In his Monthly Investment Outlook, famed bond investor Bill Gross calls our attention to the systemic risk in our leveraged financial system. He begins by explaining the concept of credit expansion and noting how leveraged we are:
[I}n 2017, the global economy has created more credit relative to GDP than that at the beginning of 2008’s disaster. In the U.S., credit of $65 trillion is roughly 350% of annual GDP and the ratio is rising. In China, the ratio has more than doubled in the past decade to nearly 300%. Since 2007, China has added $24 trillion worth of debt to its collective balance sheet. Over the same period, the U.S. and Europe only added $12 trillion each. Capitalism, with its adopted fractional reserve banking system, depends on credit expansion and the printing of additional reserves by central banks, which in turn are re-lent by private banks to create pizza stores, cell phones and a myriad of other products and business enterprises.
And he continues:
[O]ur highly levered financial system is like a truckload of nitro glycerin on a bumpy road. One mistake can set off a credit implosion where holders of stocks, high yield bonds, and yes, subprime mortgages all rush to the bank to claim its one and only dollar in the vault. It happened in 2008, and central banks were in a position to drastically lower yields and buy trillions of dollars via QE to prevent a run on the system. Today, central bank flexibility is not what it was back then. Yields globally are near zero and in many cases, negative.
And here’s what he means:
Prior to the financial crisis, the Fed Funds Rate stood at around 5% and the Federal Reserve was able to stabilize the banking system by lowering rates and flooding it with liquidity. If we were to have another run on banks today, with rates standing at less than 1%, there isn’t much more room for easing during a crisis.