|
International Capital Markets Published by the International Monetary Fund C. Risks in Foreign Exchange and Credit MarketsA risk in global currency markets is that the large volume of long dollar positions held by investors, speculators, and dynamic hedgers might have increased the sensitivity of international portfolios to downward movements in the dollar. An example of this increased sensitivity is the mid-May 1997 sell-off of dollar assets in favor of yen assets and the sharp and unexpected rebound of the yen (see Appendix I), which followed remarks about overshooting by Japanese officials and raised concerns that some of Japan's dollar reserves would be liquidated. The unwinding of yen-carry trades might have hastened the momentum of the yen's rebound as investors rushed to liquidate long-dollar positions to cover their short-yen positions. There are also market risks associated with the transition to EMU. In particular, there could be an increase in market volatility as investors rebalance their portfolios as decisions about the initial country composition and euro conversion rates are anticipated and made between now and January 1, 1999. In credit markets, there is a risk that risk-adjusted spreads may have fallen below what is justified by fundamentals. Cyclical factors increasingly suggest that monetary policy is likely soon to be tightened in some major countries, and a key question is whether markets have fully priced in the risks of a further tightening of monetary policy and associated credit risk. There appears to be significantly less leverage in credit markets than there was before the bond market turbulence in 1994. At a minimum, this would suggest a smaller likelihood of overshooting if and when an adjustment in spreads occurs. In the event that growth continues to be sluggish in Japan and Europe, a further tightening of monetary policy in the United States could lead to a widening of interest rate differentials and an increased demand for dollar instruments. |