Financial markets: quiet before the storm?

The recent headlines of geopolitical clashes or the series of stricter banking regulations that are restricting banks by forcing them to deleveraging did not stop the financial markets from growing. On the contrary, undeterred by relatively weak growth of the major economics, financial stocks are continually reaching their record highs. Volatility on the markets is provided only by geopolitical events and policymakers’ decisions. What is more, with economic fragility somewhat abating through state emissions of “safe” debt (QE or more state bonds) the bridge between effective demand and supply is growing by a generation of new and ever more sophisticated financial instruments. The derivatives market therefore keeps on growing and the question that naturally follows is how long can such a trend continue?

Role of finance

In order to find the growth of financial economy astounding, it is imperative to recognize the principal reason for the existence of finance. No matter what political, philosophical, or ideological spectrum one occupies, it is generally accepted that finance exists to assist the real (productive) economy. Thanks to the financial sector firms or entrepreneurially oriented individuals enjoy access to credit, which allows them to expand on their ideas and satisfy a demand in the economy. Apart from raising money, finance also helps economic actors to store and manage their wealth, i.e. their financial capital. But what becomes of finance that overstays its welcome? What happens when the financial economy is met with shrinking demand for credit from the real economy, yet continues to grow, as its activity becomes motivated by self-sustaining and profit maximizing intentions?

Growth of the derivatives market

According to the Bank for International Settlements, prior to the crisis, the size of the derivatives market stood at around 680 trillion US dollars and at the end of 2013 it reached 710 trillion. Some estimates speak of a number close to one quadrillion. Considering the sluggish growth of global GDP (currently at some 70 trillion) and the continued growth of the derivatives market above its pre-crisis levels, it is clear that derivative instruments are largely being built upon each other.

JP Morgan Chase & Co is now offering new types of credit swaps that are tied to Markit’s iBoxx USD Liquid Leverage Loan index, a speculative grade-loan index. Goldman Sachs plans to start selling its first structured bonds in September, which are backed by a revolving pool of fixed-income assets, including asset-backed securities. Many economists, including former Fed Chairman Paul Volcker, have blamed such instruments for bringing the financial system “to the brink of collapse. Does this necessarily mean, however, that the market is about to blow up and crash again?

Derivatives serve as an indicator of future value of an asset, thus they can be described as an instrument of “market hoping.” In other words, the nominal value of a derivative asset is mostly based on predictions about its future value. What is more, once an asset has entered this domain defined by futurity, its nominal value becomes measurable only by other derivatives, thus making it even more obscure and complex to determine the “real” value of an asset. This complexity makes it practically impossible to determine whether a speculative bubble is emerging or not.

One blow to destroy them all

In order for an inflating market to crash, a certain impetus must occur. Simply put, something must pop the bubble. The catalyst for the start of the recent financial crisis was the overheated housing market which subsequently burst due to the inability of mortgage owners to repay their obligations. The ones to blame, however, are those who supported such clearly unsustainable processes and then saved it from total collapse. Most notably, the US government even went on to openly support the ideology of house ownership.

Governments have now learned from their mistakes and aim for swift actions that limit the occurrence of any potential bubbles. For instance, the rising costs of the London housing market have been curbed by the Bank of England’s decision to limit access to mortgages. This allows the future value of housing to maintain a steady and sustainable growth, and thus supporting market confidence level. Bond prices went down and derivatives grew. Therefore, since credit providers (banks) used to be involved in an unknown degree of risky operations and no one could (or can) tell whether or when an implosion might (or may) occur, governments and regulators have taken major steps to clean up the system and restore confidence in the financial system as a whole.

Sketchy moves

The post-crisis era has been dominated by government action of “plugging” up all leaks that could potentially create a larger burst. Financial institutions came under public scrutiny and banks were forced to adopt stricter capital adequacy. Most of all, governments supplied the economy with cheap credit (in the form of QE or bond) that boosted low levels of trust and confidence in the market. This has taken away the previously observed volatility, which has now been somewhat replaced by geopolitical clashes, decisions anounced by central banks or other political decisions.

The rule on the markets dicates that the lower the confidence of market participants, the higher the premium on credit, i.e. the higher the interest rates. High-risk premium, e.g. high interest rates, means that a particular market participan or segment has overdone itself and holds too much risk. In this case it was the financial sector that had overstayed its welcome in artifically supporting economic growth. Risky obligations, however, were masked with the use of special purpose vehicles or colateralized debt obligations, thus keeping the interest rates relatively low.

Was it really necessary and above all prudent for everyone to own a property? Capitalism is based on inequality; it builds on it. Thus, how can all be equal in the housing market? Nonetheless, the purpose of the market is to determine the viability of such question. Consequently, the inflated financial sector was accordingly meant to plunge, in order for another one – an improved financial system – to emerge. Instead, governments have taken the politically easier route and sustained a crashing system by supplying it with more “finance.”

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As long as regulators and governments will be killing or the “black swans” before they hatch, the consistent growth on the stock markets will continue. Many other events can take place, though: ranging from natural disasters, through individuals or ‘rebel’ groups engaging in open conflict, to clashes over territory or access to natural resources. All of the above have already taken place in the last five years (e.g. Fukushima; Arab Spring or the current situation in Ukraine; Senkaku Islands), but their relative size has not been great enough to cause a bigger shock. Instead, only a large number of smaller corrections have taken place. We are therefore just waiting for a one major blow – a one sore “loser” that will try to revenge his defeat on the market by making a radical move. A bursting event that will “slip” the watchful eye of policymakers is much less likely.

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Categories: Europe, North America

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