Reduced leverage may have unintended consequences, Citi cautions

Selling in financial markets around the world thus far has been 'orderly' but the trends in certain market metrics were pointing to the risk that regulators had got it badly wrong in assuming reduced leverage on the part of financial institutions had made the financial system safer, Citi told clients on Friday.

"It raises the risk the entire post-crisis regulatory narrative has been incomplete. Current risks may be much higher than policymakers realize," Citi's Matt King said in a research note sent to clients.

Metrics such as swap spreads or credit default swap index skews were all showing signs of stress at the same time.

That was the result of various factors, such as constrained leverage, contracting repos and outflows from mutual fund outflows which were leading to illiquidity premiums on certain instruments, which in turn might damage confidence in markets deemed less reliable, King told clients.

"Current risks may be much higher than policy-makers realize," he concluded.

Are we headed into another major global recession?

In parallel, Citi strategist Robert Buckland issued a research piece in which he told clients that the relationship between corporate bond spreads and equities had moved to the point where it implied a sharp contraction in earnings per share, a collapse in momentum-trades and a sustained risk-off bear market.

Nonetheless, at present only five of the eighteen indicators he followed to gauge whether stocks had entered a "sustained risk-off bear market" were flashing a 'sell' signal.

Hence, his Bear Market Checklist suggested such a call was premature, unless, he added, Citi's economists were wrong in not forecasting another major recession in the global economy.

"Therefore, we see the current sell-off as a correction to be bought rather than the beginning of the next sustained bear market. We will be wrong if the global economy enters another major recession, which Citi economists do not currently forecast."