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Foreign Exchange

IMF warns scarcity of safe assets likely to drive up volatility

The IMF has warned that the scarcity of safe financial assets might lead to more frequent short-term spikes in volatility.

In its global financial stability report, released on Thursday, the IMF notes that the number of sovereigns whose debt is considered safe has fallen. It estimates that this could remove $9 trillion from the supply side of safe assets by 2016, roughly 16% of the projected total.

 

 Selected advanced and EM economies by sovereign debt rating

 
 Source: IMF estimates based on S&P ratings of 25 advanced and 48 EM economies

At the same time, however, demand for safe assets has risen in response to heightened market uncertainty, regulatory reforms and a crisis-related response from central banks engaged in quantitative easing.

The IMF says demand-and-supply imbalances in global markets for safe assets are not new. Before the financial crisis, global current account imbalances encouraged safe asset purchases by official reserve managers and sovereign wealth funds.

“Now attention has focused on safe assets’ capacity to meet new prudential requirements, increased collateral needs for over-the-counter derivatives transactions or their transfer to centralized counterparties, and the increasing use of such assets in central bank operations,” the IMF says.

The IMF warns that the shrinking set of assets perceived to be safe, now limited mostly to high-quality sovereign debt, coupled with growing demand, can have negative implications for global financial stability. “It will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets,” the IMF says. “Safe asset scarcity could lead to more short-term volatility jumps, herding behaviour, and runs on sovereign debt.”

Camilla Sutton, chief currency strategist at Scotia Capital, says the situation is echoed in the currency market, where the number of havens has shrunk. Historically spikes in risk aversion have typically led to a strong USD, JPY and CHF. However, Sutton notes that the market has shifted, with the Swiss National Bank having implemented a EURCHF floor and the Japanese having restarted official intervention and committed themselves to an inflation target, thereby shifting the safe-haven burden even more towards the USD.

“Accordingly, any major risk-aversion spike could result in an even larger spike in the USD than we have seen historically,” Sutton says.

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