RBA warns on prospects of a messy and violent correction
The Reserve Bank has warned that the low volatility that has been a feature of financial markets this year will not persist and that things could get "messy" when current conditions are unwound.RBA assistant governor Guy Debelle told delegates at the Citi Australian Investment Conference in Sydney yesterday that volatility levels in the equity, fixed interest and foreign exchange markets were "as low as it gets" - a situation that could not be explained easily.Debelle said: "If I had told you that there were heightened tensions in the Middle East and Eastern Europe, uncertainty about the turning point in US monetary policy… as well as increased concern about the strength of the Chinese economy, you would not be expecting that to make for a benign time in financial markets."Debelle said there were several reasons why a market sell-off could be "violent".The RBA has observed an increase in the supply of volatility protection as more institutions, which have not been traditional sellers of protection, have entered the market seeking high-yield returns."While that may have dampened volatility of late, these non-traditional players may pull back from the market if volatility rises, exacerbating any rise in volatility when it finally eventuates," Debelle said.Another factor is the reduced capacity of market makers. Debelle said market liquidity was lower than in the past"Regulatory changes have, as intended, increased the cost of market-making and hence shifted some liquidity risk to end investors. The question today is whether there is too little capacity," he said"There have also been some strategic decisions taken by institutions and internal constraints have been imposed which have reduced capacity."He said a number of investors were buying assets, particularly fixed interest assets, on the assumption of a level of liquidity that was not there."This will become readily apparent when investors attempt to exit their positions," Debelle said.Another concern was the impact of zero interest rates in a number of markets."There are undoubtedly positions out there which are dependent on zero funding costs. When funding costs are no longer zero those positions will blow up."