BIS Quarterly Review September 2025 | International Banking

The September 2025 BIS Quarterly Review presents a fascinating paradox in global financial markets. Despite mounting trade tensions, policy uncertainty, and elevated household inflation expectations, international banking and financial market developments reveal a persistent risk-on sentiment that defied conventional wisdom. This comprehensive analysis explores the key themes emerging from the Bank for International Settlements’ latest quarterly assessment.

Covering the period from June 1 to September 4, 2025, the review examines a remarkable market environment characterized by equity rallies to all-time highs, compressed credit spreads, and significant shifts in monetary policy frameworks. The report also introduces groundbreaking research on tariff effects, household inflation expectations, and the evolution of central bank operational frameworks.

Global Risk-On Rally Defies Trade Uncertainty

Perhaps the most striking feature of the review period was the sustained international banking and financial market rally despite unprecedented trade policy uncertainty. US equity markets, led by the S&P 500, surged to all-time highs by August 2025, with the VIX declining significantly after more than doubling during the April 2 tariff shock.

The market’s resilience proved remarkable. The S&P 500 recovered all early-April losses by the end of April and surpassed its pre-stress peak within approximately 20 weeks. The Magnificent 7 technology stocks outperformed the broader index by ~11 percentage points during the review period, driving much of the rally’s momentum.

Interestingly, retail investors played an unusual role in this recovery. Unlike during the Global Financial Crisis, retail investors were net “buyers of the dip” while institutional investors withdrew – representing a significant behavioral reversal. This shift in investor dynamics contributed to the market’s unexpected strength amid uncertainty.

US equity valuations reached concerning levels, with P/E ratios approaching the top 10% of historical distribution and nearing dotcom bubble levels. Despite these elevated valuations, the rally persisted, with approximately 75% of the S&P 500’s rise between the April 9 trough and end-July driven by non-tariff factors including corporate earnings and macroeconomic fundamentals. For more insights on market dynamics, explore our comprehensive analysis.

Credit Markets Signal Aggressive Risk-Taking

The financial market developments in credit sectors revealed a troubling disconnect between risk pricing and underlying fundamentals. High-yield credit spreads compressed to levels well below historical norms, reaching close to historical lows in the US market. This compression occurred despite elevated and marginally rising US high-yield default rates – a clear signal of aggressive risk-taking in credit markets.

The excess bond premium, as measured by the Gilchrist-Zakrajšek indicator, declined significantly during the period, suggesting reduced compensation for credit risk. This development coincided with robust high-yield and leveraged loan issuance, while private credit deals also edged upward, indicating strong investor appetite for credit risk.

Financial conditions indices painted a mixed picture globally. The Goldman Sachs Financial Conditions Index showed significant easing in both the US and UK, while the euro area remained broadly unchanged. The BIS Financial Conditions Index’s risk factor component eased considerably, primarily driven by compressing corporate yields and spreads.

France stood out as a notable exception to the global easing trend. The country experienced steady tightening of risk factors due to rising credit and sovereign spreads, reflecting growing concerns about fiscal sustainability and political uncertainty. This divergence highlighted how country-specific factors could override broader global trends in credit markets.

US Dollar Dynamics and Safe Haven Shifts

The US dollar’s behavior during the review period challenged traditional currency market relationships. The dollar’s depreciation trend, which had been ongoing, paused notably after the July 4 signing of the “Big Beautiful Bill” fiscal package. However, the currency exhibited mixed performance across different trading partners, appreciating against the yen while continuing to depreciate against the Swiss franc and euro.

A particularly concerning development was the breakdown of historical correlations that had long defined currency markets. The traditionally positive correlation between the US-German yield spread and EUR/USD exchange rate collapsed post-April 2025, suggesting fundamental shifts in how investors perceived relative value and risk.

Perhaps most significantly, the correlations between US Treasury prices and traditional safe haven assets – including gold, Swiss 10-year bonds, and the VIX – approached zero since April. This development raised questions about the weakening of US Treasuries’ safe haven properties, a cornerstone of global financial stability since World War II.

Portfolio flow evidence supported concerns about shifting dollar dynamics. Foreign investor sales of US assets in April were largely reversed in May-June, but fund flows into euro area, other advanced economy, and Asian emerging market sovereign bonds surpassed those targeting the US in Q2 2025. Asset managers also increased hedging activities, with CFTC data showing increased long positions in emerging market currencies like the Mexican peso, effectively creating short USD exposure. Understanding these currency dynamics is crucial for international banking strategies.

Bond Markets: Short-End Easing vs Long-End Concerns

Government bond markets experienced dramatic steepening at the ultra-long end, reflecting tension between expectations of near-term policy easing and longer-run fiscal and inflation concerns. The European Central Bank and Bank of England each implemented 25 basis point rate cuts, while the Federal Reserve maintained rates, creating divergent monetary policy paths.

Market pricing moved aggressively to anticipate more rate cuts than suggested by the June Federal Open Market Committee’s dot plot median, indicating investor expectations of more accommodative policy ahead. US 10-year breakeven inflation rates shifted upward by approximately 10 basis points over the review period, while the entire zero-coupon inflation swap curve moved higher, gaining additional momentum following the Jackson Hole symposium.

The 30-year minus 10-year term spreads increased across major developed markets, including the US, Germany, France, UK, and Japan. This steepening reflected structurally weaker demand from pension funds and insurers for ultra-long bonds, combined with expectations of increased government bond supply from fiscal expansion plans.

Sovereign spread dynamics told a story of shifting risk perceptions. The French-German 10-year sovereign spread widened during the period, while the Italian-German spread compressed to levels not seen since 2010, converging with France by August. These movements reflected both Italy’s improved fiscal position and growing concerns about French political and fiscal challenges.

Emerging Markets Join the Global Rally

Emerging market economies broadly benefited from the global risk-on environment, US dollar weakness, and diminishing attention to trade conflicts. International banking flows to emerging markets turned positive in Q2 2025, with Latin American and EMEA currencies appreciating most significantly while Asian currencies remained largely flat.

EME sovereign bond issuance picked up pace after a weak Q1 2025, with EMBI Global spreads compressing notably. Long-term yields across emerging markets showed regional variation: Asia and EMEA yields were broadly flat, while Latin American yields ticked lower, reflecting improved investor sentiment and reduced risk premiums.

Equity market performance varied significantly across regions. Top performers included Korea, China, Indonesia, and Colombia. China benefited particularly from stabilizing economic data, stimulus measures, and the 90-day US-China tariff pause announced in April, demonstrating how geopolitical developments could rapidly shift market sentiment.

Brazil stood out as an exception to the generally positive emerging market theme. Hit by a 50% US tariff and domestic policy rate hikes, Brazilian assets underperformed regional peers. This divergence highlighted how country-specific factors could override broader emerging market trends, particularly when trade policy directly targeted specific economies.

Multi-Sector Assessment of Tariff Effects

The BIS introduced groundbreaking research using two complementary models – MS-Trade and BIS-MS – to quantify how tariffs affect output and inflation through supply chains, sectoral spillovers, and global demand shifts. The analysis revealed that US effective tariff rates reached approximately 17% as of August 7, 2025, representing the highest level since the 1930s.

Model estimates showed significant economic impacts: US output falls by approximately 0.9% while the price level rises by 2.2%. The effects varied dramatically across trading partners – Canada faced a 1.2% output decline with essentially unchanged prices due to offsetting retaliatory tariffs, while Mexico experienced a 1% output fall with 0.5% price deflation as demand effects dominated.

The research revealed surprising sectoral dynamics. Services sectors, despite not being subject to tariffs, accounted for approximately 50% of the US output drop and over 50% of the inflation increase. This finding demonstrated how production networks amplify tariff effects far beyond directly affected industries.

The study’s comparison of one-sector versus 16-sector models proved particularly illuminating. The simpler model produced an output trough only three-quarters as deep and inflation nearly 1 percentage point lower than the multi-sector analysis, demonstrating the critical amplification role of production networks in modern economies. For professionals working with complex economic data, our interactive modeling solutions can help visualize these relationships.

Household Inflation Expectations Survey

The BIS sponsored a novel survey across 31 countries, interviewing approximately 1,000 respondents aged 18-70 in each market during March-April 2025. The results revealed that household inflation expectations are universally elevated, far exceeding actual inflation rates and professional forecasts across both advanced and emerging market economies.

In advanced economies, household inflation expectations ran approximately double professional forecasts. The discrepancies proved even more pronounced in emerging markets, with Thailand, Saudi Arabia, Malaysia, Indonesia, and Korea showing the widest gaps between household expectations and professional assessments.

Food and groceries emerged as the most salient items influencing expectations globally, followed by oil and energy prices. Households with above-median perceptions of the post-pandemic inflation surge maintained inflation expectations approximately twice as high as those with below-median perceptions, suggesting lasting psychological effects from recent price increases.

The survey revealed concerning misperceptions about real wage developments. Households perceived approximately 6% real wage losses in advanced economies during the post-pandemic period, despite actual data showing that wages broadly kept pace with prices. This disconnect between perception and reality has significant implications for consumer behavior and monetary policy transmission.

Central bank knowledge and credibility showed important variations. Only about 60% of respondents could recognize their central bank’s name, and approximately 50% understood that price stability was a central bank goal. However, informed households demonstrated significantly lower inflation expectations, highlighting the importance of effective communication strategies. Social media emerged as an important – and in emerging markets, dominant – source of information about central banks and monetary policy.

Monetary Policy Operational Frameworks

The BIS introduced a sophisticated new two-dimensional taxonomy for understanding central bank operational frameworks, moving beyond the traditional corridor/floor classification. This framework analyzes systems based on the marginal opportunity cost of holding reserves and the quantity of reserves relative to bank credit.

The analysis revealed striking differences across central banks. Marginal opportunity costs ranged from over 11 percentage points in Mexico to small negative values in the euro area, UK, and US. Reserve quantities, normalized by bank credit, varied from approximately 0% in Korea to 65% in Japan, demonstrating the diversity of operational approaches.

Several central banks achieved similar outcomes through different designs. The Reserve Bank of Australia, Bank of Canada, and Sveriges Riksbank all maintained moderate reserves with low positive marginal opportunity costs, despite employing different framework structures. This finding suggested that outcomes could be more important than specific design features.

The historical evolution proved particularly instructive. Major advanced economies transitioned from high-opportunity-cost/low-reserves systems before the Global Financial Crisis to low-opportunity-cost/high-reserves frameworks during the quantitative easing era. Emerging market economies largely maintained high opportunity costs throughout this period, reflecting different policy priorities and market structures.

Mexico’s case study illustrated the trading incentives created by high opportunity costs, with daily money market turnover reaching approximately 5% of GDP. This compared with much lower turnover rates in systems with minimal opportunity costs, demonstrating how framework design directly influenced market behavior and liquidity patterns.

The Rise of Global Bond Markets

The BIS analysis documented the dramatic expansion of global bond markets since the Global Financial Crisis. Global debt securities outstanding rose from approximately 102-107% of GDP in 2000 to over 135% by end-2024, topping $150 trillion in absolute terms – a transformation that reshaped global finance.

Government bonds emerged as the dominant force, now exceeding 80% of GDP and accounting for 52% of global total debt securities, up from approximately 46% pre-pandemic. This shift reflected both crisis responses and structural changes in fiscal policy approaches across advanced and emerging market economies.

The share of bonds in total credit to non-financial borrowers reached approximately 40% globally, with several countries including Brazil and the US exceeding 50%. This evolution from loan-based to bond-based financing created new dynamics in credit markets and monetary policy transmission mechanisms.

Currency composition revealed the continued dominance of the US dollar in international bond markets. USD accounted for 63% of all foreign currency bonds, up approximately 20 percentage points since 2007, while the euro represented 25%, British pound 5%, and Japanese yen just 1%. The Chinese renminbi remained minimal at approximately 1% of foreign currency bonds despite China’s economic prominence.

The analysis highlighted important risk transfer implications. The shift to bond financing effectively transferred currency and duration risk from borrowers to creditors, creating potential for mark-to-market losses that could trigger pro-cyclical selling. Incomplete information about non-bank financial institution and non-financial corporation hedging practices created systemic risk concerns, particularly regarding rollover risks in derivative hedging instruments with shorter maturities than underlying assets. For organizations managing these complex financial risk frameworks, interactive tools can enhance understanding and communication.

Fiscal Sustainability and Market Dynamics

Despite the prevailing risk-on environment, long-term bond markets began signaling growing unease about fiscal sustainability across multiple jurisdictions. The French-German 10-year spread widened during the review period, while the Italian-German spread compressed to levels not seen since 2010, creating an unusual convergence between French and Italian risk premiums by August.

German fiscal expansion plans contributed to expectations of increased government bond supply, while the US “Big Beautiful Bill” fiscal package signed on July 4 added to concerns about debt sustainability. Market-implied inflation expectations shifted upward across the entire US term structure, reflecting worries about the inflationary consequences of expansionary fiscal policy.

The UK gilt market faced unique challenges from Liability-Driven Investment (LDI) reform, which reduced institutional demand for long-duration bonds. Japanese markets grappled with political uncertainty that clouded the fiscal outlook, contributing to steady rises in longer-term interest rates throughout the period.

These developments highlighted the delicate balance between monetary easing and fiscal expansion. While central banks moved toward more accommodative policies, government bond markets increasingly questioned the sustainability of fiscal trajectories, creating potential tensions for policy coordination and financial stability.