Surging global equity prices, junk bond yields at record lows, the return of “covenant-lite” deals — for many observers we’re seeing a replay of the heady first months of 2007, before the first rumbles of the financial crisis began to sound through global financial markets.

The similarities are not accidental. The US central bank has kept interest rates close to zero, and started its $US600 billion bond buying program as part of a deliberate strategy to push asset prices higher. The aim is to confront investors with a choice: they can either earn close to zero on their savings accounts, or, if they want higher yields, they’ll have to invest in riskier assets, such as shares and junk bonds.

In an important article published in the Washington Post last November, Ben Bernanke left little doubt that he wanted to boost the price of shares and other financial assets in an attempt to revive the anemic US economy. “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending,” he explained.

And his policies are meeting with considerable success. US share markets are trading at their highest levels in 2½ years, while yields on junk bond have tumbled to an all-time low of 6.837 per cent — eclipsing their previous record set back in December 2004, as investors have poured money into funds that invest in high-yielding assets

But the US Federal Reserve isn’t the only central bank pursuing an ultra-loose monetary policy. Interest rates are extremely low in most of the large developed countries. At the same time, central banks in most of the emerging economies have been reluctant to raise rates, despite clear evidence that inflationary pressures are building. As a result, after allowing for inflation, global interest rates are close to zero.

The trouble is that most of the developed economies are still saddled with the massive debt overhang that was responsible for triggering the financial crisis. And while keeping interest rates close to zero might mask the problem, it certainly doesn’t solve it. In fact, keeping rates so low can actually encourage the build-up of even more debt.

And it also leaves global markets hugely vulnerable if longer-term interest rates start rising.

Some argue that this could happen quite quickly, particularly if bond markets begin to worry that inflationary pressures are increasing due to the recent surge in commodity prices — particularly the oil price.

The price for Brent crude remained above $US100 a barrel overnight, as tensions between Israel and Iran caused markets to fret about conflict in the oil-rich Middle East. Markets were unsettled by reports that two Iranian naval vessels have submitted a request to transit the Suez Canal, a plan that Israel described as a “provocation”.

A rise in interest rates in this point would reignite fears over the excess leverage in most developed countries, and quickly cause investors to lose their appetite for risk. The parallel between 2011 and 2007 could then become extremely uncomfortable.

*This article first appeared at Business Spectator.

Peter Fray

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