There are 4 big factors to watch that could bring turmoil to financial markets, research firm says

Financial crises are the new normal, according to one Yale economist. PonyWang/Getty Images

• Stocks and the economy look strong but there are four factors that could pose a problem, Capital Economics said. 
• Geopolitical risks in the Middle East and high interest rates are big risks to markets. 
• A depreciation of the Chinese yuan and soaring US debt are also the two factors investors need to watch. 

The market and the economy are on pretty solid footing but there’s a host of factors that could spark a quick deterioration of conditions, Capital Economics said in a report this week.

The low level of risk premia suggests there’s “plenty of scope [for] more material worsening of financial conditions” if four key factors start to break down, according to Capital Economics’ Ruben Gargallo Abargues and Jonas Goltermann.

First, the two economists noted that ongoing tensions in the Middle East could further disrupt the energy market, with Brent crude oil price showing no increase since mid-March despite being “the most obvious proxy” for the escalating Israel-Hamas war.

“Similarly, implied volatility on oil options remains low by historical standards. And, while risk reversals, a measure of the perceived balance between upside and downside risks, rose in early April, that increase has since been reversed,” they wrote on Friday.

Second, despite the Federal Reserve signaling no rate hike this year during Wednesday’s FOMC meeting, stubborn inflation keeping interest rates high adds substantial pressure on asset prices.

“As we saw in 2022 and 2023, and to some extent over the past month, rapid rises in real interest rates could weigh on asset prices. Moreover, a hawkish pivot by the Fed would probably lead to renewed volatility in bond markets,” Abargues and Goltermann said.

Thirdly, with the rising value of the Chinese yuan, any depreciation could trigger currency market volatility elsewhere.

“By enforcing a de facto peg against the US dollar when most other currencies are depreciating, the renminbi has appreciated in trade-weighted terms. If the Chinese authorities changed their approach and opted for devaluation, this would probably lead to higher volatility across currency markets,” the note said.

Finally, the much-feared US debt does indeed pose risk of financial instability, they argued. “Bond king” Bill Gross this week said he sees rampant borrowing as the only way to propel GDP growth, while Capital Economics said that the cost of insuring against default on US debt via credit default swaps remains slightly elevated compared to normal levels.

“Neither presidential candidate appears keen on fiscal consolidation. If fiscal policy stays on its current track, it is plausible that the US could, at some point, fall foul of the ‘bond market vigilantes’ increasing risk premia across the board, not just in Treasuries,” Abargues and Goltermann added.

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