While we’re taught in school and reminded by many that central banks are in the inflation-fighting business, history proves the opposite. Economist Murray Rothbard compared central bankers who talked about suppressing inflation to arsonists who would run down the street yelling “fire” after setting a building ablaze.

However, post financial crisis, Fed Chairs Bernanke and Yellen haven’t been able to light a fire under consumer prices. It’s asset prices that have soared with the central bank’s magic dust. Social media equity and the junkiest of debt, not to mention art and farmland, were pushed to the heavens by Fed policy arcana dubbed “ZIRP,” “QE,” and “Operation Twist”—all clever terms for money creation.

The central bank turned central planner when PhD economists took over running the place, starting with Arthur Burns’ appointment by Richard Nixon and the bumping of the gold standard. These events all set the stage for a “Fed on steroids” era since the financial collapse.

The central bank openly says its job is to push securities prices higher and yields lower. And while it can’t print jobs, it has clearly succeeded at pushing stock and bond prices upward.

Dangerously for investors big and small, the amount of risk in a security, whether it be a stock or bond, is misrepresented when the Fed inflates the price with oceans of liquidity.

The monetary mandarins have had their way in recent times: being knighted by the British queen (Greenspan); named person of the year (Bernanke); and participants in their rigged markets can’t wait to pay them six figures per speech in retirement.

But now a single market previously thought to be bulletproof has turned the junk-bond market—a market levitated by Fed extravagance—on its ear. That market is oil. Time’s Dan Kadlec wrote this week that junk bond prices have dropped 8% after investors pulled $22 billion out of the market.

He explains:

The junk bond selloff began in the energy sector, where oil prices recently hitting a five-year low set off alarms about the future profits—and ability to make bond payments—of some energy companies. In the past month, the selling has spread throughout the junk-bond universe, as mutual fund managers have had to sell to meet redemptions and as worries about further losses in a possibly stalling global economy have gathered steam.

This is quite a turnaround from the spring when the Wall Street Journal published an article titled “Investors Clamor for Risky Debt Offerings.” Investors put almost $3.5 billion in taxable high-yield bond funds and ETFs in the first quarter. “We’re in an environment where the discerning eye of real credit investors has given in to the less discerning generic yield grab,” Stuart Lippman, a portfolio manager at TIG Advisors LLC, told the WSJ.

Junk yields had fallen to 5.4%, the lowest since 2007 and bond covenants reflecting a borrower’s market. “The Moody’s Investors Service covenant-quality index, which rates high-yield bonds for investor protections, with 1 the highest score and 5 the lowest, fell to 4.14 in March from 4.05 in February,” reported the WSJ.

In June junk-bond yields were returning3.90% above Treasuries. “That spread has widened to 5.08 percentage points for junk bonds vs. 7.86 percentage points for energy bonds—an indication of how worried investors are about default, particularly for small, highly indebted companies in the fracking business,” writes John Waggoner for USA Today.

The Fed’s quadrupling of its balance sheet and rate obliteration had made junk irresistible—Exhibit A: Puerto Rico. Earlier this year the municipal bond market was off to its best start in five years according to Bloomberg, “as Puerto Rico’s record $3.5 billion junk deal leaves demand for higher-yielding securities unslaked.”

Puerto Rico is the Detroit of the tropics. The island paradise has been in recession for eight years, has an unemployment rate exceeding 15%, and half the population lives in poverty. Nearly a third of its citizens collect food stamps. and its economy has shrunk 14% since 2006.

So how big is the market for the debt of a broke territory? In normal times, the answer would be “nonexistent.” However, this has been no ordinary market. With investors groping for yield, the paper of a bankrupt territory seemed like pennies from paradise.

Puerto Rico debt was officially christened junk in February, but what the sunny territory has according to Zacks is “a stronghold on municipal bond portfolios, driven by its triple tax exemption policy.”

It took oil’s swoon to shine a bright light on Puerto Rico’s problems. The country’s benchmark general obligation bonds with an 8% coupon hit 84.657 cents on the dollar, reports Reuters. The debt of the country’s electric power authority PREPA carrying a 5% coupon have been cut in half, trading at 49.125 cents on the dollar.

The risks masked by Fed liquidity are starting to be uncovered throughout the junk-bond universe. USA Today reports, “Nuveen Symphony High Yield A fund plunged 16% Monday, bringing its total return for the year to negative 18.67%.”

“Energy is falling out of bed and will drive the entire market lower,” Riaz Haidri, head of high yield at broker-dealer Cantor Fitzgerald & Co. told the Wall Street Journal.

Energy bonds comprise 14% of the high-yield market, but “even nonenergy high-yield bonds have been hit as investors rushed to sell whatever debt they could to raise cash,” writes Katy Burne.

The Eccles Building monetary operators’ Keynesian training tells them that the answer to everything that ails the economy is more money and cheaper debt. But debt, no matter how cheap, requires that sales be made or taxes collected, and payments be made.

The junk-bond market is the first to crack. It won’t be the last.

This article originally appeared on December 19th, 2014 at Casey Research.
The photo used for the cover was taken by Berardo62 (CC BY-SA 2.0 — photoshopped).