Equity markets have been hitting new peaks. Credit markets are overheating.
Old hands in the property world are beginning to worry about an imminent shift from boom to bust. Is another financial crisis just around the corner?
Certainly there are disconcerting signals, especially in debt markets. In a low interest rate world the search for yield has caused investors to make a silk purse of many a sow’s ear. This is particularly true of Eurozone sovereign debt. At the start of this week 10-year benchmark government debt in Italy, Spain and Portugal yielded 2.96%, 2.86% and 3.6% respectively. That compares with 2.55% for comparable UK gilts and 2.45% for equivalent US Treasuries.
Have these heavily indebted Eurozone countries recovered so fully from their problems that investors are being adequately compensated for risk? Surely not. The differential against the US and UK is ludicrously narrow.
At the same time credit spreads in the corporate bond market have narrowed, making little allowance for poor liquidity in the secondary market. When hard times come and investors look for the exit, they will find no takers.
Lending standards are also declining in a way that smacks of the euphoria that prevailed before the credit crunch struck in 2007. Structured products such as collateralised loan obligations are back, as are such rickety instruments as payment-in-kind notes (PIKs).
Contingent convertibles, a novel instrument much used in the banking sector, have never been tested in a crisis. Current heady prices being paid for Cocos, as they are known, are almost certainly mispricing risk.
Most sinister of all, volatility across the capital markets has collapsed. This brings to mind what economists dubbed The Great Moderation before the financial crisis. Markets had become so stable before 2007 that central bankers were patting themselves on the back, taking credit for what they assumed would be a lasting era of unruffled financial calm.
This syndrome was accurately diagnosed in the post-war period by American economist Hyman Minsky who saw capitalism as endemically unstable. He argued that because stability breeds complacency there was an overwhelming temptation to take on more debt. Increased leverage and excessive risk-taking then invariably led to financial crises and fiscal bailouts. Minsky’s work went out of fashion after his death in 1996, so the prophylactic force of his argument was lost on the current generation of policymakers.
What is happening today appears to be following the Minsky paradigm. Because yields in credit markets are so low, investors are taking on leverage in order to boost returns through carry trades — borrowing via the lowest yielding currencies or financial instruments to invest in riskier paper with higher yields. Investors such as mutual funds, hedge funds and real estate trusts are, for example, borrowing overnight in the $4 trillion repo market, where they pledge securities as collateral against very short-term loans.
To those few observers who were around in the mid-1970s this looks dangerously familiar, becausesuch funding dries up instantly in a crisis. Back then the first property companies to go bust were the ones that had borrowed in the money markets to fund long-term development. Such carry trading thrives in low volatility markets, but it always involves a maturity mismatch. That spells disaster when volatility returns.
No longer Wild West
Before we jump to the conclusion that disaster is nigh, though, it is important to recognise that one feature of the pre-2007 scenario is missing. The property market is not going as wild as it was back then. In the US residential market, from which the worst tremors emanated, prices have recovered somewhat but are not overheating. In the UK they are too high in relation to earnings by historic standards. But they are kept high by sclerotic supply and the Help to Buy scheme.
Much the same can be said of commercial property in both countries. It is true that these markets are buoyant, but they are not leveraged as they were before the financial crisis, because bank lending to the sector has been severely curtailed. Nor has the search for yield had as dramatic an effect in property as it has had in the corporate bond market.
That said, excessive credit expansion may have decamped to the shadow banking sector. Note, too, that financial crises are not always sparked by risky behaviour in the property market.
A more pressing danger today may be the overhang of debt in both the public and private sectors of the developed world.
One of the problems with the policy response to the financial crisis is that it has left us with an even bigger debt overhang than at the start of the crisis. The implication is that we are hostage to an interest rate hike when central banks finally abandon their bond buying programmes. The timing of financial crises is inherently unpredictable, but the behaviour of central banks provides important clues.
John Plender is director at the Official Monetary and Financial Institutions Forum