WHILE the world of geopolitics looks as risky as ever, the markets seem to go on their sweet way, recording new highs for equity indices. In large part, of course, this is down to signs of an improving global economy and a sense that politics doesn’t really matter, despite the tweets of President Donald Trump (defending Vladimir Putin and attacking Theresa May is a first for American diplomacy).

Where might trouble first emerge? The most likely venue is the corporate bond market. This has changed a lot over the past ten years. As late as 2008, more than 80% of non-financial corporate bond issuance was rated A or above, according to Torsten Slok of Deutsche Bank; in the past five years, the proportion has been consistently under 60%. That means the average corporate bond is riskier than before. At the same time, the reforms that followed the crash of 2008 mean that banks have to hold more capital (quite rightly). But this also means they are less willing to devote capital to market-making; as a result, the bond market is less liquid than before. So investors in corporate bonds are holding a riskier, less liquid asset.

So you might expect that investors would demand a higher yield in compensation. But of course, the past ten years have been marked by record lows in government bond yields and corporate bond yields have been dragged down with them. The spread (or excess interest rate) on high-yield debt is not as constrained as it was in 2007; but the only time that spreads have been lower this millennium was from mid-2004 to mid-2007, a period generally seen as a credit bubble. If investors change their mind about the attractions of credit, they will struggle to exit, given the poor liquidity, which means yields could spike.

But the markets clearly don’t see an imminent problem, as long as the economy is doing well. Low bond yields also help companies by making it easier to service their debts. S&P, a rating agency, says that in advanced economies, the negative bias (the proportion of bond issuers with negative rating outlooks) is at a multi-year low. Its report said that

The outlook for global credit conditions is favourable as credit conditions remain satisfactory

But markets can surprise. The recent trend in government bond markets has been a flattening of the yield curve in America, with short-term yields rise relative to long-term ones. In the past, this has been a sign of a slowing economy, but it is not a completely reliable indicator. Geopolitics could intervene; a surgical strike on North Korea could lead to a wider war, for example, disrupting trade in Asia. Central banks could tighten too quickly (the reason for the bond sell-off in 1994). If you want an early sign of trouble, watch the credit markets.