‘Stretched’ bond markets vulnerable to instability – IMF

The International Monetary Fund warns optimism by investors may have left bond markets exposed to a sudden repricing if conditions change.

In its Global Financial Stability Report, published today (April 16), the fund says financial markets have “turned quite optimistic” since the October 2023 edition of the report. While that has helped mitigate the effect of central bank rate hikes on households and businesses, it has also led to “stretched” valuations in markets.

Tobias Adrian, the IMF’s financial counsellor, told journalists that as financial conditions eased in recent months, “there is leverage that is rising again”. He added: “That is certainly something we are watching very closely.”

Adrian said IMF economists “see a lot of strength” in the outlook, as both the US and Chinese economies recently reported higher than expected GDP growth figures. He noted the IMF’s baseline forecast, published in today’s World Economic Outlook, is that major economies will avoid a sharp downturn. The fund expects “steady” growth of 3.2% in 2024 and 2025, up from 2.3% in late 2022.

The challenge is that stretched valuations in markets could lead to a sudden correction. Adrian said a worsening of geopolitical tensions or a reassessment of the economic outlook could be the trigger for sharp movements in asset prices.

Such a change could in turn “exacerbate existing fragilities”, by tightening financial conditions, Adrian notes in the report.

“Borrowers in real estate markets, especially certain segments of commercial real estate with weak prospects, could face difficult and costly refinancings of existing loans,” he says.

The IMF estimates some $600 billion of US commercial real estate debt is coming due this year. Any defaults could put pressure on banks that have concentrated exposures to these sectors. Fabio Natalucci, deputy head of the IMF’s monetary and capital markets department, said there was still a “weak tail” of US banks, mostly regional lenders, that remain vulnerable.

Danger of “depreciation pressure”

Conditions in global financial markets and particularly the US will be important for the outlook in emerging market economies (EMEs), the IMF notes in the report. Tighter global conditions would likely lead to capital outflows from some EMEs, putting currencies and other assets under “depreciation pressure”.

Over the medium term, the IMF warns relatively easy global financial conditions have encouraged the build up of debt. It says governments need to consolidate their finances, adding that this could help EMEs in particular to lessen the “incidence and severity” of capital outflows.

“Since the outbreak of the Covid-19 pandemic in 2020, financial sectors and economies have been hit by a series of adverse shocks, and further downsides could materialise,” Adrian writes. “Only prudent policy and alert readiness will ensure that potential future scenarios can be tackled effectively.”