December 11, 2016 / 11:27 AM / in 7 months

Market 'paradigm shift' may be under way, but more volatility likely - BIS

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Specialist Meric Greenbaum works at his post on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., December 9, 2016.Brendan McDermid

LONDON (Reuters) - Financial markets have been remarkably resilient to rising bond yields and sudden shift in outlook following last month's shock U.S. election result, but the sheer scale of uncertainties ahead means the adjustment will be "bumpy", the BIS said on Sunday.

While the resilience to recent market swings following the U.S. election and Brexit vote have been welcome, investors should be braced for further bouts of extreme volatility and "flash crash" episodes like the one that hit sterling in October, the Bank for International Settlements said.

"We do not quite fully understand the cause of such unusual price moves ... but as long as such moves remain self-contained and do not threaten market functioning or the soundness of financial institutions, they are not a source of much concern: we may need to get used to them," said Claudio Borio, Head of the Monetary and Economic Department at the BIS.

"It is as if market participants, for once, had taken the lead in anticipating and charting the future, breaking free from their dependence on central banks' every word and deed," Borio said.

This suggests investors may finally be learning to stand on their own two feet after years of relying on central bank stimulus, signalling a potential "paradigm shift" for markets, he said.

"But the jury is still out, and caution is in order. And make no mistake: bond yields are still unusually low from a long-term perspective," Borio said.

The BIS, often referred to as the "central banks' central bank", acts as a forum for the world's major monetary authorities. Its commentaries on global markets and economics give an insight into policymakers' thinking.

Bond yields have risen sharply since the middle of the year. The benchmark 10-year U.S. Treasury yield has jumped 100 basis points since July's multi-decade low, with a growing number of investors saying the 35-year bull run in bonds is now over.

That rise has come against the political shocks of Britain's vote in late June to leave the European Union and Donald Trump's election victory last month.

The surge of 20 basis points in U.S. bond yields the day after the election was the largest since the "taper tantrum" market sell-off in 2013, and greater than all but 1 percent of one-day moves in the last quarter century, the BIS said.

Yet U.S. stocks are chalking up record highs, market volatility is anchored at historic lows and corporate spreads have remained relatively tight. Liquidity has been "adequate", according to the BIS.

This all points to investors anticipating stronger growth resulting from easier U.S. fiscal policy, lower taxes and looser regulation, particularly in the financial sector, the BIS said.

Banks will generally benefit from higher rates and a steeper yield curve, and the recent surge in U.S. bank stocks is "a telling sign of a brighter perceived outlook," the BIS said.

But higher yields and a stronger dollar also pose risks, especially to emerging markets, even though some EM equity and credit markets held up better than they did at the time of the taper tantrum in 2013.

The starting point for emerging markets wasn't so severe as investors had already withdrawn "massive" amounts from EM funds between 2013 and 2015, while loans in recent years had generally been taken out over long maturities and at fixed rates.

Still, nearly 10 percent of dollar-denominated corporate debt in EM comes due next year, meaning firms must either pay back $120 billion or refinance it at a higher and rising cost, according to the BIS.

Dollar funding costs and money market spreads rose sharply in the latest quarter as investors adjusted to new U.S. money market rules that took effect in October. Short-term dollar funding from money market funds shrank by some 70 percent.

But unlike 2008 when widening spreads tightened financial conditions and torpedoed banks' creditworthiness, this was a regulation-driven move that had "limited" spillover effects on broader financial markets. Borrowers simply raised cash elsewhere, the BIS said.

Meanwhile, the BIS also said that new data show that banks in China are the 10th largest lenders in the international banking market and banks in Russia the 23rd largest.

Reporting by Jamie McGeever; Editing by Toby Chopra

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