Guest post from Ben Emons, author of Financial Domino Effect.
Global financial markets have been subjected to gyrations that seem to come in greater numbers. These have been associated with so called domino effects, chain reactions caused by something unexpected. Often times a chain reaction occurs because there is linkage between markets, economies, societies and politics. There are three kinds of domino effects; social-political, economic and financial. Each in their unique way are playing out in markets today, often characterized in lingo as risk on and risk off. This characterization has been in motion since the European sovereign debt crisis intensified.
The European crisis is a combination of political, economic and financial elements, each time set in motion by a unique factor. Such was the Greek election on May 6th that put in doubt the country’s membership of the European monetary union. Stocks, commodities, currencies and peripheral government bonds fell in value, a negative domino effect. When this effect escalates, at some point there is anticipation of a policy response by central banks. Those actions are intended as portfolio balance, a rotation from risk free to riskier assets that cause a positive domino effect. As this happens, sentiment shifts from risk off to risk on, and this has become an annual recurring event since 2010. It could be described as a juncture where a political crisis (Europe, Middle East), meets an economic crisis (global economic slowdown) and a financial crisis (Spanish banking system).
As each day goes by, global policy makers are becoming increasingly hostage to markets. In turn, they try to impress with more bold and creative measures that lack credibility as market skepticism overwhelms. Markets react negatively, that adversely affects economies as credit conditions tighten. The result is that a financial domino effect turns into an economic domino effect. Since politicians react with even more measures, those provoke protests on the street, and an economic domino effect becomes a political domino effect. Domino effects work through channels of contagion such as currency borrowing, trade balances, the level of outstanding government debt, and the financial state of the domestic banking system.
Trade links strengthen contagion in areas with high intra-trade, economic and political commonalities. These links can cause contamination to countries with broadly similar economic and political conditions. Because of globalization, the channels of contagion do not just exist in the Euro-zone but basically everywhere. The linkage of debt, trade, economy and politics sets in motion spillover effects global central banks respond to. That creates an inherent momentum behind positive and negative domino effects that empowers the kind of risk on, risk off reactions markets express every day. Financial domino effects eventually subside when a corner solution is reached. Given the amount of debt deleveraging in many countries, such solution is either debt restructuring or debt monetization.
Like a domino field, the toppling of stones at some point does end.