LONDON (Reuters) - Financial markets have coped well with Brexit and other potentially disruptive political developments recently but asset prices may be running too high and the potential risks to market stability are growing, a report warned on Sunday.
In its Quarterly Review, the usually guarded Bank for International Settlements didn't explicitly say that stock and bond markets are bubbles waiting to burst. But valuations are high, especially given that the foundations they are built on may not be so solid.
BIS reports aren't known for their stark language and blunt warnings, but they offer an insight into what's occupying the thoughts of the world's most powerful and important central bankers.
"There has been a distinctly mixed feel to the recent rally – more stick than carrot, more push than pull, more frustration than joy. This explains the nagging question of whether market prices fully reflect the risks ahead," said Claudio Borio, Head of the BIS Monetary and Economic Department.
"The apparent dissonance between record low bond yields, and sharply higher stock prices with subdued volatility cast a pall over such valuations. Banks' depressed equity prices and budding signs of tension in bank funding markets added another sobering note," the Switzerland-based BIS added.
Central bank pledges after Brexit to provide liquidity and ensure smooth market functioning if needed, and the perceived shift toward a more accommodative global monetary policy framework soothed market jitters after Brexit, the BIS said.
This helped ensure markets functioned smoothly, especially in fixed income markets, even though the UK referendum outcome took markets by surprise.
The perception of "lower for longer" global monetary policy drove bond yields to record low levels, compressed corporate bond spreads, and pumped up stock markets and emerging market bonds.
"As Brexit receded in the financial markets' rear-view mirror, exuberance resumed in full force," said the Switzerland-based BIS, often seen as the central banks' central bank, in its review headed "Dissonant Markets".
Borio repeated the BIS's view that central banks should scale back their extreme policy accommodation, and that a more "balanced policy mix is needed to bring the global economy into a more robust, balanced and sustainable expansion."
To see the BIS review, click on: www.bis.org/publ/qtrpdf/r_qt1609.htm
Stock prices are buoyant despite weak earnings, while comparisons between bond yields and economic growth rates across the world's major economies suggest government bond markets are extremely overvalued.
Defining overvaluation for bonds is an inexact science, but over the past 65 years 10-year U.S., Japanese, German and UK yields have broadly tracked nominal growth rates in these countries. Bond yields have been well below growth rates in all four for some time, the BIS said.
On top of potential asset bubbles, risks include the increased reliance on electronic trading platforms and proliferation of trading algorithms, the BIS said. Both reduce the human element in trading, help lower trading costs and boost liquidity in normal circumstances, the BIS said.
"(But) the spread of complex and often opaque trading strategies has raised concerns about potential implications for market stability in times of stress," the BIS said.
Pressures in the banking system are building too. Low and even negative interest rates, notably in the euro zone and Japan, have hurt banks' profit margins and depressed the value of their shares.
"Recent strains in money markets added to this overall adverse landscape," the BIS said, noting that U.S. money market regulatory reform has led to heavy outflows of around $250 billion from the sector and pushed up Libor rates and spreads.
This week, the spread between three-month dollar Libor and the federal funds U.S. interest rate widened to its highest since 2009. Widening spreads are often seen as signs of underlying tension in the banking system, although this time around it appears to be more a result of the regulatory reforms.
(Reporting by Jamie McGeever; Editing by Hugh Lawson)