Beware the ripples of risk in the US market

Ultra-low interest rates have created a veneer of calm in the US, but latent risk bubbles under the surface. We could see a bloody scramble for the exits once the asset-purchasing program ends.

After this week’s US Federal Reserve Board’s monetary policy statement, chair Janet Yellen professed to be unconcerned that the continuation of the US’ ultra-low interest rate environment could lead to asset bubbles. Then she qualified that view.

While Yellen said she didn’t see the kinds of broad trends that would suggest that the level of financial stability risks had risen above a moderate level, she did point to some areas of concern: the amount of lending for mergers, acquisitions and buy-outs; the pricing of junk bonds; inflated or inflating housing markets; and signs of a "reach for yield".

While the Fed has been steadily reducing the volume of its bond and mortgage purchases, it has pledged to maintain low US rates for a "considerable time" after the asset purchasing program ends. That’s like a green light for risk-taking.

It has been notable that, after the spike in volatility that occurred when the Fed first flagged the winding back of its quantitative easing program last May, volatility in financial markets has been unusually low. That suggests a confidence (or perhaps complacency) among investors.

Issuances of junk bonds in the US have been at record levels (double those experienced ahead of the financial crisis); the spreads between US Treasuries and corporate debt have been compressed to pre-crisis levels; equity markets have risen inexorably as investors reach for returns better than the low yields available from bonds; and cash and 'covenant-light' lending has re-emerged.

That would tend to suggest that investors aren’t particularly concerned about risk, even though it would appear inevitable that the latent risk in the system has been increasing throughout the period of central bank-orchestrated low rates.

Since the start of the crisis, the Fed’s balance sheet has expanded from about $US880 billion to $US4.3 trillion as a result of its asset purchases, designed to lower borrowing costs for corporates and banks.

At some point, once the program has been wound down and there is a slightly stronger tone to the US economy, rates will rise. It is also conceivable that an event elsewhere makes investors abruptly more conscious of risk.

It wouldn’t take much to trigger the kind of mass exodus of risk positions that would send shock waves (and losses) through the system. This would destabilise economies and financial systems, including the US but more particularly Europe, which remains vulnerable.

The relative calm within global financial markets over the past year -- indeed, over the past five years -- is built on the shaky foundations of zero or negative real interest rates that are designed to push up asset prices -- and have.

The longer the current settings remain in place, however, the greater the risk that when the market starts to look to that moment when they start to be unwound, there will be a bloody scramble for all the exits.

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