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Rising anxiety in financial markets

  • Writer: Macroprudential Policy
    Macroprudential Policy
  • Jun 22, 2020
  • 5 min read

Updated: Aug 16


A volcano with smokes on top of it

With QE programs suppressing yields on traditional safe assets, investors face limited options for storing wealth.

U.S. corporate BBB-rated debt grew from $1 trillion in 2008 to $3.5 trillion by 2023 (S&P Global, 2023), and China's shadow banking sector reached $9 trillion in wealth management products.

Investors become more anxious against bad news as they are pushed to take excessive risks.


Understanding the Safe Asset Problem


The safe asset problem refers to a growing global shortage of high-quality, low-risk financial instruments that investors can use to reliably store value. Safe assets—primarily government bonds like U.S. Treasuries and German Bunds—play several critical roles in the financial system. They serve as collateral in lending markets, liquidity buffers for banks, and benchmarks for pricing riskier investments. However, demand for these assets now far exceeds supply, driving yields to artificially low or even negative levels. This forces investors to accept greater risk in search of returns, destabilizing the financial system.


How Quantitative Easing Worsens the Shortage


Quantitative easing (QE) operations exacerbate the safe asset problem in three key ways:

  1. Absorbing Safe Assets from Markets

    Central banks purchase vast quantities of government bonds and high-grade corporate debt, removing them from private circulation. For example:

    • The Federal Reserve holds $5.4 trillion in U.S. Treasuries, equivalent to 35% of all outstanding debt (Federal Reserve, 2023).

    • The European Central Bank (ECB) owns €3.2 trillion in sovereign bonds, amounting to 25% of Eurozone GDP (ECB, 2023).As a result, private investors—such as pension funds and insurers—face a shrinking pool of genuinely safe assets, pushing them into riskier alternatives.

  2. Distorting Risk Pricing

    By suppressing yields across all debt markets, QE blurs the line between safe and risky investments. For instance:

    • Corporate bond spreads collapsed during QE, with BBB-rated yields falling to 2.5% in 2021 (compared to 5.5% pre-2008) (BIS, 2022).

    • Investors seeking returns are forced into junk bonds, leveraged loans, and structured products, amplifying systemic risk.


  3. Encouraging Moral Hazard

    QE creates a false sense of security by implicitly backstopping risky debt. Examples include:

    • Zombie firms (unprofitable companies reliant on cheap credit) now make up 12% of U.S. public firms (Banerjee & Hofmann, 2023).

    • AAA-rated collateralized loan obligations (CLOs) often contain risky loans, yet investors treat them as safe due to central bank interventions (Moody’s, 2023).


The Consequences: Japan’s QE Trap


Japan provides a stark example of how prolonged QE deepens the safe asset crisis. The Bank of Japan (BoJ) now holds:

  • 133% of GDP in assets, including 52% of all Japanese government bonds (BoJ, 2023).

  • 7% of domestic stocks via ETFs, further distorting markets.

Effects:

  • 10-year government bond yields remain near 0%, starving pension funds of returns.

  • Insurers and pensions take on riskier foreign investments (30% of portfolios) to meet obligations (IMF, 2023).


Central Banks and the Zombie Finance Trap


Quantitative easing (QE) has fundamentally distorted financial markets by preventing credit defaults for over a decade, creating a dangerous accumulation of risk in the system. The Federal Reserve's balance sheet expanded from $900 billion in 2007 to $8.9 trillion today (Federal Reserve, 2023), while the ECB now holds €5 trillion in assets (ECB, 2023). These interventions have fostered a surge in zombie borrowing - firms that cannot cover interest payments from earnings now comprise 12% of U.S. public companies and 16% in the Eurozone (Banerjee & Hofmann, 2022). Investors knowingly hold these precarious assets because central banks have suppressed yields on traditional safe assets like government bonds. The Bank of Japan's ownership of 7% of Japanese stocks through ETFs (BoJ, 2023) exemplifies how extreme these interventions have become. This creates a doom loop where each crisis demands larger bailouts - during the 2008 collapse, governments absorbed $1.5 trillion in bad bank debts (IMF, 2009), setting a precedent that incentivizes ever-riskier behavior.


The Investor's Dilemma in a Distorted System


With QE programs suppressing yields on traditional safe assets, investors face limited options for storing wealth. Cryptocurrencies remain too volatile - Bitcoin's 90-day volatility averaged 65% in 2023 (CoinMarketCap, 2023) - while physical stores like gold face liquidity constraints. This forces capital into increasingly risky debt instruments: U.S. corporate BBB-rated debt grew from $1 trillion in 2008 to $3.5 trillion by 2023 (S&P Global, 2023), and China's shadow banking sector reached $9 trillion in wealth management products (PBOC, 2023). The situation creates perverse incentives: when the 2020 COVID crisis hit, the Fed had to intervene in even Treasury markets to maintain liquidity (BIS, 2021), demonstrating how the system now requires constant central bank support.


Financial anxiety stemming from the safe asset problem


The concentration of default risk makes financial anxiety in the system. In 2023, Silicon Valley Bank collapsed when depositors withdrew $42 billion in 24 hours (FDIC, 2023), illustrating how digital banking accelerates panic. The logic remains simple: early movers preserve capital. This dynamic is exacerbated by securities like AAA-rated collateralized loan obligations (CLOs), where 35% of underlying loans now go to zombie firms (Moody's, 2023). When the next crisis hits, the mismatch between perceived and actual safety will trigger a scramble for genuine safe assets that central banks cannot satisfy without unprecedented intervention.


The CBDC Accounting Imperative


Central banks must classify CBDCs as assets on their balance sheets to avoid recreating the distortions of quantitative easing (QE). Under current QE operations, central banks purchase government bonds (assets) while issuing reserves (liabilities) - a process that removes safe assets from private markets. If CBDCs are similarly structured as liabilities, their issuance would require offsetting asset purchases, perpetuating the safe asset shortage. The Federal Reserve's $8.9 trillion balance sheet (Federal Reserve, 2023) demonstrates how this dynamic has already distorted markets.


Asset-classified CBDCs enable direct monetary interventions without secondary market effects. When the ECB records its digital euro as an asset, it can conduct helicopter money operations by writing down CBDC holdings without needing to sell Treasuries. This contrasts with QE unwind programs, where the Fed's $95 billion/month runoff (Federal Reserve, 2023) mechanically tightens financial conditions.


Conclusion: Breaking the Doom Loop


The current system, where $25 trillion in global central bank assets (BIS, 2023) props up increasingly fragile debt structures, is unsustainable. Lasting solutions require:

  1. Normalizing balance sheets through gradual QT

  2. Introducing CBDCs as genuine safe assets

  3. Macroprudential tools targeting zombie debt


As former Fed Chair Paul Volcker noted, "The most important financial innovation of recent decades was the ATM" - a reminder that sometimes simplicity beats financial engineering.


References





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