What lurks beneath? Market calm unnerves global central bankers

Global central bankers sounded the alert about the calmness in financial markets, saying it risked creating future instability and complicating monetary policy.

Twenty-four hours of warnings were led by Federal Reserve Bank of New York President William Dudley's acknowledgment that the slide in market volatility "makes me a little nervous." Bank of England Deputy Governor Charlie Bean said conditions were "eerily reminiscent" of the pre-crisis era, while Bundesbank board member Andreas Dombret said "we do see risks despite the fact that the markets are calm."

The concern of policy makers is that their easy money is making investors complacent, pushing them to search for risk and leaving markets prone to a swift reversal similar to that which began in 2007. Reflecting the lull, Bank of America Corp.'s Market Risk Index last week reached its lowest in seven years.

"It's maybe a shot across the bows of the markets," said Peter Dixon, global equities economist at Commerzbank AG in London. "It's an attempt to flag up that markets can go down as well as up which will be a concern when central banks do start to raise rates."

The complication for central bankers is they still need to maintain stimulus for the good of their economies, said Lena Komileva, managing director at G Plus Economics Ltd. in London.

The European Central Bank is poised to cut interest rates as soon as next month to fight low inflation, while the Fed is continuing to buy assets on a monthly basis even as it slows the pace. Bank of England and Fed officials also are signaling that they don't plan to raise borrowing costs before next year -- and then only slowly.

Too Much

"Policy is working too much in the financial economy and less so in the real economy," said Komileva. "Sustaining generous policies when recoveries are under way could backfire by spurring excessive risk taking."

Sovereign debt from Spain to Ireland is paying out record- low yields, while property markets are surging from the U.K. to Norway. Fluctuations in the $5.3 trillion-a-day currency market also are around the lowest since 2007, according to JPMorgan Chase & Co., and the MSCI Index of world stocks reached a record this month.

Bank of America's Market Risk Index, which uses options to forecast fluctuations in equities, currencies, commodities and bonds, dropped to minus 1.22 on May 14, the lowest level since June 2007. That was two months before the ECB first reacted to money-market strains at the start of the financial crisis.

Dudley, the Fed's point man on Wall Street, said in New York yesterday that he's concerned about the "unusually low" volatility because "it's not just fixed income, it's fixed income, foreign exchange, and equities."

'Sense of Complacency'

Bean, who steps down next month after 14 years at the Bank of England, echoed that concern in saying there is a possible "sense of complacency and an underestimation of market risk by investors."

"It is inevitable that at some stage, market perceptions of uncertainty will revert to more normal levels," Bean said. "That is likely to be associated with falls in risky asset prices."

While the geopolitical crisis in Ukraine or economic stresses in China could be triggers, Bean said market interest rates are also "bound to become more volatile" when central banks begin tightening monetary policy. The Bank of England today said the risk of financial imbalances is strengthening the case in favor of rate increases for some of its officials.

In the euro-area, Dombret said in an interview that low volatility "leads to market participants thinking that they don't need to hedge," and that new risks to stability could emerge as investors seek out bigger returns.

'Great Moderation'

The environment is prompting speculation that the world is repeating the "Great Moderation" witnessed in the two decades prior to 2007 when markets were similarly quiescent only to be roiled by a series of unforeseen banking failures.

"Low volatility encouraged an underestimation of the likelihood and severity of adverse tail risks crystalizing," Bean said yesterday as he reflected on the past decade. "Seen in this light, the Great Moderation sowed the seeds of its own destruction."

So long as policy makers are aiding their economies the likelihood is that the market calm remains, according to currency strategists at Nomura Holdings Inc. led by Jens Nordvig in New York.

"Continued global liquidity injections by major central banks may continue to prevent volatility increases for some time," the Nomura team said.