An Asynchronous and Divergent Recovery May Put Financial Stability at Risk

IMF Blog, April 6, 2021

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After enduring a tumultuous 2020, the global economy is finally emerging from the worst phases of the COVID-19 pandemic, albeit with prospects diverging starkly across regions and countries—and only after a “lost year” spent in suspended animation.
The economic trauma would have been much worse without unprecedented policy actions by central banks and fiscal measures by governments.
The Fund’s Global Financial Stability Report documents that both nominal and real interest rates have risen, although nominal yields have risen more, suggesting market-implied inflation is recovering.

Since August 2020, the yield on the US 10-year Treasury note has risen by 1¼ percentage points to around 1¾ percent in early April 2021, returning close to its pre-pandemic level of early 2020.
The rise in US rates has been spurred in part by improving vaccination prospects and strengthening growth and inflation.
The increase in yields may also reflect:
- uncertainty about the future path of monetary policy;
- investor concerns about the increased supply of Treasury debt to finance the fiscal expansion in the United States;
- sharply rising term premia (investors’ compensation for interest-rate risk).
Market participants are beginning to focus on the timing of the Federal Reserve’s tapering of its asset purchases, which could push long-term rates and funding costs higher and potentially trigger a tightening of financial conditions if associated with a decline in risk assets’ prices.

Global rates remain low by historical standards, but the speed of adjustment can generate unwelcome volatility in global financial markets.
Assets are priced on a relative basis; every financial asset is directly or indirectly linked to benchmark US rates.
The rapid and persistent rise in rates this year has been accompanied by an increase in volatility, with a risk that fluctuations might intensify.
Any abrupt and unexpected increase in rates in the United States may translate into a tightening of financial conditions as investors shift into “reduce risk exposure, protect capital” mode, which could depress risk asset prices.
Valuations appear stretched in some segments of financial markets, and vulnerabilities are rising further in some sectors.
In countries with slower recoveries and lagging vaccinations, economies may not be ready for tighter financial conditions, potentially forcing policymakers to use monetary and exchange-rate policies to offset tightening.

The greatest concern comes from emerging markets, where investor risk appetite may shift quickly and many countries confront large external financing needs.
Recent volatility in portfolio flows to emerging markets highlights the fragility of these flows.
Emerging market local currency yields have risen meaningfully, driven importantly by an increase in term premia.
The IMF’s estimate: a 100 basis point rise in US term premia is associated, on average, with a 60 basis point rise in emerging market term premia.
Many emerging markets have sizeable financing needs this year and are exposed to the risk of higher rates when they refinance debt and fund large fiscal deficits in the months ahead.
Countries in weaker economic positions (for example owing to limited access to vaccines) may face portfolio outflows.
For many frontier market economies, access to funding remains a primary concern given limited access to bond markets.
While several emerging market economies have adequate international reserves, and external imbalances are generally less pronounced because of large import compression, some may nonetheless face challenges if inflation rises and borrowing costs continue to grow.

Major central banks must carefully communicate policy plans to prevent excess volatility in financial markets.
Emerging markets may need to consider policy measures to address excessive tightening of domestic financial conditions, taking into account:
- interactions among policies and their own economic and financial conditions;
- the use of monetary, fiscal, macroprudential, capital-flow management, and foreign-exchange intervention.
Continuing policy support remains necessary, but targeted measures are also needed to address vulnerabilities and protect the economic recovery.
Policymakers should support balance-sheet repair—for example, by strengthening the management of nonperforming assets.
Rebuilding buffers in emerging markets should be a policy priority to prepare for a possible repricing of risk and a potential reversal of capital flows.
The Fund remains ready to support its member nations’ policy efforts in the uncertain period ahead.

Author: Tobias Adrian — April 6, 2021 (IMF blog post).