As the economy weakens, so does the ability of companies, consumers and countries to pay back what they have borrowed. It is not just the fear of rising interest rates that can prick a bubble. What can bring an end to the bull market is simpler: the fear of losing money

Investors in the US bond market experienced their worst monthly loss since December 2010. Despite the continuing easy money policies of the Federal Reserve (Fed), bond yields have moved up from 1.6% to 2.2% in May.  Is this the beginning of the end? Is there a bond bubble? If so, has it burst?

Central bankers and famous economist would argue that it has not. Western central bankers have issued an estimated $7 trillion worth of quantitative easing, about equal to the GDP (gross domestic product) of China. This has pushed interest rates down to historic lows. Generally when bond yields get this low, or their prices get this high, they represent a losing proposition. The last time the Federal Reserve owned a large chunk of the US government bonds market was in 1945. In that year, yields on American Treasury Bonds were also just 2%. Investors who bought those bonds did not see a gain in purchasing power until 1989. The only exception has been Japan where, thanks to deflation, 2% bonds still have a positive return at least until now.

In theory we don’t have to worry about bond bubbles because the central banks have infinite fire power to force yields down. A few key strokes and there are another trillion dollars or yen to buy up bonds. Paul Krugman, the Nobel Laureate economist and columnist, rests his case against bond bubbles on this idea.

His argument is that there isn’t a bond bubble created by the Fed because the Fed won’t let there be a bond bubble. The bubble won’t burst because the Fed won’t let interest rates rise during periods of high unemployment and low inflation. We should not worry about historically low interest rates because the economy is in such terrible shape. With a bad economy “the usual rules about what constitutes a reasonable level of interest rates don’t apply.”

But isn’t that the point? If the rules don’t apply, how can we assume that the Fed can prevent a bubble? The argument is circular. We assume that the Fed can prevent any problem that crops up. But the problem is that the Fed does not operate in a closed system. History is the only place to begin a forecast, but it is imperfect because the environment keeps changing. An integrated global economic system introduces issues far beyond the US economy, the limit of the Federal Reserve’s mandate.

There is another issue. The Fed has suppressed interest rates. Let us assume that the Federal Reserve will continue to do so even though rates have already risen in both the US and Japan. The assumption is that if the Fed can prevent interest rates from rising, there won’t be an issue. But there is another aspect to bonds than just interest rates. A more important aspect: solvency. Interest rates could easily rise regardless of central banks, if investors are worried about getting their money back. As a result of the Fed’s distortion of the market and risk, the question of solvency is more important than ever. So even if the US government bond market is not a bubble does not mean they don’t exist.

The first candidate would be Asia. The global hunt for yield has made raising money in Asia easier than ever. Companies which never could have issued bonds are now issuing them at a rapid rate. Since the beginning of last year the number of Asian companies issuing local currency debt for the first time has risen to 20% of the market. In the US and Europe the proportion is usually 3%. The Asian debt market has doubled in size to $6.5 trillion since the end of 2008. It is not just companies. Consumer debt has grown even more rapidly than corporate debt. In Malaysia it has grown to 76.6% of GDP from 65.9% in 2007. In the US consumer debt has fallen from 100% in 2007 to 85% now.

It is argued that Asian debt growth is simply following the economic and demographic growth. But economics and demographics do not determine risk. Risk is a function of the probability of getting repaid. Getting your money back is determined by institutional efficiency. Economic growth diminishes the probability of reform, so institutional efficiency has not kept up.

It is not just Asian corporations and consumers. The hunt for yield has spread money to new sovereign borrowers. The sovereign debts of peripheral European countries have been shown to be questionable, but at least these countries do have revenues. Rwanda just issued its first bonds, $400 million, to finance a new conference centre. Rwanda gets a large part of its revenue from gifts of aid. Rwanda is not alone. Honduras and Mongolia have recently issued debt. These countries barely have institutions.

The bubble in bonds is also in the level of risk accepted for Western debtors. The returns on “high yield” or junk bonds have reached a historic low of 5.39%. The alphabet soup of financial products has reappeared. We have a return of structured finance. There is a great demand for the demand for collateralized loan obligations (CLOs), and an even greater demand for commercial mortgage-backed securities, (CMBS). These debt are being issued with ever fewer creditor protections. The number “cov-lite” loans has increased to more than 50% of all leveraged loan issuance so far this year, double the level during the credit boom in 2007.

Apparently the global economy has not gotten the memo. Despite the central bank cash, it has refused to be stimulated. The International Monetary Fund trimmed its global growth forecast last month and recently did the same for its forecast of the Chinese economy. As the economy weakens, so does the ability of companies, consumers and countries to pay back what they have borrowed. It is not just the fear of rising interest rates that can prick a bubble. What can bring an end to the bull market is simpler: the fear of losing money. 

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)