The recent move towards monetary tightening led by the Federal Reserve has failed to raise government bond yields, the path of which will now decide the fate of "nearly all" asset classes, according to the Bank for International Settlements.
Only exchange rates have visibly priced in the Fed's tighter stance, with the dollar strengthening as a result of the central bank's decision to reduce its balance sheet very gradually from October, said the BIS in its quarterly review.
But financial conditions "paradoxically eased further" in the U.S. and globally, the BIS said.
"As long-term yields remained extremely low, valuations across asset classes and jurisdictions stayed stretched, though to different degrees. Near-term implied volatility continued to probe new historical lows, while investors and commentators wondered when and how this calm would come to an end.
"Ultimately, the fate of nearly all asset classes appeared to hinge on the evolution of government bond yields."
What tightening?
Global central banks' pivot to a tightening stance appears well underway, with the European Central Bank signalling an end to its quantitative easing program in September 2018, the Bank of England hiking rates in early November and Bank of Japan officials now hinting at a tightening move in December.
But with the exception of a 2% trade-weighted rise in the dollar between early September and end-November, investors had "essentially shrugged off" these moves, said the BIS.
Two-year U.S. Treasury yields have risen by more than 60 basis points since December 2016, but the yield on the 10-year Treasury note has traded sideways, the S&P 500 has surged over 18% and corporate credit spreads have narrowed over the same period.
The BIS is not alone in its concern about this response from investors, with growing numbers of market participants seeing the current situation as unsustainable and others looking for safe havens in anticipation of a serious correction in risk assets.
Complacency? Maybe
A mid-November sell-off in corporate high yield and emerging market sovereign bonds illustrated these sectors' particular vulnerability to sudden swings in market sentiment, said the BIS, but it added that other asset classes are ultimately also at the mercy of longer-term rate expectations.
"At the root of these uncertainties are questions about how the compression of term premia in core sovereign bond markets may affect other asset valuations," it said.
"There is also significant uncertainty about the levels those yields will reach once monetary policies are normalized in the core jurisdictions."
Investors and analysts have been debating whether markets are demonstrating complacency, given that valuations in bonds, equities and credit are all looking expensive just as central banks are withdrawing support.
Corporate credit and equity markets both look "frothy" according to the BIS, given that the cyclically adjusted price/earnings ratio (CAPE) of the U.S. stock market currently exceeds its post-1982 average by almost 25%, and both the U.S. and European investment-grade corporate spreads are below their 20-year averages.
"In the past, very low spreads in U.S. high yield and [emerging market] dollar sovereign bond spreads were a harbinger of stress," it said, adding that expectations of Treasury volatility and low demand to hedge higher interest rate risks showed bond investors remained sanguine.
"That may leave investors ill-positioned to face unexpected increases in bond yields."
