The edifice of inflated equity and asset markets is built on the premise that interest rates will remain pinned to the floor. The latest stability report by the U.S. Treasury’s Office of Financial Research warned that a 100 basis point rate rise would slash $1.2 trillion of value from the Barclays U.S. Aggregate Bond Index, with further losses once junk bonds, fixed-rate mortgages, and derivatives are included.

The global fall-out could be violent. Credit in dollars beyond U.S. jurisdiction has risen fivefold in 15 years to over $10 trillion. “This is a very big number. As soon as the world gets into trouble, a lot of people are going to have trouble servicing that dollar debt,” said White. Borrowers would suffer the double shock of a rising dollar, and rising rates.

While banks now have high capital buffers, the risk has migrated: to investment funds concentrated in crowded trades. The share of equities traded in “dark pools” outside the exchanges has mushroomed to 33 per cent.

One worry is what will happen to “risk parity” funds when the inflation cycle turns. RBI Capital warned in its investor letter that these funds could lead to a “liquidity crash.” Deutsche Bank has advised clients to take out June 2018 “put” options on the S&P 500 – a hedge against a market slide – arguing that the rally looks stretched and that risk parity funds will amplify any correction.

These funds manage risk by matching bonds and equities through dynamic weighting. The strategy worked during the “Goldilocks” phase of low inflation and rising stock markets. Both wings of the trade did well. The danger is that both could go wrong at the same.

Whether the inflation cycle is really turning, and how fast, is the elemental question of this bull market. What is clear is that the U.S. has closed the output gap and is hitting capacity constraints.

The great disinflation of the last three decades was essentially a global “supply shock.” The opening-up of China and the fall of the Berlin Wall added 800 million workers to the traded economy, depressing wages and unleashing a tsunami of cheap goods. The “Amazon effect” of digital technology capped price rises. The demographics of the baby boom era played its part by boosting the global savings glut.

But there was another feature that is often neglected. Central banks intervened “asymmetrically” with each cycle, letting booms run but stepping in with stimulus to cushion busts. The BIS says one result was to keep insolvent “zombie” companies alive and block the creative destruction that leads to rising productivity.

“Everything could now go into reverse: the baby boomers are gone; China’s working age population is falling; and zombie companies are going to be forced out of business at last as borrowing costs rise,” said White.

While higher inflation is needed in one sense to right the global ship – since it lifts nominal GDP faster, and whittles down debt – the danger is that the shock of higher rates will hit first.

Central banks are now caught in a “debt trap.” They cannot hold rates near zero as inflation pressures build, but they cannot easily raise rates either because it risks blowing up the system. “It is frankly scary,” said White.

The authorities may not yet have reached the end of the road but this strategy is clearly pregnant with danger. Global finance has become so sensitive to monetary policy that central banks risk triggering a downturn long before they have built up the safety buffer of 400 to 500 basis points in interest rate cuts needed to fight recessions.

“We are running out of ammunition. I am afraid that at some point this is going to be resolved with a lot of debt defaults. And what did we do with the demographic dividend? We wasted it,” he said.

This article was originally published by "The Telegraph" -