During this tumultuous month, both the Australian and US share markets experienced significant volatility. Although they have largely recovered lost ground, the IMF warned that the events of August should be seen as a warning of potential chaos if volatility continues to grow along with uncertainty.

In early August, we saw a sharp decline in global stock prices, driven by investors exiting trades that borrowed the yen to fund long positions in risk assets. That selling strengthened after the Bank of Japan’s monetary policy decision in late July and a weaker-than-expected US labor market report for July.

The resulting equity volatility rose from earlier lows, exacerbating the sell-off before stabilizing in the coming days.

Although the volatility was short-lived, the IMF’s latest Global Financial Stability Report stressed that this episode offers a glimpse into the violent market reactions that can occur when spikes in volatility intersect with leveraged positions held by financial institutions, leading to non-linear market reactions and accelerated sell-offs.

“Further increases in economic uncertainty could increase downside risks to future growth, asset prices and bank lending growth,” the IMF said.

The fund explained: “For example, if we assume that global real economic uncertainty jumps by a value equivalent to its rise during the global financial crisis, the negative outcome of global real GDP growth one year ahead worsens by 1.2 percentage points. This effect is stronger when macro-financial vulnerabilities are higher or when market volatility is more detached from uncertainty. Insecurity can also trigger cross-border 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 could create liquidity imbalances, increasing market volatility.

“With the growth of open-end bond funds, hedge funds and private credit, the use of leverage among several segments of NBFIs is increasing,” it said.

“Even in the absence of a default that could introduce counterparty risk and lead to contagion in financial institutions, the rapid unwinding of leveraged positions can generate liquidity imbalances that exacerbate market disruptions.”

He also stressed that the lack of adequate data poses a significant challenge for authorities, hampering their ability to assess vulnerabilities related 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, he pointed to “elevated” asset valuations in the capital and corporate credit markets, driven by “buoyant investor sentiment that appears unfazed by slowing corporate earnings growth and continued deterioration in the weaker segments of the corporate and commercial real estate’.

Rising government debt represents another critical imbalance, while increased leverage among financial institutions – especially NBFIs such as hedge funds and private equity funds – represents the third.

“These imbalances could exacerbate future risks to financial stability by amplifying adverse shocks that have become more likely due to heightened economic and geopolitical uncertainty,” the IMF said.

Much of this uncertainty stems from the fact that half the world’s population has elected or will elect new governments this year, making future policies — ranging from fiscal to trade to geopolitical — difficult to predict. Ongoing military conflicts, particularly in the Middle East and Ukraine, further contribute to this unpredictability.

The IMF warned that adverse shocks were “not only likely”, but the growing divergence between uncertainty and relatively low volatility in financial markets suggested that a spike in volatility could soon bring them in line with prevailing uncertainty.