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#dnaEdit: Confusing trends

One might reasonably expect another round of volatility in the global financial markets. A confluence of events might induce several uncertainties

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The US Federal Reserve is finally to ring down the curtain on its quantitative easing (QE) programme on October 28. A programme started in 2008 to fight the global financial meltdown, it was simply sustained asset purchases by the Federal Reserve. This had till now infused $4.8 trillion into the US financial system, a good part of which has percolated into the global financial system. With its final end, injection of fresh liquidity will come to a halt but going by indications from Fed Chairwoman Janet Yellen, the US central bank will carry this humongous amount of financial assets on its portfolio. This will thus continue to put downward pressures on interest rates and keep prices of bonds higher. 

With the end of QE, the investment and global funds managers will reassess their portfolios. They will look into the attractiveness of various financial markets and try to reshuffle their pack of instruments and decide on funds deployment. That is a source for volatility. So long as all are not moving towards the same markets, the volatility will be somewhat contained. But herd mentality prevails among investors. 

The second event that is now slated to introduce a kind of nervousness is the changed monetary circumstance in Europe. The European Central Bank is set to become the sole banking sector regulator in the 16-nation Euro countries. ECB will become the sole supervisory authority from November 4, but before that the bank has undertaken Europe’s most extensive and credible banking stress tests. The results of the stress tests are none too comfortable.

Stress tests for banks have become almost a fad among banking regulators since the outbreak of global financial meltdown. These are, in effect, simulation of financial crises and how that should affect a bank. Thus, for example, in case, say, home loans turn bad, how will it affect a bank’s ability to overcome such incidence with its own capital and other assets. Again, other parameters are taken into consideration like drastic fall in interest rates and the bank’s earning capacity and the effect on its finances. 

The ECB’s stress test of around 135 banks has shown that 25 European banks do not pass muster. What happens to these banks? They will be required to raise fresh capital and funds to build enough cushioning to face possible adverse developments. Preliminary indications show that Germany’s Deutsche Bank has performed fairly well under the stringent stress test. 

Obviously, these revelations would leave their imprint on the financial markets. Once the European or the American markets enter a turmoil or adjustment zone, these will spill over into other markets, say, in the emerging market economies. In fact, we have seen such volatility over a day recently when markets had gone up in Japan in their morning trade on positive news from USA, only to slide by the end of the day as European markets crashed due to French and Italian governments’ debt concerns. Thirdly, what the markets now fear is central banks working at cross-purposes in different countries. While the ECB is talking of introducing ultra-loose monetary policies, almost mirroring US QEs, the Bank of England is said to be at the cusp of launching a monetary tightening cycle. Bank of Japan, on the other hand, has already gone on an expansion mode to bring down the Yen’s exchange rates. These pulls and pressures will work on the markets and keep the players on their toes. 

 

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