Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

How many red flags does it take to make a problem? 

It's not always easy to tell. This is especially true when it comes to U.S. debt markets, which have been confounding traders with ultralow yields on everything from government debt to risky corporate bonds. But other than coming to grips with the existential question of how low benchmark yields can go before they've gone too far, investors have mostly shrugged off other warning signs. But these warnings are starting to pile up, indicating a growing amount of stress in the financial system.

The most prominent example is the U.S. dollar London Interbank Offered Rate, often thought to be a barometer of financial markets stress, which has surged to the highest levels since 2009. 

Moving Up
Libor, a key floating-rate benchmark, has been rising ahead of new money-market rules
Source: ICE Benchmark Administration

This red flag has been dismissed as merely a side effect of money-market rules that go into effect in October, which are reducing demand for very short-term, floating-rate debt and causing these rates to rise.  

Another example is 30-year U.S. swap spreads, which are agreements to exchange floating for fixed-rate payments for three decades. This rate fell to the lowest ever last week, of negative 56 basis points, after first turning negative in October 2008. Historically, these spreads were positive because Treasuries are backed by the U.S. government and thought to be the most reliable, while floating payments are based on rates that contain credit risk.

Swap Stress
Global grab for duration has pushed 30-year swap spreads to an all-time low
Source: Bloomberg

This, too, has been attributed to new regulatory changes, which make the swaps less risky (because they are centrally cleared) and the Treasuries more expensive to secure (because banks pay more to hold repurchase agreements on their balance sheets.) But it does have other implications, such as a higher likelihood that long-term yields will decline further in coming weeks. 

Yet another example is the increasing amount of debt relative to income among U.S. companies, with leverage ratios rising to the highest levels in more than a decade. This is problematic because it makes corporations more vulnerable in an economic downturn, when revenues are prone to decline.

Rising Leverage
The leverage ratios at U.S. investment-grade companies have been rising
Source: Bank of America Merrill Lynch Global Research
Data include median values for U.S. investment-grade non-financial issuers ex-energy, materials and utilities

And, of course, there's the U.S. yield curve, which has steadily flattened as investors pile into long-term bonds while selling shorter-term notes ahead of a possible Federal Reserve interest-rate hike. The gap between yields on two-year and 30-year U.S. government bonds is now the narrowest since the beginning of 2008. Typically, this signals that bond buyers foresee slower growth, and, if the yield-curve inverts, near-term recession.

Yield Curve
The U.S. yield curve has contracted as investors ratchet back growth expectations
Source: Bloomberg

Once upon a time, these would all add up to a clear warning signal to investors. But in a world awash with central-bank money, it's unclear how they should respond. Do the signs suggest imminent financial collapse? Probably not. Should traders just ignore them? Again, probably not.

The signs of stress in financial markets are real, but they are unique. No two financial crises look the same. The last one stemmed from overleveraged banks suddenly realizing their assets were worth far less than they thought.

Most investors don't seem to be anticipating another crisis yet, but there are some significant imbalances in the financial system that will keep emerging, sometimes at inopportune times. This could come in the form of the Fed being unable to influence the broader economy any longer simply through changes in near-term interest rates. Or there could be pockets of unexpected corporate defaults, such as the one in the energy industry. Or consumers could suddenly face higher borrowing costs on floating-rate loans, even as other benchmark rates remain low. 

The latest signs of stress are real and do have consequences. The fact that they don't appear to repeat history doesn't mean investors should give them any less credence.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net