The Bank for International Settlements, the world’s most prestigious financial body, has warned that years of loose monetary policy has fuelled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump than generally understood.

“Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived”, said the bank.

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The recent breakdown in long-dated bonds was interesting and potentially significant, but the action at the short-end of the market has been even more interesting. What we are referring to is the extraordinary divergence since mid March between the yield on a 3-month T-Bill and the yield on a 2-year T-Note, with the 3-month yield falling from 4.85% to 4.55% in parallel with a rise in the 2-year yield from 4.55% to 4.97%. The following chart illustrates the divergence.

(http://www.bloomberg.com/markets/rates/index.html)

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