resilience, not stability

Negative Real Interest Rates and the Risk Premium

with 20 comments

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.


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Written by Ashwin Parameswaran

May 12th, 2011 at 6:37 am

Posted in Monetary Policy

20 Responses to 'Negative Real Interest Rates and the Risk Premium'

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  1. “violent negative consequences for risky asset prices”
    I wonder if the risk is greater for real estate as opposed to equities?


    12 May 11 at 6:56 am

  2. vk – hard to say definitively but residential real estate for many is more than an investment which should mean less risk. But in places where its being bought just as an investment property, it’s probably quite similar to equities.


    12 May 11 at 11:05 am

  3. Pushing real rates negative in a sense introduces risk to the previously risk free asset (the loss of purchasing power). It pushes investors to purchase other risk assets until the spread between their expected future returns and the expected future return of the previously risk free asset is restored. I wouldn’t say there is no risk premium. If the expected future return of stocks was say 6% when the expected future return of the risk free asset was 1% and subsequent Fed action reduces the expected future return of the risk free asset to -3%, one should expect stocks to rise until their future expected return is reduced to 2%. Shouldn’t the spread be relatively stable?

    Joe Calhoun

    12 May 11 at 11:42 am

  4. Joe – in my opinion (and it’s only my opinion), the price of stocks in your example would rise to a level that would make its future expected return closer to -3% than 2%. To me, the biggest component of the risk premium is the difference between a risk-free and a risky asset. When there is no risk-free asset to talk of, risk premiums collapse. To put it in behavioural terms, investors will accept a lower return for certainty, but they will not accept too much lower a return for a less uncertain payoff. When real rates are negative, different assets only differ in their relative uncertainty.

    Just to give you an idea of my thought process, I’m drawing on the behaviour of investors and common people in developing markets like India and China where negative real rates are common. The typical response is to invest most of one’s savings in real assets – real estate if one is “conservative” and equities etc if one is more adventurous.


    12 May 11 at 11:55 am

  5. Yes, I understand what you’re saying and you did note that the risk premium probably isn’t zero. On the other hand, US investors don’t seem to understand real interest rates and they sure don’t understand inflation. I know a lot of investors who are hanging onto their “risk free” assets for dear life. I live in Miami and interact a lot with Latin Americans. They understand exactly what inflation is and the effects. I guess Americans will figure it out eventually.

    Joe Calhoun

    12 May 11 at 12:22 pm

  6. Exactly! After a few years of negative real rates, bank deposits will start looking a lot less attractive.


    12 May 11 at 12:48 pm

  7. I’d argue that the risk premium is zero right now. the prospective 7-year real returns of all traditional financial asset classes is zero, and there is no incremental reward for taking on additional risk. this is a massive market distortion with unpredictable consequences. see John Hussman’s commentary last week:

    Jeremy Stark

    16 May 11 at 10:20 am

  8. Jeremy – Thanks for the link to Hussman’s commentary. I agree – the aim of this post was to tie this zero risk premium to the real rate environment. If nothing’s risk free, then what is a risk premium anyway?


    16 May 11 at 11:45 am

  9. a theoretical construct of no practical value. :) paradox of equities now is that they are priced with a zero risk premium, and yet for that very reason are much more “risky” (defined as probability of long-term capital loss) than they were, say, in 1981 or 1992. the Greenspan/Bernanke era has been a fantasia for asset prices & valuation; a complete disconnect from the rest of the history of asset-class behavior. and this exact moment is the weirdest yet.

    Jeremy Stark

    17 May 11 at 12:08 pm

  10. :-) I agree with you that this makes real assets that much more risky and in fact, the repricing risk is distinctly non-linear.

    Contrast this opinion with Bernanke’s opinion in the 2003 speech linked above: “easier monetary policy not only allows consumers to enjoy a capital gain in their stock portfolios today, but it also reduces the effective amount of economic and financial risk they must face.” He sees the reduction in risk premium and concludes that risk in investing in stocks reduces when monetary policy is easy! Incredible.


    17 May 11 at 4:04 pm

  11. This site has very interesting posts. Unusually, I find myself drawn into thought by the author’s writings but in quite heated opposition to some of the quotes referenced.

    For example, Ben Bernanke’s quote above: “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.”

    Someone like Ben Bernanke is devoted to understanding. As best as he can, he is a follower of the truth, and so the above quote can only be construed as a deliberate lie.

    Bernanke knows that “perceived risk” and “willingness” are not effects, not in epistemically sound sense. Perceived risk, and willingness, can only be infered on the basis of purchases and sales, and are therefore secondary to actual facts, not the cause of them.

    It evangelises the position that is really centric to the US model, that of freedom and choices made by autonomous agents. In a way, it is cynical and quite demeaning. To those who can see that the unscientific nature of such comments, they only serve to exaggerate the ideological nature of monetary policy in the USA: it doesn’t matter what happens, so long as you feel you are the one responsible for your actions and choices.

    Frank Sz

    19 May 11 at 3:31 pm

  12. There is plenty of evidence that sustained negative real rates increase equity risk premiums. This could be for a number of reasons. First, the “catastrophe” risk attached to an increase in real rates rises the longer an economy is addicted to negative real rates. Thus, the more QE, the higher the discount rate attached to l.t. corporate earnings. Second, high and variable inflation inevitably results from sustained negative real rates. Under high and variable inflation, l.t. corporate margins are virtually impossible to forecast: investment suffers, and real revenue growth stagnates. Third, governments inevitably intervene to dampen the adverse political effects of price distortions. The resulting price controls and complex taxation regimes are another weight on equity valuations.

    The real question is why most observers accept the view that equities should benefit from sustained negative real rates. The case where they do is limited to the early-in-the-recovery experience of rising profit margins and low inflation; however, this is not a sustainable source of profit growth (as input inflation inevitably claws back economic rents).

    David Pearson

    23 May 11 at 6:26 pm

  13. David – some interesting points.

    I think the catastrophe risk is being ignored given the perceived commitment from the central bank that they will step in if any such thing happens. Obviously this cycle does not end well but the combination of having a fiat currency and the reserve currency enables the United States to maintain this commitment for a lot longer.

    Inflation is suppressed and profit margins are maintained by the slack in the labour market which is a consequence of our crony capitalist system. If the extent of real rate suppression is limited, this can go on for a long time before the system breaks out.


    24 May 11 at 5:03 am

  14. Ashwin,

    I disagree with the, “this can go on for a long time” comment. The implication of flat wage growth is misunderstood. Yes, it restrains inflation; but it also puts the consumer between a rock (flat wages) and a hard place (rising commodity/import prices). Every time the Fed takes the consumer to this place, demand suffers and inflation expectations crash — we are experiencing this now. Without nominal wage growth, stimulus will not work. With it, we will have high and variable inflation. Either way, not a good situation for equities.

    In the long term, equities are a bet on organic real growth, and gold is a bet on stimulus-dependent nominal growth. (A caveat: at single-digit P/E’s, stocks should at least keep pace with inflation.)

    BTW, Brazil had plenty of crony capitalism, and large companies there earned robust rents primarily through financial speculation. Unfortunately, this did not help P/E’s much.

    David Pearson

    24 May 11 at 9:24 am

  15. BTW, in Brazil, the government responded to the “rock/hard place” problem by raising public salaries and subsidizing staple foods. In other words, both wage inflation and high deficits were required for monetary stimulus to produce nominal growth.

    David Pearson

    24 May 11 at 9:35 am

  16. David – again some excellent comments.

    You’re saying that real rate suppression without wage growth is unsustainable i.e. we end up in the Japan scenario where real rates turn positive despite the central bank’s efforts. I agree with this! My point was just that running this policy for a long time without risking demonetisation or high/variable inflation is possible. If I’m a saver and am losing 2% per annum by holding cash, it’s not clear that there’s any savings alternative out there that can help me avoid this “tax”. That was the point I was trying to make in my previous post .

    The only way to avoid the Japan scenario here is either increased leverage or increased fiscal deficits both of which are not an option right now.

    On your comment on Brazil, my contention is that we have a peculiar Anglo-Saxon “efficient” variant on cronyism which is different from the crony socialism of countries like Brazil and India pre-liberalisation .


    24 May 11 at 10:20 am

  17. Ashwin,

    Latin Americans made a science of avoiding the negative real rate “tax”. It is certainly possible for this psychology/capability to take hold here. I would argue that the dollar deval and commodity price run-up is evidence of that. Each time we begin to get this “tax avoidance” psychology, the Fed backs off stimulus. Each time they back off, we face deflation. This is not a stable corridor, but an unstable transition between two equilibria (deflation/inflation). My contention is that each round of stimulus produces a narrower “real recovery” duration between the two poles. The first stimulus lasted roughly from 2003 to 2007, the second one, IMO, lasted from 2q09 to 4q10. The third one (following QE3) is likely to have a much shorter effect on real growth. In the end, the Fed will have to choose between the piercing the upper or lower bounds of the too-narrow corridor.

    One does not need more private leverage or higher fiscal spending to create wage inflation. Just (implicitly) promise to monetize already-high projected deficits, and the rest will follow. This will probably happen in Greece as they re-adopt the Drachma.

    David Pearson

    24 May 11 at 11:57 am

  18. David – we agree that the more the psychology takes hold, the less effective this monetary policy will be.

    I agree with you on the narrowing corridor – I made an analogy a while ago that the effect will be like a shower that is either too hot or too cold. Which is kind of the oblique message that I was making in my river flood management post. Ultimately the commitment of constant inflation becomes untenable.

    My only addition would be that the forces have been building up for a long time. Build up of corporate surplus and lack of exploratory investment due to increased incumbent corporate power meant that growth and full employment could only be maintained with increased consumer leverage, increased govt spending and so on. Now we’re close to exhausting all the bullets.


    25 May 11 at 2:54 am

  19. “I’d argue that the risk premium is zero right now. the prospective 7-year real returns of all traditional financial asset classes is zero, and there is no incremental reward for taking on additional risk. this is a massive market distortion with unpredictable consequences.”

    Its not a massive market distortion. Markets exist to equalise yields subject to perceived differentials in risk premia.

    The way they do this when risk free assets earn an unwarranted postive nominal return is to bid up the price of other assets so risk adjusted yield equalises. The flip side of this is to increase debt until it reaches a maximum, at which point risk free yields hit zero and like ashwin says risk premia converge amongst other assets.

    The biggest single distortion in play here is risk free assets that generate a risk free real return. One cannot ‘declare a yield by fiat’ (essentially a yield on fictional assets represented only by numbers in a central bank computer) and expect that to be stable situation.

    What I am saying is, that peak debt is the only stable equilibrium for a fiat money economy, and that there is no other choice apart from a fiat money economy, or at least an economy based on other electronic media of exchange. Because nothing real can be sent down a wire, which a pre-requisite of a modern medium of exchange.


    9 Jun 11 at 3:23 pm

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    26 Nov 12 at 5:53 pm

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