The economic data out of Europe, the US and Japan have been very good in the last few months. And I believe this will continue. But equity valuations have become stretched and bond market spreads are razor thin. With the US treasury yield curve flattening to almost 60 basis points between 2 and 10-year maturities and the Fed proposing 4 rate hikes in the next 13 months, we need to ask where the vulnerabilities in the market are, because this spate of good news could end. I believe we should look at high yield, leveraged loans and commercial real estate because this is not just where balance sheet risk lies, but also where there are problems with ‘fake’ liquidity as well.

Now, it should go without saying: complexity and leverage are the handmaidens of financial distress. Financial crises are all about forced selling by leveraged investors creating such a violent repricing of a specific asset class or market that investors end up selling what they can in unrelated markets, rather than the repriced assets they want to sell. It’s all about complex financial relationships that are difficult to untangle creating contagion as motivated sellers liquidate positions in any and all assets. These things move so fast that regulators simply don’t have the time to ring fence the risks.

The last financial crisis was no different. In the real economy, we saw a violent repricing of residential property – an inherently leveraged market due to mortgage lending. And this led to a similar repricing of mortgage-backed securities that metastasized – through fear generated by complex financial instruments and opaque financial relationships – into a general global asset repricing, financial sector distress and eventually crisis.

While the present cycle doesn’t have to end in crisis, market excess has become acute enough to ask where the fingers of instability lie. One place to look is in markets where ‘fake’ liquidity is being generated by exchange-traded funds of inherently illiquid markets like high yield bonds and leveraged loans. These markets are ones dominated by institutional investors like pension funds and insurance companies who often buy and hold to maturity, such that underlying assets do not trade as readily or frequently as they do in equity markets.

The problem is that these markets now have ETFs to give retail investors exposure. And these ETFs have what I am calling ‘fake’ liquidity, because the market in the ETFs is more liquid than the markets in the underlying assets. This liquidity mismatch is not a problem when prices are rising and spreads are narrowing as they are now. However, when prices fall and leveraged investors are forced to sell, you have a big problem because there will be no one on the other side of that trade until and unless prices gap down enough to entice someone onto the buy side. It is like catching a falling knife; no one wants to do it.

And of course, these markets are already stretched. Today’s Wall Street Journal explains – and notice the prominence of the ETFs in their description of what’s happening:

The market for packaging risky loans is running hot-as-hell. It may not be a bubble yet, but troubling characteristics make it an area to watch.

Money has flooded of late into so-called leveraged loans, which have the credit quality of junk bonds and are arranged by banks often to help private-equity firms leverage up companies they buy. The banks then sell the loans on to investors.

U.S. retail investors in particular have piled into loan-focused mutual funds and ETFs. There have been outflows in recent weeks, but these funds still hold $97 billion of investors’ money compared with less than $18 billion a decade ago, according to Lipper.

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Now, again, this doesn’t have to end badly. The market outflows in 2014-2016 were due to the shale oil bubble’s popping. And while that episode put the US economy at stall speed, it did not lead to recession. But today, we are talking about froth in both the US and Europe since the market for European leveraged loans is performing even better than the one in the US. Here’s the Wall Street Journal again:

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Funds struggling to put investors’ money to work have been accepting cheaper and looser terms. Borrowers now have the whip hand. This has allowed them to slash interest rates on their debt by refinancing quickly. They have also managed to kill the traditional covenants, which protect lenders from businesses developing problems in repaying their debt.

Fewer covenants mean fewer defaults as borrowers have no conditions to breach. But this could also mean that when defaults do come, borrowers will be in a much worse state and lenders get less back.

These loans and the CLOs that invest in them are typically less easily tradable than securities such as corporate bonds. It is this illiquidity that gives them the extra sliver of yield that investors desire. As such, loans and CLOs fit into the broader pattern of investors’ drift into illiquid and private assets in the hunt for better returns.

As these markets climb, illiquidity has become a feature, not a bug. And that’s because investors, starved for yield are taking on risk in order to seek return. Right now, I am not truly worried even though these markets have experienced some down weeks. The economy is still in good shape and defaults in this asset class are still low. Now is not when we should expect a major correction in high yield or leveraged loans. But when the market turns down in earnest – as it inevitably will when defaults start to pile up – illiquidity will work against motivated sellers and cause prices to drop more violently.

When both the Fed and the ECB are tightening at the same time, that’s when I would be looking for an economic impact. That’s when investors dependent on Ponzi financing and rolling over loans to make payments will get caught out. And because we will be seeing distress on both sides of the Atlantic and not just in shale oil in North America as we saw in 2014 and 2015, we should expect the stop of financing to have a larger interaction with the real economy. 

The first market to look for regarding contagion beyond high yield, leveraged loans and their ETFs would be commercial real estate because of its dependence on leverage and the froth we are seeing in that market as well.