Global Debt at Risk of “Qualitative Change”

Global markets, spurred by policies, have emerged from the March panic during the spread of the COVID-19 pandemic. For now, all major economies, including Europe and the United States, are at the crossroads of a new direction. Although the U.S. stock market experienced a certain degree of correction in October and began to hover around high levels, it is still far from the all-time high it reached in early September. In the current stock market, the global market is still plagued by two factors, i.e., the recurring COVID-19 pandemic and a new round of stimulus policy changes. In fact, in the case of the second outbreak of the pandemic, there was no obvious fluctuation in the market, which meant that the capital market stimulated by the policy could hardly get rid of its dependence on the policy. This kind of policy risk that accumulates ceaselessly in the long run also implies the possibility of “qualitative change”.

In the bond market, there have been signs of a pullback as the dollar index has been flooded with dollar liquidity. In the United States, investment-grade corporate bonds with maturities of more than 10 years underperformed short-term bonds last month and fell the most in August of all maturities, according to Bloomberg Barclays Indices. In the options market, the cost of hedging against inflation of more than 2% over the next five years has more than doubled since February. In Asia, dollar-denominated corporate securities with maturities of more than 10 years performed worst in the two months to September. Some bond markets around the world have begun to signal long-term inflation risks, reflecting growing concern that a prolonged flood of liquidity might drive up future inflation, with the resulting change in interest rates that could be potentially disastrous for capital markets.

Reports from international rating agencies have further heightened concerns about the future situation. S&P Global warned that the second wave of sovereign downgrades could come in the coming months as a result of the new wave of the pandemic, with some of the world’s top economies likely to suffer credit downgrades or downgrade warnings. S&P has already downgraded the ratings or outlooks of nearly 60 countries this year. Some of the world’s developed economies, including the European Union, Japan, the United Kingdom, and the United States, are also at risk from a new wave of the pandemic. S&P has revised its outlook for Japan from positive to stable. Canada’s rating was also downgraded to AA by Fitch. These changes suggest that while countries are expanding their fiscal deficits to cope with the pandemic, the long-term sovereign debt problem is worsening.

In particular, the size of the U.S. debt has ballooned to more than USD 20 trillion from about USD 13 trillion five years ago, and the nation’s latest annual fiscal deficit has hit a record USD 3.1 trillion. The economic impact of COVID-19 implies that the scale will inevitably be further expanded. In recent days, Randal Quarles, the Fed’s Vice Chair for Supervision, said the Treasury market is so large that the Fed may have to stay involved to keep it functioning.

Quarles also said that the Treasury market’s scale has grown so large that it may have outpaced the ability of the private sector to cope during periods of stress. This means  there is an “open question” about whether there will be an indefinite need for the Fed to participate as a purchaser to support market functioning, a question that according to Quarleshas yet to arrive at an answer on. The Fed is also stressing that the future of the U.S. economy depends on another round of fiscal stimulus.

The Federal Reserve and the U.S. government are likely to continue their massive easing policies in the face of rapidly ballooning U.S. government deficits. In Europe, the European Central Bank (ECB) has begun to note the threat posed by the build-up of corporate debt risks in the future and has stressed the ECB’s policy role, hoping to allay market fears. For the financial market, although continuous easing policies are conducive to maintaining market stability, it also means that the capital market is increasingly dependent on policies, and it is difficult for the capital market to form its own endogenous growth momentum. The continued spread of the pandemic will further aggravate this “vicious circle”. If capital markets are losing their function, policymakers need to consider the possibility of a future qualitative change in growing government and corporate debt that could cause markets to stall and the global economy to reboot. The only hope for governments and regulators is that the economy recovers its momentum before the crisis occurs.

Final analysis conclusion:

At present, the massive stimulus policies adopted by countries in response to the pandemic and economic recovery will continue to strengthen in the short term, making the capital market increasingly dependent on policies. As emergency policies continue to trend towards the long-term, the capital markets are facing the threat of losing their function, raising the risk of a “qualitative change” in the overall debt problem.