“High-yield bonds have certainly caught our attention,” Janet Yellen, Federal Reserve’s chairwoman, remarked after the US central bank’s June policy meeting. “There is some evidence of ‘reach for yield’ behaviour.” Yet, the Fed’s broader message to investors was clear: we are not concerned and we will keep interest rates low; keep on dancing. I believe this is a policy error. The Fed is underestimating a build-up of risk in credit markets which is threatening financial stability.
The International Monetary Fund warned in its last assessment of the US economy that bond markets were becoming vulnerable to a sell-off. “Longer-term treasury yields and the term premia have been compressed to very low levels,” it noted. The IMF cited increased risk-taking by mutual funds and credit exchange traded funds, which are exposed to daily redemptions but invest in illiquid assets (junk bonds or loans), as well as worsening credit standards and low secondary market liquidity.
The European Central Bank and Bank of England have also raised red flags. The worry is that a combination of complacency and illiquidity could turn a snowball into an avalanche when “low-for-long” interest rates come to an end. With US unemployment falling and the Fed’s asset purchase “tapering” ending in the fourth quarter, this moment is getting closer. Markets are unprepared.
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