In my post on monetary policy and real rates, I made a provocative assertion: “in the absence of a truly risk-free asset that preserves purchasing power, the very idea of a “risk premium” is meaningless. In the language of Kahneman and Tversky, it is the category boundary between certainty and uncertainty that matters most to an investor.” The idea that monetary policy has an impact on asset prices is not controversial. In a speech in 2003, Ben Bernanke concluded that easy money policies increase asset prices primarily via a reduction in risk premiums: “The most powerful effect of an unanticipated monetary tightening is to increase the perceived risk premium on stocks, either by increasing the riskiness of stocks, by reducing people’s willingness to bear risk, or both. Reduced willingness of investors to hold relatively more risky stocks drives down stock prices.” In the same speech, Bernanke concludes that the changes in the expected evolution of real rates from changes in the Fed Funds rate are minimal. This conclusion does not hold for programs such as QE2 which directly drive down the level of the real rate curve.
My conjecture is simply the following: As the real rate curve turns negative, there is a non-linear transition in the risk premium for all “risky” assets towards a level close to zero (see below for an idealised chart). Risk premiums may never be exactly zero – even under the most dovish monetary regime, the market expects real rates to turn positive at some time in the future. But the effective risk premium in a market that expects negative real rates for above 5 years may not be very far above zero. A great example of such a regime is a developing market like India which has experienced long and frequent periods of negative real rates (see below for current real rates across emerging markets). A consequence of such a pronounced negative real rates regime is that almost no one in India regards short-term bank deposits as a “risk free” asset. Of course this means that a move back from negative real rates territory towards positive real rates will likely have violent negative consequences for risky asset prices – a fate that Indian equity prices (see below) may be experiencing right now in the wake of the Reserve bank of India’s unexpected acceleration of the tightening cycle.