World Economy

Risks to Market Stability Growing

Government bond markets are extremely overvalued.Government bond markets are extremely overvalued.

Financial markets have coped well with the Brexit vote and other potentially disruptive political developments but asset prices may be running too high and the risks to market stability are growing, a report warned on Sunday.

The Bank for International Settlements–the central bank for central bankers—said in its quarterly review that valuations are high, especially given that the foundations they are built on may not be so solid. It did not explicitly say that stock and bond markets are waiting to burst, Reuters reported.

BIS reports are not known for their stark language and blunt warnings, but they offer an insight into what is 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 towards 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 in its review headed “dissonant markets”.

Borio repeated the BIS 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”.

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 US, 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.