Practically every financial meltdown or crisis can be traced back to a misunderstanding of which assets are “risk-free.” Investors think they have a risk-free asset — it could be a mortgage-backed security, shares in a Bernie Madoff fund, Greek debt — and are surprised when it turns out not to be.
For the last several years, the term has been used a lot to describe one of the most widely traded securities in the world: US Treasuries. The markets for 10- and 30-year government bonds experienced more volatility this month in response to uncertainty around tariffs and the future of the world financial order. Rising yields and falling prices amid market turmoil suggest markets no longer see Treasuries as a “safe haven” (another favorite two-word description). Treasuries, which have long held a special place in the global financial system because of their ubiquity and liquidity, may be less special in the future.
All of this means that US bonds may be losing some of their status as a risk-free asset. But make no mistake: Treasuries were never risk-free, aren’t now, and won’t be anytime soon.
The proximate cause of last week’s volatility is the possibility of a trade war: Treasury prices rightly fell in response to the prospect of less trade. President Donald Trump has articulated a desire to shrink the current account deficit, which by definition means foreigners will have less need or desire to buy bonds.
It adds up to a world where yields are much higher. The prospect of a trade war does change the role of bonds in financial markets. It does not necessarily mean the dollar and Treasuries are now risky, even if they are certainly going to be less valuable going forward (which would be true whether it was foreigners ditching bonds or hedge funds unwinding their positions).
Risks in the Treasury market had already been brewing for the last several years. Bond prices have been falling and becoming less predictable, in response to higher inflation and the realization that the US government has no serious plan or desire to reduce its debt. Even before Trump took office, Treasuries were cheaper than other similar or synthetic bonds.
For a variety of reasons, it was easy for investors to ignore all this. Regulations define highly rated government debt as low-risk, increasing demand for Treasuries despite their troubling issues. It was also reassuring that the US debt market was so liquid and well-functioning, and that a credible and independent Federal Reserve was ready to step in if there were any problems.
And overall, despite everything, it remains highly unlikely that the US government will default. As globalization proceeded and the world became more financially integrated, Treasuries were “the least dirty shirt on the floor.”
Bond buyers could also ignore risk because “risk-free” remained ill-defined. If you think of a risk-free asset as one that is liquid and has a guaranteed return — or as one with low volatility — then a short-term Treasury could be considered risk-free. Longer-term bonds have more risk. They tie up your money for longer. You can of course sell them before they mature (as most bond investors do), as the market for them is fairly liquid, but their prices are more volatile than those of short-term bonds.
And yet it is not so simple that a short-term Treasury is risk-free for everyone. If you have a longer-term liability — if you are a pension fund that has benefits to pay decades into the future, for example — then a short-term bond does not ensure you can make your pension payments and exposes you to inflation risk. The definition of “risk-free” is complicated; it depends on what you are investing for, the inflation environment and the fiscal outlook.
From this perspective, Treasuries were never risk-free, especially longer-term debt. Inflation is always in danger of returning, and the fiscal situation in the US is not sustainable. And Treasury yields do revert, which means the low-rate era was never going to last and bond investors were bound to lose money. Every dozen years or so, investors convince themselves that Treasuries of all duration are risk-free, and vulnerabilities build up based on that assumption. Even so, the level of cognitive dissonance in the last few years was something to behold.
The threat of a trade war may have brought the risks that were always lurking into the light and hastened the inevitable. And while investors may be changing how they think of risk in the bond market, it is premature to say that Treasuries are no longer a “low-risk” (I nominate this modifier to replace “risk-free”) asset. There will still be high demand for US debt, even if it’s smaller than before. The market for European debt is not as liquid or deep, and the structure of the eurozone means high-risk debt is often overpriced and volatile.
The test of a risk-free asset is not low volatility in good times, or even a lower yield relative to US debt. It is how it performs in times of market turmoil. If there is a global trade war, there will probably be a global recession, which will also subject European countries to financial stress. And the euro region still has structural weaknesses that could make their debt markets more tumultuous than America’s.
A world in which the US retreats from trade and runs high debt will change the US’s role in debt markets. It will still be a low-risk asset and in high demand. But what is considered “risk-free” will probably be a portfolio of different lower-risk bonds — some from Europe, some from America, some from Asia, or maybe some digital currency. Maybe it should have always been that way, since US bonds were never risk-free to begin with.
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