"When will the good times end?"

Economists seem to be split into two camps - soft landing (there will not be much flow on to the rest of the economy from the dramatic U.S. housing slowdown) and hard landing camp (U.S. economy is headed for a recession). With credit spreads at their lows and emerging markets powering ahead, it looks like the soft landing camp are the dominant group.

The background fundamental support for credit has deteriorated (see model below). Average credit quality has come down as the re-leveraging rolls on. Default rates have shown some modest rises from very low levels.If you apply fundamental analysis to the current market you get a profile like the one below. The European High yield model is forecasting a big rise in spreads over the next 12 months. This assumes defaults start to rise and the European Central Bank rate increases start to have a dampening effect.

But corporate profits remain robust and absolute borrowing costs are low. With ample liquidity, and an army of highly paid investment bankers constructing instruments that leverage spreads, then the spread reduces. These same investment bankers are then paid even more to use more leverage to extract a similar return from the smaller spread.

If we have reached the top of the interest rate cycle then someone forgot to tell the credit markets. European high yield spreads just made a new low. The market should be concerned about the possibility of falling corporate profits and declining commodity prices at this stage of the cycle. So a strong credit market when the next move in rates could be down is unusual. Liquidity drives all before it.

If liquidity is this abundant then central bank rates cannot be restrictive.

Where is the liquidity coming from and when will it dry up? You could argue that the U.S. has been fighting a liquidity bubble and quite successfully. If the loose monetary policy, following the dotcom bubble, found its way into the housing market then the Federal Reserve has successfully slain another of its own creations.

Elsewhere things are different. The build up of reserves by the Asian central banks post 1998 has been compounded by the windfall of reserves by the oil exporting countries since oil bottomed around the same time. This massive source of liquidity has been recycled into the west and shows up in many money supply data.

If the high oil price is a tax on growth and keeping a lid on wage inflation in the west and the reserves are fuelling an explosion of financial engineering, then why worry?

The longer we don't get a catalyst that upsets the cosy scenario, the longer it goes on. The sharp U.S. economic slowdown may be postponed. Political shocks like this week's Thai currency controls fiasco seem to come and go and one or two corporate or hedge fund blow-ups may not be enough.

The biggest risk to this cosy scenario is not, perhaps, the recession scenario but one that has a rebound in growth as its central theme. If the housing led slowdown starts to threaten employment growth then the Federal Reserve may be quick to react and cut rates. The U.S. bond market has already considered this possibility and mortgage rates have fallen modestly as a result. A rebound in growth is not factored in at the moment and may be more of a concern to the credit markets. Initially the reaction should be positive and the market shouldn't get nervous until the forecasts for rate increases start to dominate.

Rising government bond yields could be the catalyst for widening spreads. While we are looking for the economy to undermine the credit story, it could actually be the government bond market.

With the ISM index at a sub 50 level, this scenario seems a long way off. Whilst the soft landing clan are in the ascendancy then the credit markets should do well. But the second half of next year could spell the end of the party. Instead of worrying about the punchbowl being drained the credit market may do better to worry about when it might be taken away by the central bankers.