By John O'Donnell
FRANKFURT (Reuters) - The European Central Bank said on Wednesday that investors' pursuit of higher profits could be generating new price bubbles, sounding the alarm as financial markets chase quick gains.
In a strongly-worded message that underscored concerns in Frankfurt about the downside to runaway market enthusiasm, the ECB cautioned that the dash for higher returns could suddenly unravel, sending the investor herd charging in the opposite direction.
"As the search for yields intensifies, so do concerns regarding the build-up of imbalances and the possibility of a sharp and disorderly unwinding of recent investment flows," the central bank said in a closely-watched biannual report.
With the financial crisis and any fear of a break-up of the euro all but forgotten, governments in debt-strapped countries from Italy to Ireland are finding it ever easier and cheaper to borrow.
European stock markets have seen stellar gains with those in Germany hitting record highs. Even Greece, which defaulted on a large swathe of its national debt just over two years ago, has started borrowing from investors again.
But the ECB flagged concerns that governments' debts, at a record high throughout the 18-country euro zone, could become unmanageable as economic reforms stall and growth stays low.
Investor demand for this debt could prove "fickle", it said, cautioning on fallout from any slowdown in China or the crisis in Ukraine.
Drawing comparisons between countries' low cost of borrowing with "levels last seen before the eruption of the ... second wave of the global financial crisis in 2010", the ECB says: "The challenge ahead is ... to ensure that the crisis conditions do not re-emerge."
SUDDEN UNWINDING
Many central bankers have been privately concerned about an abrupt change of mood among investors, but the bank's Financial Stability Review delivered a more public warning.
It also flagged a boom in prices for prime commercial property, where deals have reached their highest level since 2008 in large part thanks to foreign buyers.
Banks, insurers and pension funds, it says, must prepare "sufficient buffers ... to withstand a normalisation of yields."
The problems described in the report represent a conundrum for the ECB, which together with counterparts in the United States and Japan has made the cost of borrowing ever cheaper, helping fuel the leap in confidence.
Its warning may encourage investors to take a more cautious stance. But it is unclear whether the possible perils would divert the ECB from taking further steps to keep confidence buoyed as the economic recovery too remains delicate.
(Reporting By John O'Donnell; Editing by John Stonestreet)