Swiss-based BIS warns of another 2008-style credit bubble about to burst

Posted on 10 December 2012 with 4 comments from readers

The Bank of International Settlements was one of the few global financial institutions to correctly warn of the 2008 credit bubble that brought us the Great Recession. Now the Switzerland-based BIS is warning that another bubble has formed in the bond market, the largest liquidity pool on the planet.

With the interest paid on bonds at the lowest levels for 30 years this is self evident. Bonds are valued most when their yields are lowest. When yields rise bond prices fall. Are we about to reach such a tipping point?

Tipping point

Blame the global central banks and their low interest rate regimes. ‘Some asset prices appeared highly valued in a historical context relative to indicators of their riskiness,’ concludes the latest BIS report.

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‘Unusually, equity and fixed income gains coincided with a weakening of the global economic outlook. In the past, falling growth forecasts have usually been associated with rising expected default rates and higher bond yields.’

Lest we forget Japan has just confirmed it is in recession as has Italy. Nobody expects any growth in the huge European Union next year. The US is hovering on the edge of a ‘fiscal cliff’ and China is supposed to carry on expanding in this deteriorating trade environment for the workshop of the world.

The bond bubble is perverse indeed, contrary to the laws of economics. Increased risk ought to be met with higher, not lower borrowing costs. Savers therefore feel forced to pursue higher yields by buying lower quality debt such as the bonds of near bankrupt nations as if the risk of such bankruptcy had gone away.

Yet the central banks continue to print money by buying bonds to keep interest rates low. It is bizarre again that the banks of the world are deleveraging and cutting back on loans at a time when the bond markets continue to offer capital for almost nothing. A credit bubble is what a bond market bubble is called.

Bond bubble

The over-lending of the banks has been replaced by a bubble in bond credit. It is having the same impact, driving up asset prices against a falling economic background, that is directly causing inflation of asset prices.

When the bond bubble bursts it will therefore have a very similar impact to the 2008-9 bust, with the bond holders most badly burnt. Their creditors may actually feel better off without these liabilities that have depressed certain asset prices in the debtor nations.

One thing is for sure this would be a major trauma in global financial markets again and imply huge losses for bond holders. Shifting out of bond and into hard assets like precious metals and undervalued real estate is the only logical course for investors as we explained in the last issue of the ArabianMoney investment newsletter.