Satyajit Das: This is not a credit bubble, we are told. But it certainly looks like one

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Andrew Feinberg

White House Correspondent

Central banks insist that there is no credit bubble. But to resurrect the global economy from the Great Recession, central banks implemented a policy of ultra-low interest rates and quantitative easing (QE) to restore growth. The policy relies, in part, on the asset inflation and portfolio rebalancing channel. In effect, low rates and abundant liquidity drive up asset values and also encourage switching to riskier investments.

The justification was that the policy would encourage additional consumption, increasing economic activity. But only about 1 to 2 per cent of the increased wealth of American households – up more than $25 trillion (£15 trillion) since early 2009, mostly from increased house and equity prices – has flowed through into added consumption. In the eurozone and the UK, the effect of higher asset prices on consumption has also been low. Instead, this monetary methamphetamine has driven a desperate dash for trash, which now threatens financial stability.

Equity markets have risen strongly. Desperate for capital appreciation, investors are chasing “blue sky” technology and biotech stocks which promise earnings and/or revenue growth that is faster than the industry average or the overall market. Established technology companies are using their highly priced stock as currency to acquire smaller start-ups, further inflating values.

Many companies have borrowed at low current rates to finance buybacks of their own shares. In the US, 2013 buyback authorisations totalled $755bn, the second-highest on record, further supporting share prices.

Property prices have risen, supported by low financing costs and the absence of yields from other assets.

Sovereign bond interest rates are at historical lows, fuelled by central bank buying and an artificially created shortage of safe assets. The most striking change has been the fall in rates for government bonds in the beleaguered eurozone countries such as Greece, Ireland, Portugal and Spain, which, in some cases, have returned to pre-crisis levels.

In April 2014, Greece issued €3bn (£2.4bn) of five year bonds at a yield of 4.95 per cent, below market expectations. There was more than €20bn in investor demand. It was a return to rival Lazarus’s rise from the dead.

The successful issue belied the fact that Greece had defaulted on its debt only two years earlier. Greece’s debt levels remain unsustainably high, even before adjusting for unpaid government bills or the potential recapitalisation needs of the banking sector. A further debt restructuring cannot be ruled out.

Investors are still betting that Greece is too big to fail and that Germany and France will continue to support both the Greek economy and the euro.

Demand for risky debt has increased above 2007 levels, driving the additional return available to historical lows. Transactions with low underwriting standards and weaker credit conditions have recovered to 2007 levels. Even volumes of the notorious collateralised debt obligations (CDOs) have almost recovered to 2007 levels, with sub-prime car loans taking the place of sub-prime mortgages.

With 40 to 50 per cent of government bonds returning less than 1 per cent, bonds investors desperate for yield have moved beyond emerging markets to frontier markets, embracing less-known African and Asian borrowers. The reasoning is that these countries have better growth rates and prospects than the Brics and other emerging markets that face significant challenges.

Issuers have included Nigeria, Zambia, Rwanda, Tanzania, Kenya, Mozambique, Sri Lanka and Bangladesh. A key driver has been the phenomenon of the “index tourist” whereby inclusion in major bond indices forces index trackers to buy the relevant securities.

Investor enthusiasm is inconsistent, with concerns raised about issuers’ reliance on foreign aid; volatile commodity export revenues; political instability; and “governance issues” – a euphemism covering a lack of institutional infrastructure, grandiose projects, corruption and the misuse of funds.

The market’s animal spirits are supported by a belief that authorities have no option but to maintain abundant liquidity conditions in the face of low growth and the risk of disinflation or deflation. In effect, there is a deep-rooted belief that central bankers cannot and will not risk a sharp fall in asset prices in the current fragile conditions. There is also a belief that defaults on borrowings are unlikely as the available liquidity will not be withdrawn, allowing even weak borrowers to refinance or increase their borrowings as required.

In the worst case, investors have faith in their ability to anticipate changes in the environment and exit positions. Buyers of flirty technology stocks, Greek debt and highly speculative bonds assume that they will be able to flip them at will.

But there are fewer dealers and market-makers in financial securities today, and higher capital and liquidity requirements, and regulations such as the Volcker rule, mean dealers can hold far less inventory of un- sold securities.

Inventory levels are down 50 to 100 per cent depending on the asset class. The ability of investors to exit positions without creating sharp price falls and volatility is now heavily constrained, increasing risk.

The end will inevitably be sudden and unexpected. Describing the collapse of the South Sea Bubble in 1720, Alexander Pope wrote: “Most people thought it wou’d come but no man prepar’d for it; no man consider’d it would come like a thief in the night, exactly as it happens in the case of death.”

Satyajit Das is a former banker and the author of ‘Extreme Money’ and ‘Traders, Guns & Money’