Markets wrestle with reflation prospects: BIS Quarterly Review

• Prospects of a more robust economic recovery buoyed risky asset prices, with signs of exuberance reflected in the behaviour of retail investors.
• Sovereign yield curves steepened as investors priced in higher inflation and fiscal support.
• Sentiment towards emerging market assets remained favourable, in particular in East Asia.

The latest BIS Quarterly Review reports that risky assets strengthened further during the review period.¹ This buoyancy was set against a backdrop of continued strong monetary accommodation, growing expectations of fiscal stimulus, and cautious but fluctuating optimism about recovering from the pandemic.

Elevated risk appetite was reflected in continued strong corporate debt issuance, especially by lower-rated firms. Many stock indices reached all-time highs in February with equity fund-raising reviving memories of the late 1990s tech boom as retail investors flexed their increasing influence on market dynamics.

Search for yield underpinned the broadly positive sentiment towards emerging market assets, particularly in East Asia, supporting portfolio flows into these economies.

As the likelihood of substantial US public support rose, fixed income investors demanded more compensation for inflation risks. Government yield curves steepened in the United States and Europe.

The recent market jitters confirm that the back-up in bond yields and reflation trade are casting the financial market outlook in a completely new light.

Claudio Borio, Head of the BIS Monetary and Economic Department

The March 2021 issue of the BIS Quarterly Review also:

• Notes that stock returns are more sensitive to monetary policy news in periods of low interest rates and high price/earnings ratios.
• Analyses the rising influence of retail investors on equity markets, where substantial and erratic activity can amplify price volatility.
• Examines features of banks' loan loss provisioning during the Covid crisis.
• Discusses the reasons behind the widening gap between the nominal yield on fixed rate bonds and the real yield on comparable inflation-linked investments in the United States.

Four features analyse developments in markets and the global economy:  

The time elapsed since the financial turmoil of last March gives us an opportunity to review some of the lessons on the functioning of non-bank financial intermediaries that were not apparent in the heat of the moment.

Hyun Song Shin, Economic Adviser and Head of Research

• Fernando Avalos and Dora Xia (BIS) analyse withdrawals from money market funds in March 2020 and find that large investors paid little attention to the liquidity conditions of individual funds. They also find that portfolio managers responded to the surge in redemptions by hoarding liquid assets.
• Iñaki Aldasoro, Egemen Eren and Wenqian Huang (BIS) report that, despite the market stress, the dollar liabilities of non-US banks grew in 2020. These banks have witnessed a shift in US dollar funding sources since March 2020: from money market funds to other non-bank financial institutions.
• Karamfil Todorov (BIS) examines the arbitrage mechanism behind bond exchange-traded funds (ETFs), which manage more than $1.2 trillion of assets. While this mechanism is weaker than for equity ETFs because of the illiquid nature of bond trading, it allows bond ETFs to support market functioning by absorbing shocks.
• Benoît Mojon, Daniel Rees and Christian Schmieder (BIS) use sectoral output data to project how much stress the pandemic could put on corporate credit in the Group of Seven countries, Australia and China. The analysis suggests that, since the sectors most affected by the pandemic account for a smaller share of total corporate borrowing, credit loss rates could be lower than during the Great Financial Crisis of 2007–09.

¹ 1 December 2020 to 22 February 2021.