A Credit Crunch in a Highly Leveraged Economy

The collapse of the subprime mortgage market has caused fixed income investors to demand higher risk premiums from not only all grades of residential mortgage-backed securities, but also commercial mortgage-backed securities, corporate bonds and debt from emerging markets.

Treasury yields, on the other hand, have been declining due to a flight to “quality” creating wider interest rate spreads. However, as the following graph shows, spreads are still low by historical standards:

High Yield SpreadsSource: Bear Stearns

But I am still worried because a record amount of non-government debt is required to create each unit of GDP.

US Debt to GDPSource: Federal Reserve

Therefore, rising interest rates can induce a monetary contraction that can have a bigger impact on the economy than in the past. This is why the current credit crunch should be closely watched.

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