Why markets increasingly becoming correlated spells trouble?

Ahead of today's announcement from ECB president Mario Draghi relating to a decision whether to make the monetary environment in Europe more expansive than where it currently stands, we heard yesterday from Sweden's Riksbank who gave promising commentary regarding the country's economic outlook yet added that it's monetary toolbox remained opened and should further intervention take place on the part of the ECB it wouldn't shy away from continuing its extended run of stimulus.

I expressed concern over the matter by saying the ECB's partial contribution towards distorting asset markets along with other advanced nations enacting the same strategy with similar force, namely the Bank of Japan and Swiss National Bank, was overstating central bank's need to influence these markets closely but also directly competed against their smaller counterparts like Sweden who had no choice but to put up a brave defence in imitating what the bigger central banks were doing but were likely to be defeated due to comparative size.

New evidence shows that assets have become so distorted that the utilisation of diversification through the process of portfolio management won't mitigate the risk often associated with having a variety of distinct assets.

Asset contagion worse than 2008 as markets held hostage to rates https://t.co/44y6zYxZYX via @luwangnyc pic.twitter.com/so5w6ILsn3

— Bloomberg Markets (@markets) September 8, 2016 

The Credit Suisse Cross-Market Contagion Indicator measures the interconnectedness of different instruments price movements in relation with one another in finding the correlation amongst the basket of instruments that includes foreign exchange, commodities, bonds and equities. An optimal outcome for this indicator would be to suggest there's little correlation between instruments however the current reading says the risk of contagion is higher than it was pre-Financial Crisis.

Contagion would occur due to the direct relationship asset prices have taken on with one another and if a market crash were to happen the effects wouldn't be isolated to one asset class.

We've seen an extensive rally into bonds returning positive yield and in some extreme occasions investors being forced to accept longer term maturities in exchange for meagre coupon payments. The zero yield parade not only pushes the prospects of bond investors into jeopardy since the convexity (the rate of change in bond prices when rates increase/decrease) is alarmingly high, the tiniest of interest rate hikes could trigger a full blown financial market crisis it seems.

The responsibility falls squarely on central banks around the globe but as much as we can play the blame game perhaps we should give thought to the idea of a state in the global economy where monetary policy has exhausted it's options, government coffers are burdened with huge debt bills to pay with lenders insisting on reducing the load, effectively creating a situation where no interventionist policy is in place to guide the world economy forward. Absolute chaos but closer than what you think.

Riksbank highlights the risk the ECB is creating for other economies

Often a precursor to an announcement from the ECB, Sweden's central bank Riksbank assessments of the economy, inflation and international events affecting its currency, the Krona, are ordinarily interpreted as steps towards aligning it's monetary policy closer to its counterparts in Europe with the most notable being the European Union in having the greatest influence on the Nordic nation.

So you can imagine the reaction of market participants when governor Stefan Ingves reiterated that the central bank was ready and able to reopen it's monetary toolbook if further expansionary policy was needed to avert a short lived weakness in it's currency due to the actions of the ECB.

The central bank went on to say the uptick in both inflation and economic activity were positives for the country saying it was producing the desired effects that were intended from the use of an unconventional yet radical approach of negative interest rates which has caught on in a number of advanced economies.  

Riksbank Reiterates Readiness To Do More https://t.co/C68PQgitDg

— Livesquawk (@Livesquawk) September 7, 2016

Its use amongst some of the most trusted central banks in the world has called into question the integrity and perhaps desperation these policymakers who are willing to go to extreme lengths in reaching their economic objectives. Although not tested, the potential pitfalls of such policies will only be seen after the damage has been done which could be little to late.

The commentary provided by Riksbank in relation to this highlights the additional risk being introduced into the financial system as a result. With an economy 25 times larger than Sweden's the European Union's armoury needed to defend it's economy from the contagion of deflation would be so much larger.

It goes without saying that the money creation process needed to avoid a crisis in the EU is to such an extent it adversely impacts the positioning of the Swedish Krona against the Euro with the only response that can be used by Riksbank is to imitate the actions of the ECB.

This only serves to further supply liquidity to an existing global economy that's become distorted by the years of low rates and excess money.