There are fiscal challenges in most countries, and government debt levels, yield levels and the term premium are rising across the G7, see charts below.
This raises questions about debt sustainability and the ability of governments to repay their debt, particularly in Europe and Japan, where growth is structurally weak due to demographics and years of policy choices that have dampened growth.
What are the consequences if the risk-free asset is no longer risk-free?
1) Higher government borrowing costs and, as a result, higher borrowing costs for consumers and firms.
2) Loss of monetary policy effectiveness, as cuts by the central bank don’t lower long-term interest rates.
3) Financial instability, because the risk-free rate is used for valuing assets and pricing risk.
In extreme cases, the central bank may decide to do YCC or QE to lower long-term interest rates. But this comes at the risk of a dramatic depreciation of the currency, as the central bank essentially intervenes to support fiscal policy and, as a result, the central bank loses credibility among investors.
Sources: US Department of Treasury, Macrobond, Apollo Chief EconomistNote: The NY Fed measure for the term premium is based on a five-factor, no-arbitrage model. Sources: Federal Reserve Bank of New York, Macrobond, Apollo Chief Economist
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