The markets are weird right now. The value of risk-free assets has gone completely off the rails, and if that doesn’t sound scary, keep reading.
Sri Lanka is facing a debt crisis, yet its stock market has risen more than 60% in the past year. The Federal Reserve is preparing to raise rates to fight inflation, and the more interest rates rise, the more stock prices are expected to fall. The S&P 500 may have fallen in recent weeks, but it’s still up more than 20% in the past 12 months.
Rate hikes in America are particularly dangerous for emerging markets, which face additional headwinds, and yet emerging market funds are up 25% from pre-pandemic. Yields on low-quality BBB bonds are lower than inflation. And now celebrities can’t help but talk about investing in cryptocurrencies.
All this shows how our sense of risk has become disconnected from reality or, more precisely, how the value of security has become distorted.
The purpose of financial markets is to fix the price and spread the risk. But the most important asset price is the price of security, which is essentially the return on risk-free assets. Whether something is truly risk-free is an important and existential question. But for convenience, we’ll call an asset “risk-free” if you’re certain to recoup your investment with a promised return.
Common examples are 3-month treasury bills and other close substitutes like money market funds, as they promise a certain return, the US government is very unlikely to default, and there is a deep and liquid market for them. And because they are short-term loans, their price will not change much even if interest rates change.
We care about “risk-free” value because it is the most systemically important asset in financial markets. It determines the value of just about everything: stocks, loan guarantees, bond yields, investment allocation. The risk-free rate is the basis of asset pricing; if it’s wrong, so are the markets.
In theory, the risk-free rate should reflect how much you have to pay investors to defer spending from today to tomorrow. But in reality, the rate is determined by politics, and that has become even more true since the pandemic. The government provides and buys risk-free bonds. Fed policy aims to lower the risk-free rate (to stimulate investment) in bad times by buying lots of bonds, and to raise the rate by selling bonds when the economy is overheating.
And it’s not just the US Federal Reserve that influences risk-free bond yields. Over the past 25 years, countries around the world have bought many safe assets and driven their prices up to manage their currencies.
During the pandemic, the Fed has become the biggest buyer of Treasuries and corporate bonds, dominating the inflation-linked bond market and pushing the risk-free rate much lower than it should. to be.