Irrational Exuberance, the sequel?

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Ben Bernanke remains adamant that the Federal Reserve is on the right track.

But prominent voices are beginning to wonder whether it's not the same track Alan Greenspan went down a few years ago, the one that leads straight to Irrational Exuberance, U.S.A.

Bill Gross, who, as head of money-management giant Pacific Investment Management Co. LLC, is essentially the world's biggest bond investor, raised this concern in his note to clients Wednesday.

He warned that the corporate credit market was starting to show the hallmarks of irrational exuberance – a famous phrase first uttered in 1996 by Mr. Greenspan when he held the top job at the Fed that Mr. Bernanke now occupies.

The term is typically applied to financial assets that have become overvalued beyond justification of the underlying economic fundamentals – a bubble, in other words – and that are often highly disruptive to broader economic stability when the bubble bursts.

(As he pointed out, we have now seen such irrational exuberance end badly three times since Mr. Greenspan's speech – the 1998 Asian currency crisis, the 2000 dot-com crash and the 2007-2009 subprime meltdown.)

In support of his argument, Mr. Gross turned to no less an authority than Jeremy Stein, the former Harvard economist who works with Mr. Bernanke as one of the seven members of the powerful Federal Reserve Board itself.

In a speech earlier this month, Mr. Stein wondered aloud whether credit markets are starting to show signs of overheating after years of highly stimulative Fed monetary policy, even though the broader economy clearly isn't.

In the current extended low-interest-rate environment, "we are seeing a fairly significant pattern of reaching-for-yield behaviour emerging in corporate credit," he said.

The evidence is not so much in the spreads for interest rates on high-yield corporate bonds (often referred to as junk bonds) relative to government bonds, which for most observers is the favourite yardstick for investor over-exuberance in the riskiest classes of corporate credit.

The spreads have certainly narrowed significantly in the past 18 months, but they haven't shrunk to alarmingly low levels by historical standards; they're still considerably wider than they were in the years before the credit crisis.

Rather, the key is in the sheer volume of high-yield corporate debt that the market has been gobbling up.

Both Mr. Stein and Mr. Gross point to research by Harvard's Robin Greenwood and Sam Hanson, who found that elevated levels of high-yield bonds as a proportion of total corporate debt issuance is a "powerful" predictor that corporate credit returns are headed for a fall.

Last year, Mr. Gross noted, investors bought more than $100-billion of high-yield and leveraged corporate paper, "a record level even exceeding the ominous levels of 2006 and 2007."

The pace accelerated sharply in the second half of the year. The share of this higher-risk credit as a proportion of all corporate debt issues has risen substantially, and is well above its historical average.

Neither Mr. Gross nor Mr. Stein believe we've reached potential crisis levels in this credit over-exuberance; both think that at this point, it may signal nothing more than a likely decline in returns that the investment community can expect from these assets.

That sounds eerily like another "soft landing" prediction, and we've seen those go wrong before.

At very least, this is the kind of yellow flag the Fed will be watching carefully in the coming months as it gauges the unintended effects of its quantitative easing programs – and we would be well advised to watch it along with Mr. Bernanke and company.