Where is the risk in global financial markets?

At the root of concerns that global credit markets have become overextended is the observation that long-term interest rates have been unusually low for a lengthy period of time, a development which may have led to a mispricing of risky assets and an excessive inflow of funds into those assets. Certainly the rise in US long-term rates that has occurred in the current tightening cycle has been low by recent historical standards. A simple model of 10-year rates based on the ISM, core CPI and Fed Funds rate and estimated over 1985-2006 suggests 10-year yields are some 50-60bp below 'fair value', with the discrepancy having grown since 2004Q3.

A more optimistic view is that the last few years have seen a paradigm shift in the pricing of longer rates, permanently reducing the term spread over short yields. If we re-estimate our model over the 1958-1968 period instead and then apply the parameters to recent data, the 'fit' improves substantially. This lends some support to the optimistic view - but only if we accept the premise that global financial and economic conditions have returned to a similar state to that seen in the 1950s and 1960s. The real position is likely to fall somewhere between these two views, so that there is room for long-term rates to correct higher, although probably not drastically so unless the inflation picture worsens notably.

A modest rise in global long-term rates would put some downward pressure on economic growth, but seems unlikely by itself to tip the world into a significant slowdown. The bigger risk for us is that such a rise in rates might trigger large corrections in a number of asset markets which look to be overvalued - it is notable in this regard that credit spreads have been unusually stable during the latest Fed tightening cycle. Weakening asset markets could inflict substantial losses on financial institutions and investors, resulting in 'fire sales' of assets. Such financial contagion could in turn lead to a knee-jerk tightening of credit conditions across the board and negative wealth effects. The magnitude of this risk will be examined in the sections below.

...risking a reversal in the LBO market...

One area of major recent expansion has been the leveraged buy-out (LBO) market. In 2006, loans to finance LBOs totalled over US$500 billion - more than double the total in 2004 - and the pace of borrowing remained high in the first half of 2007 at over US$220 billion. As a proportion of G7 GDP, LBO financing is now at a higher level than its previous peak in the late 1980s - a peak which was followed by a rapid decline and an extended period of weak activity in this area.

LBO activity appears to be related to the global liquidity cycle, suggesting that a contraction in liquidity growth associated with monetary tightening by the major central banks should result in a notable drop in activity in the quarters to come. Another concern is that LBO deals have become increasingly highly leveraged of late. S&P estimate that average debt/EBITDA ratios are edging toward 6 versus 4.9 in 2004 - and with some deals working off ratios as high as 10.