14 November 2014

ESMA issued financial markets risk dashboard for third quarter of 2014

The Dashboard finds that in 3Q14 EU systemic stress indicators increased, after experiencing a calm 2Q14. Contagion risk augmented and liquidity and market risk remained on high levels, with potential for further increases ahead. Credit risk receded though remaining at a high level. Overall, market sentiment continued to be at odds with sluggish economic fundamentals and guarded expectations. An environment of ultra-low interest rates supported markets and preserved the current hunt-for-yield behaviour of investors.

However, markets recognised resulting new balance sheet risks, as risk spreads increased, equity valuation moderated and expectations for future short-term interest rates fanned out. Due to these offsetting forces liquidity risk and market risk remained stable, preserving the risk of critical market corrections for the future. The systemic impact of such corrections could be exacerbated by liquidity bottlenecks, such as might arise from structural factors such as thin dealer markets or rising collateral requirements.

Liquidity risk in 3Q14 persisted on high levels and looks set to increase further, depending on the materialisation of snapbacks in interest rates. Aggregate liquidity appeared ample, though its distribution was uneven across markets and structural trends such as thin dealer markets and rising collateral needs remained present. Both this unevenness as well as dependence of short-term interest rates on monetary policy support are important determinants.

The risk of a snapback in interest rates and related liquidity demands that would arise from asset reallocation increased, as signalled by rising implied bond market volatilities. Liquidity in sovereign bond markets increased, yet was sensitive to new macroeconomic signals for countries experiencing weaker economic growth. In equity markets liquidity conditions continued to be favourable, though showing signs of intensified risk perception.

Market risk remained elevated in 3Q14, notably on account of continuing sanguine market sentiment potentially overly reliant on sustained policy support. Revaluation risk continued to be of high concern, it may have already partially materialised in lower rated corporate bond and equity markets. Price and quantity adjustments accommodating potential changes in monetary policy could result in bottlenecks and dislocations, with resulting increases in market and liquidity risk.

While aggregate equity PE ratios peaked below their average, valuations in some markets were close to historical highs until mid-September. Current yields on bonds remained very low. Moreover, corporate bond spreads started to diverge across the risk spectrum, with an increase in lower-rated spreads signalling a heightening of risk perception. After the robust growth registered in the previous quarter, high-yield issuance was low. Where prices are fuelled by short-term and cheap credit rather than expectations about economic recovery, valuation risk could further rise in near future.

Full media release

Risk Dashboard No.4

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