Central Banks Are Hiding The True Price Of Risk

Authored by Thorstein Polleit via The Mises Institute,

If you invest your money, you will have to deal with numerous risks. For instance, if you buy a bond, you run the risk of the borrower defaulting or being repaid with debased money. As a stock investor, you face the risk that the company's business model will not live up to expectations, or that it, at the extreme, will go bankrupt. In an unhampered financial market, prices are formed for these and other risk factors.

For instance, a bond with a high default risk will typically carry a high yield. The same goes for debt denominated in an unsound currency. Stocks of companies that are deemed risky tend to trade at a lower valuation level than those considered low risk. All these risk premiums, if determined in the unhampered market, constitute a portion of an asset’s price, be it a bond or a share. They play a vital role in the way capital is allocated in an economy.

Risk premiums are meant to compensate investors for the risk of losses resulting from adverse developments. If you buy a stock at a depressed price relative to the firm’s earnings power, it tends to reduce your downside (while offering the chance of great gains). At the same time, risk premiums increase investors’ cost of capital. This, in turn, discourages them from engaging in overly risky investments.

Decline in risk premiums:


In other words, risk premiums determined in an unhampered market align the interests of savers and investors. Of course, one cannot be sure that ex ante risk premiums are always correct. Sometimes it turns out that risks were overestimated, sometimes they were underestimated. However, the unhampered market is still the best and most efficient means to determine the price of risk.

Central Banks Suppress Risk Premiums

Central banks, however, interfere and corrupt the best practice of the formation of the price of risk. In the last financial and economic crisis, central banks had lowered interest rates to unprecedented low levels and ramped up the quantity of (base) money to keep financially ailing governments and banks afloat and the economy going. In fact, they effectively put out a ‘safety net’, providing insurance to financial markets against potential systemic losses.

Decline in risk premiums:


By doing so, central banks have put investor risk aversion to sleep: Under their guidance, financial markets are now betting on, and have high confidence in, monetary policy makers successfully fending off any new problems in the economic and financial system. This seems to be the message the price action in financial markets is conveying to us. For instance, stock price fluctuations have returned to very low levels, accompanied by strong stock market gains and high valuations.

The yield spread of risky corporate bonds over US Treasuries has returned to levels last seen in early 2008. Or look at the prices for credit default insurance for bank bonds. They also have returned to pre-crisis levels, suggesting investor credit concerns have markedly declined. In other words, investors are back again, eagerly taking on additional credit risk and willingly financing corporates’ investments at suppressed costs of capital.

Central banks have thus not only artificially reduced interest rates by lowering credit costs, they have also artificially reduced risk premiums by (explicitly or implicitly) signaling to the financial markets that they are prepared to basically ‘do whatever it takes’ to prevent another meltdown as witnessed in 2008/2009. The consequence is that financial markets and economies depend on central bank action more than ever before.

There is no easy way out of this situation. If interest rates go up — be it through rate hikes or the elimination of the ‘safety net’ — the current recovery will most likely come to a halt, if it does not turn into a bust straight away: With higher interest rates, the economic structure, built on artificially low interest rates, would run into serious trouble. The idea of central banks ‘normalizing’ interest rates without output losses or even a recession appears illusionary at best.

Against this backdrop, it is interesting to see that, for instance, the US Federal Reserve and the European Central Bank (ECB) may want to bring short-term interest rates back up (further). At the same time, however, there is no evidence that monetary policymakers have any plans to remove the ‘safety net’ that has so successfully brought down risk premiums in asset markets and thus the cost of capital.

That said, even an increase of central banks’ short-term funding will not bring about a normalization of the cost of capital — as risk premiums will most likely remain artificially suppressed. Capital misallocation will continue and the artificial boom is kept alive and well. Investors, therefore, face quite a challenge: Malinvestments continue, and downside risks increase, while it might be too early to jump ship.



Batman11 Aug 11, 2017 2:22 PM Permalink

The Central Bankers strategy relied on trickle down, but it didn’t exist and inflation never picked up.Central Banks flooded the markets with liquidity to create a “wealth effect”.Central Banks waited nine years and found nothing had really trickled down; inflation was going nowhere.All the stimulus has gone into asset price inflation and artificially inflated asset prices will just crash when the liquidity supply dries up.The Central Banks have disproved the trickledown theory and set up the next crash.When the Central Bank liquidity dries up everything heads back to reality as the “wealth effect” wasn’t based on any underlying fundamentals.What they really should have done, was pump money into the real economy to boost that, which in turn would have lifted the markets.Unfortunately, they are supply side ideologues who relied on trickle down when the system trickles up.

Batman11 Batman11 Aug 11, 2017 2:25 PM Permalink

Where is the Adam Smith institute when you need it?It's always trickled up.Adam Smith:“The labour and time of the poor is in civilised countries sacrificed to the maintaining of the rich in ease and luxury. The Landlord is maintained in idleness and luxury by the labour of his tenants. The moneyed man is supported by his extractions from the industrious merchant and the needy who are obliged to support him in ease by a return for the use of his money. But every savage has the full fruits of his own labours; there are no landlords, no usurers and no tax gatherers.”It’s not just taxes that are the problem; there are the landlords and the usurers.The landlords and their rentsThe usurers and their interest payments, e.g. mortgages.  

In reply to by Batman11

Batman11 Batman11 Aug 11, 2017 2:37 PM Permalink

Capitalism aka "the money scam"We pay you to do the work and you give it back to us when you buy things, you live a bare subsistence existence and we take the rest (profit).There would be just enough there to keep everyone on board and those at the top could skim off nearly all the surplus to live in luxury and leisure.The money scam for extracting the surplus forms the basis of capitalism and quite a few early companies had a company shop where wages had to be spent to ensure there was no leakage into the pockets of others.

In reply to by Batman11

Kickaha Aug 11, 2017 10:02 AM Permalink

"...financial markets are now betting on, and have high confidence in, monetary policy makers successfully fending off any new problems in the economic and financial system."Well, why not remain confident?  All "emergency measures" applied in 2008 remain in place.  This market, as well as all of the other asset bubbles, can remain in place until Central Banks around the world own all of the bonds, all of the stocks, and all of the real estate.  It is easy to buy up everything when you have the right to print all of the fiat currency you feel you need to "stabilize the financial system" for "the benefit of the citizenry".  While I hope and pray that the crash will come soon and therefore leave some vestige of civilization behind when it does, I don't think we are close to the point yet where the central banks have bought up everything with fiat, operating mostly in secrecy, nor are we near the point where people have realized what is happening and started any meaningful process, if there is one, to politically stop it from continuing. The ZH article that ran earlier this week about the Fed saving the financial world via currency swaps, was a bit startling.  As I understood it, it was basically analogous to a con man kiting checks to maintain the impression he was a man of means.  I imagine there are other ways these financial magicians can continue to flood the financial system with liquidity and keep their maneuvers out of the public eye.Why should the Chinese pull the plug on their printers until they have exchanged fiat renmimbi for all of the gold in the universe?  And as long as the Chinese keep printing, all of the other CBs feel compelled to join in the race to the bottom to prevent even worse trade imbalances.Yes, the bull market has to end some day, but predicting exactly when is extremely hard to say as long as the buyers of last resort keep buying, even after everybody else had exited the markets.

LawsofPhysics Aug 11, 2017 9:46 AM Permalink

That is because money creation by bankers/financiers no longer requires REAL COLLATERAL OR FACING REAL RISK (the fuckers keep getting a BAILOUT no matter how badly they behave)!!!!!!!!!!!!!!! Damn it, where is Hank "tanks in the streets" Paulson to explain it all to you fuckers... The death of all FIAT or WWIII is going to happen before the "markets" collapse.  That is unless people start taking heads...In the meantime..."Full Faith and Credit"

FreeNewEnergy Aug 11, 2017 9:20 AM Permalink

While everything else was down Friday in Asia and EuroDisneyland, the Nikkei was basically flat (down like nine points). So, if Japan isn't taking the Nork-US war of words seriously, why should anybody else?This little market turmoil is just a warmup for the fireworks when congress comes back from vacation and begins to pretend to deal with the debt limit and federal budget. Mid-September to late October should be berrrrrry interesting.

onthedeschutes yogibear Aug 11, 2017 9:48 AM Permalink

I wonder...Since the FED is not audited...what's to stop them, and the rest of it's foreign central bank counterparts, from using newly printed fiat to purchase crypto's?  It would not take that much money to buy up enough to cover an entire days float.  And it is non-traceable.  They can then cause flash crashes at will with the intention of eroding confidence.  Heads they win, tails we lose.

In reply to by yogibear

eclectic syncretist shizzledizzle Aug 11, 2017 9:29 AM Permalink

A good day to be out and have a nice long weekend is more like it.If this were a top you could expect to see heightened volatility, with prices going both up and down almost randomly (but with a slight downside trend) for at least a month or two before any seriously sustained sell-off. For now, a massive move in any direction would be a harbinger of darker days to come for what they call a "market".

In reply to by shizzledizzle