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The most significant risk to markets doesn’t stem from financial crises in indebted emerging markets, geopolitical tensions or even “unknown unkowns”.

Instead, Luiz Awazu Pereira da Silva, deputy general manager, and Előd Takáts, economist, at the Bank of International Settlements argue in a new paper that the most significant risk for financial markets is perhaps complacency and self-delusion.

In the US, equities markets have rallied and bonds have sold-off on expectations that Donald Trump will unleash fiscal stimulus and roll out tax reforms as the Federal Reserve continues to normalise monetary policy. However, they reason that if the Fed were to fall behind the curve in normalising rates there could be a harsher drop in bond prices, that causes yields to “snapback” to higher levels.

And across the pond, European Central Bank chief Mario Draghi’s bold 2012 claim to do “whatever it takes” to preserve the euro and efforts to make the banking system safer haven’t been enough and structural reforms haven’t picked up the baton from monetary policy. They note that public discontent that is giving rise to a wave of populism could pose a risk to social and economic stability. And yet there is a disconnect between high policy uncertainty and low market volatility.

Messrs da Silva and Takáts also note that the populism and protectionism seen in emerging markets in recent decades, and that failed to improve societies well being, is now beginning to appear prominently in advanced economies.

Indeed, Mr Trump, for instance, made trade one of his key campaign promises and has threatened a punitive border-adjustment tax to companies that shift manufacturing outside of the country in hopes of bringing jobs back to America.

But the authors argue that pointing fingers at globalisation and trade for job losses and greater inequality is an oversimplification. That policymakers should instead work on pursuing policies that can help improve skills and human capital. Some of the complacency in markets, they argue, stems from the bet that short term returns can be achieved by muddling through policies without undertaking sustainable structural reforms.

Ultimately, they note:

Some exuberance today cannot replace the need to fix our economies, increase productivity and mend the social fabric with more inclusion and fairness. It is with markets’ cooperation and alertness that policymakers will be more capable to act for the common good.

Copyright The Financial Times Limited 2017. All rights reserved.
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