Markets are 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 Federal Reserve is getting ready to hike rates to combat inflation, and the higher interest rates move, the lower stock prices should be. The S&P 500 may be down the last 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, and yet emerging-market funds are up 25% from before the pandemic. Yields for low-quality BBB 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 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. 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 3-month Treasury bills and other close substitutes like money market funds, because they promise a certain return, the U.S. government is very unlikely to default, and there is a deep, liquid market for them. And because they are short-term loans, their price won’t change that much even if interest rates move around.
We care about how to value "risk-free" because it's the most systemically important asset in financial markets. It determines the value of pretty much everything: stocks, lending collateral, bond yields, investment allocation. 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's become even more true since the pandemic. The government both supplies and buys risk-free bonds. 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 U.S. 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.