The Bliss trade is reflected in the divergence between the prices of stocks and government bonds. While equity markets have held up surprisingly well, government bonds have suffered even as long-run inflation expectations have stayed mostly anchored. Since the start of the Iran conflict, long-term government bond yields have risen across major economies including the US, Europe and Japan. This divergence has become a pattern over the past several years. Term premia on 10-year US treasury yields are now close to 100 basis points higher than they were before the pandemic, driving up the interest rate bill. … The IMF predicts that in a severe scenario, the Iran conflict could cause global growth to fall to 2 per cent (instead of the reference forecast of 3.1 per cent) and global debt could rise past 120 per cent of GDP. … As compared to before the pandemic, the scope to deliver on fiscal largesse is limited. Even in advanced economies, the sensitivity of borrowing costs to debt issuance has increased, which then spills over into emerging and developing economy borrowing costs. Even as bond prices have declined, markets may be too sanguine about the consequences of rising debt on fiscal health.

Policymakers would do well to use this period in which stock markets seem disconnected from heightened risk to craft a new playbook for crisis support that is both fiscally sustainable and supportive of long-term growth. The experiences of the pandemic and Ukraine war provide a valuable lesson in what that should look like: support targeted to the vulnerable; bailouts only to companies that are liquidity constrained but otherwise viable — and whose failure poses systemic risks; and co-ordinated fiscal and monetary policy so they do not work at cross-purposes.

If a new course is not charted, governments constrained by fiscal space may rely on heterodox measures, including broad-based price controls, financial repression, nationalisations, and pressure on central banks to absorb fiscal risk.

None of this would be good for the economy with synchronised sell-offs across stocks and bonds as markets realise that the backstop they were counting on is no longer there.