Easy money policy from leading central banks boost markets, but investors ignore warning signs

Investors have ignored poor economic news as stocks have risen, leaving markets now vulnerable to unsettling volatility and potential losses, an organization of the world's central banks said Sunday.

The Bank for International Settlements said central banks' policies of record low interest rates and monetary stimulus had helped investors "tune out" bad news — every time an economic indicator disappointed, traders simply took that as confirmation that central banks would continue to provide stimulus.

That has left markets exposed to losses, particularly for bond holders, when interest rates begin to return to more normal levels, the BIS said in its quarterly report.

"Further monetary easing helped market participants to tune out signs of a global growth slowdown," the report said. "But the rapid gains left equity valuations vulnerable to changes in sentiment, as witnessed in the recent bout of volatility."

The BIS, based in Basel, Switzerland, represents the world's central banks.

In its report, it said markets were "under the spell of monetary easing" to the point where negative news such as downbeat U.S. jobs data in March did not always stop stocks from going up. The U.S. Standard & Poor's 500 reached an all-time high of 1,687.18 on May 22 and remains up more than 15 percent on the year.

The BIS said the volatility of the situation was underlined by a 7 percent drop in Japanese stocks on May 23, triggered by data suggesting China's economy might slow and speculation the U.S. Federal Reserve might be getting ready to slow its aggressive stimulus policies.

The BIS said investors had several times shrugged off uncertainty because they expect any bad news to be followed by more central bank stimulus, such as continued low interest rates or bond purchases that increase the supply of money in the economy. It said the dominant driver for financial markets in recent weeks was the shift in Japan's monetary policy announced April 4, when the Bank of Japan said it would vastly increase the supply of money in the economy through regular purchases of financial assets over the next two years in an attempt to increase the rate of inflation to 2 percent.

That monetary stimulus is aimed at getting Japan out of years of economic stagnation marked by corrosive deflation, a sustained fall in prices that discourages consumption and investment.

Investors and financial institutions should be ready for an eventual normalization of interest rates, said Stephen Cecchetti, head of the BIS monetary and economic department.

That will cause losses for bond holders, since bond prices move in the opposite direction from interest rates.

"The losses, when they do occur, will be spread across banks, households and industrial firms," Cecchetti told journalists on a conference call.

Central banks typically cut rates to stimulate the economy during slowdowns and raise them during recoveries to prevent excessive inflation.

Cecchetti stressed it was important that banks make sure their finances are strong enough before central banks end their stimulus programs and start raising interest rates. "Robust balance sheets with high capital buffers are the best ways to guard against the possible disruptions that this can bring," he said.