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Investors take zero-rates for granted and unwisely believe that central banks will protect them, says the capital markets chief of the Bank of International Settlements

The BIS's "Botta" building in Basle Photo: Bank of International Settlements

The global financial markets are dangerously stretched and may unwind with shock force as liquidity dries up, the Bank of International Settlements has warned.

Guy Debelle, head of the BIS’s market committee, said investors have become far too complacent, wrongly believing that central banks can protect them, many staking bets that are bound to “blow up” as the first sign of stress.

In a speech in Sydney, Mr Debelle said: “The sell-off, particularly in fixed income, could be relatively violent when it comes. There are a number of investors buying assets on the presumption of a level of liquidity which is not there. This is not evident when positions are being put on, but will become readily apparent when investors attempt to exit their positions.

“The exits tend to get jammed unexpectedly and rapidly.”

Mr Debelle, who is also chief of financial markets at Australia’s Reserve Bank, said any sell-off could be amplified because nominal interest rates are already zero across most of the industrial world. “That is a point we haven’t started from before. There are undoubtedly positions out there which are dependent on (close to) zero funding costs. When funding costs are no longer close to zero, these positions will blow up,” he said.

The BIS warned earlier this summer that the world economy is in many respects more vulnerable to a financial crisis than it was in 2007. Debt ratios are now far higher, and emerging markets have also been drawn into the fire over the last five years. The world as whole has never been more leveraged.

Debt ratios in the developed economies have risen by 20 percentage points to 275pc of GDP since the Lehman Brothers crash.

The new twist is that emerging markets have also been on a debt spree, partly as a spill-over from quantitative easing in the West. This has caused a flood of dollar liquidity into these countries that they have struggled to control. It has pushed up their debt ratios by 20 percentage points to 175pc, and much of the borrowing has been at an average real rate of 1pc that is unlikely to last.

China was able to act as a stabilizing force during the global downturn of 2009, letting rip with an immense burst of credit. These buffers are now largely exhausted. All of the BRICS (Brazil, Russia, India, China, South Africa) countries have hit structural limits, and face difficulties of one form or another.

Mr Debelle said the markets may at any time start to question whether the global authorities have matters under control, or whether their pledge to hold down rates through forward guidance can be believed. “I find it somewhat surprising that the market is willing to accept the central banks at their word, and not think so much for themselves,” he said

The biggest worry is a precipitous sell-off in the bond markets once the US Federal Reserve and the other major central banks begin to tighten in earnest. Mr Debelle cited the US bond crash in 1994, but warned that it could be even more violent this time with a “fair chance that volatility will feed on itself”.

The picture is further complicated by a fall in the depth and inventory of market makers, the side-effect of new regulations that have raised costs and caused firms to exit this specialist business. “Market liquidity is structurally lower now than it was in the past. The question today is whether there is too little capacity. When volatility returns, it may well rise quite rapidly,” he said.

Mr Debelle may be especially sensitive to the risks, given his ring-side seat in Australia where authorities are grappling with a housing bubble and a commodity shock from China. Yet his warning is global: investors have taken on too much risk, and the illusion of liquidity can vanish almost overnight. “That strikes me as a dangerous combination and unlikely to be resolved smoothly,” he said