During this turbulent month, both Australian and US share markets experienced significant fluctuations. Although they have largely recovered lost ground, the IMF cautioned that August’s events should be viewed as a warning of potential chaos ahead if volatility continues to rise alongside uncertainty.
Early August witnessed a sharp decline in global stock prices, triggered by investors unwinding carry trades that borrowed yen to fund long positions in risk assets. This selling intensified after the Bank of Japan’s late July monetary policy decision and a weaker-than-expected US labour market report for July.
The resulting equity volatility surged from previously compressed levels, exacerbating sell-offs before stabilising in the days that followed.
While the volatility was short-lived, the IMF’s latest Global Financial Stability Report highlighted that this episode offered a glimpse of the turbulent market reactions that can arise when spikes in volatility intersect with leveraged positions held by financial institutions, leading to non-linear market responses and accelerated sell-offs.
“Further rises in economic uncertainty could increase downside risks to future growth, asset prices, and growth in bank lending,” the IMF said.
The fund explained: “For example, assuming global real economic uncertainty jumps by an amount equivalent to its rise during the global financial crisis, the downside outcome of one year-ahead global real GDP growth worsens by 1.2 percentage points. This effect is stronger when macro financial vulnerabilities are more elevated or when market volatility is more disconnected from uncertainty. Uncertainty can also trigger cross-border spillover effects through trade and financial linkages.”
Drawing parallels between the August turmoil and the role of non-bank financial intermediaries (NBFIs) in transmitting financial stress, the IMF noted that rapid unwinding of leveraged positions can create liquidity imbalances, increasing market volatility.
“With the growth of open-ended bond funds, hedge funds, and private credit, the use of leverage among several NBFI segments is increasing,” it said.
“Even in the absence of defaults, which could give rise to counterparty risk and lead to contagion across financial institutions, rapid unwinding of leveraged positions can generate liquidity imbalances that amplify market disruptions.”
It also emphasised that a lack of adequate data presents a significant challenge for authorities, hindering their ability to assess vulnerabilities tied to non-bank leverage and identify large, concentrated positions.
The IMF’s concerns extend to global financial stability, with the fund identifying three key imbalances that could exacerbate risks and amplify shocks.
First, it pointed to “lofty” asset valuations in equity and corporate credit markets, driven by “buoyant investor sentiment seemingly undeterred by a slowdown in earnings growth of firms and the continued deterioration in more fragile segments of the corporate and commercial real estate sectors”.
Mounting government debt represents another critical imbalance, while heightened leverage among financial institutions – particularly NBFIs like hedge funds and private credit funds – constitutes the third.
“These imbalances could worsen future financial stability risks by amplifying adverse shocks, which have become more probable due to elevated economic and geopolitical uncertainty,” the IMF said.
Much of this uncertainty stems from the fact that half of the world’s population has elected or will elect new governments this year, making future policies – ranging from fiscal to trade to geopolitical – hard to predict. Ongoing military conflicts, particularly in the Middle East and Ukraine, further contribute to this unpredictability.
The IMF cautioned that adverse shocks are “not only probable”, but the growing disconnect between uncertainty and relatively low volatility in financial markets suggests that a spike in volatility could soon bring it in line with prevailing uncertainties.
