Safe assets are now clearly the biggest risk that investors face
PremiumA warped price of safety means all assets are riskier than they look
Markets are quite weird right now. The value of risk-free assets has gone all out of whack, and if that doesn’t seem scary, keep reading.
Sri Lanka is facing a debt crisis, and yet its stock market is up more than 60% in the last year. The US Federal Reserve is getting ready to hike its policy rate of interest to combat high inflation in America, and the higher that interest rates move, the lower stock prices should be. The S&P 500 index in the US may be down over the past few weeks, but it’s still up more than 20% for the last 12 months.
Rate increases in America are especially treacherous for emerging markets, which face additional headwinds. Yet, emerging-market funds are up 25% from before the pandemic. Yields for low-quality BBB-rated bonds are less than inflation. And now celebrities can’t stop talking about investing in cryptocurrencies.
What all this shows is how disconnected our sense of risk has gotten from reality—or, more precisely, how the value of safety has become distorted.
The core purpose of financial markets is to price and distribute risk. But the most important asset price is the price of safety, which essentially is the yield on risk-free assets such as government-issued bonds. Whether anything is truly risk-free is an important and existential question. But to be practical, we’ll call an asset ‘risk-free’ if you’re certain to get your investment back along with some promised return.
Common examples are the 3-month Treasury bills of the US government and other close substitutes, like money-market funds, because they promise a certain return, the American government is very unlikely to default, and there is a market for them that is both deep and liquid. And because these are short-term loans, their price will not change that much even if interest rates move around.
We care about how to value ‘risk-free’ because such assets are simply the most systemically important assets available in financial markets. They determine the value of pretty much everything: stocks, lending collaterals, other bond yields and investment allocations. The risk-free rate is the foundation of asset pricing; if it’s askew, so are markets.
In theory, the risk-free rate should reflect how much you need to pay investors to postpone spending today until tomorrow. But in reality, the rate is determined by policy, and that has become even more true since the pandemic. The government both supplies and buys risk-free bonds. US Fed policy aims to lower the risk-free rate (to spur investment) in bad times by buying lots of bonds, and to increase the rate by selling bonds when the economy overheats.
And it’s not just the US Federal Reserve that influences risk-free bond yields. In the last 25 years, countries around the world bought up lots of safe assets, and drove up the price, to manage their currency. In the pandemic, the Fed became the biggest buyer of treasuries and corporate bonds, dominating the market for inflation-linked bonds and pushing the risk-free rate much lower than it should be.
Since the 2008 financial crisis, the real (inflation-adjusted) risk-free rate has been consistently negative, and now it’s even more so. Dips below zero here and there are normal, but it’s hard to understand why the market would price the risk-free rate in the negative for so many years at a trot. Here’s why that can be dangerous: Depressing the risk-free rate is presumed to cause excessive speculation, because investors seek out higher returns from riskier assets to reach their investment goals. And it also distorts the exposure of investors to risk: They may have more or less than they realize, since the risk-free rate is the baseline for assessing the value of less-safe assets.
Maybe that explains why stock markets around the world are so high and why crypto assets are worth so much despite offering such little value. This may all gradually work itself out, and strong growth and high profits will keep stock prices high. Or perhaps inflation will fall to tolerable levels and central banks will continue their negative-rate policies for another decade and celebrities will keep talking about how crypto is the future.
But if interest rates do suddenly rise, either from persistent inflation, Fed policy or concerns about debt, markets could get shocked back to reality. Stocks could fall and stay low, bond prices will shoot up, and the price of credit will rise to levels investors haven’t seen in decades. Super-risky assets like crypto will also fall, again showing that they don’t hedge anything. By distorting the price of safety, the risk-free rate has become a big danger. And when that happens, everything is riskier than it looks.
Allison Schrager is a senior fellow at the Manhattan Institute and author of ‘An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk’.
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