With "significant" financial stress pervading the markets, it is hardly surprising that systemic risk concerns are rising rapidly. What we have been experiencing in markets this year, as BofA's FX team notes, is the impact of multiple shocks, at a time when central banks cannot come to the rescue, in a market that has been addicted to the central bank policy put. This leave cross-asset correlation soaring as shocks become larger leaving market fragility increasing.
With plenty of Tail risks lurking…
This year has been challenging for financial markets as potential tail risks seemingly rear their ugly heads every time there is any semblance of stability. We continue to expect that volatility could rise from any of the following events. Although these risks are not our base case, their possibilities must still be considered. Even if the probability of each of them materializing may be small, the probability that at least once of them materializes is higher.
1. China financial instability – the rapid debt growth over the past several years could destabilize the financial system if improperly managed.
2. Central bank policy exhaustion – the ineffectiveness of negative interest rate policy may be a sign that the market has become desensitized to monetary stimulus. Thus, central banks may become constrained in their ability to smooth volatility.
3. Credit cycle turning and US recession – deteriorating conditions in the credit market could create a credit crunch and lead to debt deflation. The Treasury curve may already be signaling a recession and the Fed could implement negative rates if the US economy weakens significantly. Furthermore, EPS growth is declining.
4. Brexit – an exit by the UK may have negative consequences for both confidence and growth throughout Europe.
"Significant Stress" has been reached…
And shocks are becoming larger and/or market fragility increasing…
The correlation of cross-asset volatility is increasing, suggesting instability in one market tends to bleed over to other markets.
This is concerning, as it implies that shocks are getting stronger and/or the global financial system is becoming more sensitive to them.
Indeed, rising correlations have coincided with every major crisis in the past two decades.
via Zero Hedge http://ift.tt/21xPYIK Tyler Durden