Central banks are still calling the shots The search for yield turned 2012 into a veritable dash for trash in global markets. The lower the credit quality, the better the performance was the guiding principle, with poor quality credit outperforming investment-grade credit. At the same time, credit securities more generally tended to outperform government bonds and equities. With the notable exception of Japan, it was a triumphant year for the central banks, whose unconventional measures to secure ever looser monetary conditions worked a remarkable spell on global markets. In the first two weeks of 2013 it has been more of the same as risk appetite remains rampant across the world. The sense of déjà vu is palpable and points to a serious vulnerability. In many parts of the market credit spreads are now nearly back to pre-crisis lows. As the Institute of International Finance points out in its latest Capital Markets Monitor, bonds with relaxed credit discipline are back. Among them are instruments such as "payment in kind," a particularly hairy product of the credit bubble, while the issuance of covenant-lite loans is now above its previous record level set in 2007. In the meantime, all manner of seemingly anomalous valuations are to be found across markets. The fact that dividend yields on many very stable big companies are higher than the yield on their corporate bonds has been widely noted. In the UK, it is possible to buy index-linked property leases in food retailing on a similar yield to that on related corporate bonds on which the income is fixed. The nature of a market driven by central bank liquidity is that momentum triumphs over fundamentals. Anomalies are thus to be expected, but are hard to exploit when the authorities are firmly committed to continuing market manipulation. That does not necessarily mean that there is no case for switching from credit into equities in the short term. Yet it is important to recognise that what central banks give can equally be taken away, a point that applies particularly to the US Federal Reserve. This is partly because the Fed has been the driving force behind global markets over the past 12 months. The clearest evidence for this comes from the relative performance of developed world economies and emerging markets. While emerging market economies were harder hit at the start of the crisis they very quickly exceeded previous peak levels. By contrast, the big developed economies, with the exception of the US, are still not back to their previous peaks. Yet emerging market equities have not followed the stellar performance of their underlying economies back to pre-crisis levels. They have simply tracked the developed markets, which remain below their previous peak. The other concern for equities is the marked polarisation in the developed world between the US and the rest. The US is more advanced in its deleveraging process. Its banking system is now better capitalised than that of Europe. The housing market is on the turn. With fiscal concerns showing the potential to become more manageable, the likelihood of some of the non-financial corporate sector's near-$1.4tn nest egg finding its way into increased investment is growing. So if unemployment comes down faster than expected, the markets will become increasingly preoccupied with an early retreat by the Fed from quantitative easing. Nobody can be entirely certain how much the rise in equity prices owes to these liquidity injections. Last year's analysis by the Bank of England of the macroeconomic impact of its gilt buying programme between March 2009 and May 2012 for the Treasury select committee nonetheless provides clues. Using the Bank's numbers, the independent pension consultant John Ralfe estimates the great majority of the increase in the FTSE 100 index since the start of that period is a result of QE. There must be a chance that any retreat from QE in the US would thus have a pretty significant impact on equities, as well as on overblown government debt and corporate credit markets. The US economy is probably now sufficiently robust to weather any resulting storm, even if the financial system retains its capacity to spring nasty surprises. The same can hardly be said of Europe. The European Central Bank would not find it easy to offset the market impact of the Fed in tightening mode. And investors would inevitably refocus on Europe's underlying structural weaknesses, along with unresolved faultlines in the monetary union. In the enduring risk-on/risk-off game that has prevailed since the crisis began, the scope for a juddering reversion to risk-off is painfully clear. The key message for markets in the year ahead is that the central banks will once again call the shots. Much - almost certainly too much - is riding on their ability to steer a stable course back to normality.