Excessive leverage poses a huge risk to markets.

During the past few the Bank of England and European Central Bank have joined the US Federal Reserve and Bank Of Japan by issuing relatively hawkish statements on monetary policy, signaling what could be the beginning of the end of the great post-financial crisis central bank experiment.

Even though some might welcome the end to the over-easy monetary policy, reducing stimulus and raising interest rates is not going to be an easy task. During the past decade, consumers and companies have piled on a record amount of debt, taking advantage of low-interest rates and banks have been more than happy to accommodate this demand.

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Excessive Leverage Is Massive Problem

Analysts and policymakers have been increasingly warning about the risks rising leverage pose to the financial system. Federal Reserve Vice Chairman Stanley Fischer warned earlier this week that while excessive leverage among financial institutions is at historically low levels, “the corporate business sector appears to be notably leveraged, with the current aggregate corporate-sector leverage standing near 20-year highs.”

But investors don’t seem phased. The yields on high yield securities remain at record lows, a development that has been attributed to investor overconfidence. Earlier this month Bloomberg cited comments from Societe Generale analyst Andrew Lapthorne who claimed that excess leverage in the system is “disguised in the S&P 500 because these risky stocks are typically small, and the big guys are putting up the market right now.” He went on to say, “but credit markets are not bothered. The overconfidence may be misplaced.”

Analysts at Bank of America seem to agree. In a report issued earlier this week, credit analyst Hans Mikkelsen points out that the bank believes the current largest risk to US markets is US high-grade corporate bond spreads. Even though leverage is a factor, Mikkelsen and team are more concerned about a large increase in global interest rates, led by foreign countries. “In that situation, we could lose the foreign inflows that dominate buying in our market, get a rates shock domestically and large retail investor outflows from bond funds and ETFs,” he writes.

Excessive Leverage Is Now The Biggest Problem Facing Markets

Ultra-easy monetary policy by central banks overseas has published international investors into the US high yield market, and companies have been more than happy to meet this extra demand. However, corporate America’s debt binge could come back to haunt it as central banks overseas turn hawkish.

Mikkelsen’s report points out that since 2007, the size of the US high yield market has tripled in value to $6.3 trillion, an expansion driven by “the Fed’s super-easy monetary policy generating positive bond price performance that attracted retail inflows to bond funds and ETFs” and increasingly in recent years, “yield-sensitive foreign investors.” This means there’s a strong risk of a “partial unwind leading to much higher yields” when foreign central banks tighten monetary policies.

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