing on changing perceptions of the policy outlook: BIS Quarterly Review

• Markets fluctuated as investors adjusted their views of central banks' response to persistent inflation amid a deteriorating growth outlook; the US dollar reached record highs.
• An easing of financial conditions reversed in August as the policy focus on inflation sharpened and fears of an energy crisis increased, notably in Europe.
• A special feature argues that effective restrictions on Russian energy output would come with spillover effects for industrial production and the crops used in biofuels.

Market swings reflected investors' evolving perception of the outlook for inflation and monetary policy during the period under review,¹ the Bank for International Settlements says in the September 2022 BIS Quarterly Review, released today.

News about inflation, and investors' views of the policy response, drove markets while the growth outlook deteriorated on fallout from the war in Ukraine and further weakness in China. From mid-June to end-July, equity and credit markets rallied on expectations that the path for policy rates would flatten after aggressive hikes. In August, risky asset markets reversed course and yields climbed amid a more forceful policy response to higher inflation.

Market developments diverged across emerging market economies (EMEs), often shaped by the policy response to elevated inflation. The currencies of EMEs beset by high and entrenched inflation depreciated steadily against the US dollar. Having started the hiking cycle early on, some Latin American countries had sovereign yields considerably higher than those in Asia, and these currencies stopped depreciating against the US dollar in the later part of the review period. 

The latest sell-off in markets, which occurred after the review period, has confirmed that investors have been rather sanguine over the past three months about the resolution of economic challenges. They've now woken up to the fact that policymakers are battling tenacious inflation against a backdrop of financial vulnerabilities.

Claudio Borio, Head of the Monetary and Economic Department

While many commodity prices declined from peaks reached after the outbreak of the Ukraine war, natural gas prices soared, particularly in Europe after Russia sharply cut supply.

Liquidity stresses in the European electricity market serve as a salutary reminder of the challenges of shielding the real economy from financial shocks.

Hyun Song Shin, Economic Adviser and Head of Research

Five features analyse commodity markets, market stress indicators, sovereign sustainable bonds, borrower vulnerabilities and bank funding:

• "Commodity markets: shocks and spillovers" by Fernando Avalos and Wenqian Huang, argues that a substitution of Russian oil output in global markets – if needed – would be difficult, resulting in persistently high oil prices with spillover effects on crops used in biofuels. And high natural gas prices will drive up electricity prices further, hurting industrial production.
• "Under pressure: market conditions and stress" by Iñaki Aldasoro, Peter Hördahl and Sonya Zhu, introduces new market conditions indicators for three key segments – foreign exchange, US money markets and US Treasury markets – that can be used to identify stress episodes. Signals of market fragility can help anticipate stress several months in advance.
• "Sovereigns and sustainable bonds: challenges and new options" by Gong Cheng, Torsten Ehlers and Frank Packer, focuses on the fast-growing market for "sustainable" bonds, where sovereigns arrived late but can set ambitious best practices for private issuers. Sustainability-linked bonds with penalties for non-compliance that are material in the public's eye could help sovereigns advance towards carbon emission reduction objectives.
• "Borrower vulnerabilities, their distribution and credit losses" by Ryan Banerjee, Francesco Franceschi and Stéphane Riederer, argues that granular data on borrowers are a useful complement to aggregate measures in predicting credit losses in the household and corporate sectors.
• "Bank funding: evolution, stability and the role of foreign offices" by John Caparusso and Bryan Hardy, finds shifts in the funding sources of local banking systems: from cross-border to local funding, which typically enhances stability, and from inter-office to other, less stable cross-border sources. These changes are driven by the sustained retreat from global banking.

¹  The period under review extends from 1 June 2022 to 12 September 2022.