Is the risk of global financial crisis worrying?

Whether that’s the case or not, it is customary to think that the most ‘risk’ lies in the riskiest assets. But what if it does not; what if it lies in the ‘safest’ assets?

The various financial crises over the years have conditioned the markets and policymakers to look for risks in the riskiest parts of the financial system. The various emerging market crises, US sub-prime and collateralised securities in 2008, Greek bonds in 2010, and more have spread these fears.

Right now, it seems that US regional banks are in the crosshairs again, while, in the UK, Bank of England Governor Bailey was warning about the opaque private credit sector in testimony to parliament this week. But what if the riskiest sectors of the market are not where the most risk lies? What if it is the safest assets that hold the most risk? That might seem an odd thing to say but, in a sense it follows from the very fact that crises have happened in the past and policymakers have had to step in to devote fiscal – and monetary – resources to end the crisis.

The Global Financial Crisis and the eurozone debt crisis are two examples, and there have been other crises that have required large amounts of fiscal and monetary support, such as the pandemic and, in Europe, energy-related support after Russia invaded Ukraine. It stands to reason that if these ‘bailouts’ have, at least in part, been done to ease debt burdens within the private sector, the public sector’s assimilation of this debt has made its bonds more ‘risky’ relative to ‘riskier’ assets. Of course, everything is relative. A government bailout might close the risk gap between its debt and the debt of the private sector, but it might still be the safest asset out there.

Another point is that government debt is different from private sector debt because governments can employ tools that extract revenue from the private sector to ease the debt burden. This might mean straightforward taxation, but if things get really tough, it can lower its real debt burden by creating unanticipated inflation or, in a similar way, engage in financial repression by holding interest rates at artificially low levels, something that can be done in conjunction with the central bank via quantitative easing, for instance.

In other words, the government can live with a high debt burden for far longer than somebody in the private sector who is more likely to go bankrupt. But could this still mean that supposedly ‘safe’ government bonds are becoming riskier assets, while traditionally riskier assets become relatively safe? Steven Barrow, Head of Standard Bank G10 Strategy, doesn’t know. But what he suspects could happen is that we experience a test of this theory given not just the rise in public debt levels but also the way in which the US Administration is leaning on the Federal Reserve to cut rates, specifically in order to lower interest costs on the debt. We’d go further and say that in a number of ways the treasury market has already displayed traits of not being the safest asset (or, at least, less safe than it was). These include the way that yields have risen as the Fed has cut policy rates, which is highly unusual.

Steven Barrow also notes that treasury yields did not fall when there was a risk-off panic in the market over Trump’s tariffs in the spring. In fact, Trump had to postpone the tariffs because the treasury market became “yippy,” in his words. The surge in the gold price may be another sign of the decline in treasuries' safe asset status, along with the rise in the term premium.

In sum, it would seem to suggest that the risk the financial sector faces is not that there’s some sort of ‘top-down’ cascading of financial fallout that stems from highly risky assets at the top of the risk pyramid. But instead from a bottom-up cascade that starts with ‘safe’ assets, namely treasuries. Needless to say, this would present policymakers with a vastly different challenge and very possibly one that’s far harder to tackle than the more ‘traditional’ top-down crises we’ve seen in the past when ‘riskier’ assets have been the instigator of financial market stress.