The Bank of England has warned that financial stability could fall under threat if investors’ search for yield continues to intensify while underlying risks remain unrecognised.
In its latest Financial Stability Report the central bank notes that market sentiment improved between the last report, which was published in November, and today – with asset prices increasing strongly before the recent sell-off.
“Earlier in the period, there were signs of investors seeking higher yields by moving into riskier assets. This is an intended consequence of the monetary policy stance,” the report says. “But if investors search for yield while misjudging the underlying risks, it can also be a potential source of financial instability.”
Investors have rebalanced their portfolios towards higher yield assets since November, with the Bank noting reports that global fund managers moved from a cash overweight in the third quarter of 2012 to an underweight position in 2013’s second quarter.
Towards the end of 2012, there was an increase in flows into emerging market equity and bond funds, the Bank says. Flows into dedicated emerging market local currency bond mutual funds were higher in the first four months of 2013 than over the whole of 2012, for example, although some of this has now reversed.
“Over much of the period since the previous report, there were signs that conditions in some parts of fixed-income markets, in particular in the advanced and emerging economies, had become relatively exuberant. It is too soon to tell whether the more recent rise in market volatility and falls in risky asset prices represent the beginning of a longer-run shift in investor sentiment,” the report says.
“A concern from a financial stability standpoint is that investors seek to exit common risk positions simultaneously, causing market liquidity to dry up in pockets of the financial system. Contagion could occur if, for example, initial asset disposals by investors in some markets led to broader spillovers to other markets where liquidity conditions were better. The effects could be aggravated if concerns about counterparty credit risk rose in tandem.”
The Bank warns that funds which offer “instantaneous liquidity”, such as exchange traded funds, could be especially vulnerable to a change in investor sentiment and subsequent moves away from an asset classes. It adds that recent reports of ETFs restricting redemptions adds evidence to this.
“Sharp moves in the prices of some financial assets since the end of May were associated with a rapid unwinding of some positions, including those held by hedge funds in popular or ‘crowded’ trades,” the study warns.
“Market liquidity was reported to have become strained in some financial assets over this period, illustrating both the risk of abrupt changes in asset prices should expectations on the path of interest rates shift materially, and the danger of relying unduly on market liquidity remaining robust to a widespread exit from widely held positions.”