It is not known how the markets will deal with this. This has already prompted the question of what constitutes a risk-free asset. This is how government bonds were viewed. During the pandemic, a third of global government bonds traded at negative yields, meaning investors considered them truly safe. Effectively, governments were rewarded for borrowing.
Now, government bonds have seen negative total returns over the past three years due to inflation, rising policy rates and tight global liquidity. If you bought this safe haven, you would have lost money.
Financial markets have changed since the 2008 global financial crisis with the rise of shadow banking. A recent report by the Financial Stability Board shows that by the end of 2021, total financial assets will rise to $485 trillion. Yes, trillion. And the amount provided by non-bank financial institutions accounted for nearly half of this, reaching $239 trillion.
Collateral, often in the form of government bonds and other quality debt, plays an important role in this system. If it is now being questioned as a safe asset, this implies not only greater financial instability but also greater risk aversion, meaning that global liquidity conditions will naturally tighten further. Stabilization of policy rates and yields may be more important.
So the focus shifts from inflation to growth. Next, I expect the focus of financial markets to shift to debt. Global public and private debt levels remain high, limiting room for policy maneuver and exposing many individuals and institutions to prolonged periods of high interest rates. Keep seat belts fastened.
Gerard Lyons is Chief Economic Strategist at NetWealth. Liam Halligan is on holiday.