Central Banks’ Crusade Against Risk

Since the latest, the crisis in 2008/2009, central banks around the world have been doing their best to expel risks from financial markets. By lowering interest rates, fixing them at extremely low levels, or issuing more credit and money, monetary policymakers make sure that ailing borrowers are kept afloat. In fact, central banks have put a “safety net” under the economies and the financial markets in particular. As it seems, this measure has been working quite effectively over the last ten years or so.

Investors do no longer fear that big borrowers – be it big governments or big banks and big corporates – could default, as evidenced by the low credit spread environment. Liquidity in basically all important credit market segments is high, and borrowers experience no trouble rolling over their maturing debt. What is more, stock market valuations have continued to increase, significantly propped up by central banks’ easy monetary policy. For low-interest rates help drive stock prices and their valuation levels up.

Artificially suppressed interest rates lead to higher present values of firms’ discounted future profits. Furthermore, the decline in credit costs tends to increase corporate profits, thereby also boosting stock prices and their valuations. By no means less important, the low-interest rate regime has caused firms’ capital costs to go down, encouraging additional investment activity, which is stoking investor optimism and feeding a buoyant stock market.

(Click on image to enlarge)

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As a measure of risk perception, figure 1 shows a “financial market stress indicator”, together with the price-earnings ratio of the US stock market. From eyeballing the series, one can easily see that, since around 2009, the PE ratio has been rising considerably, while risk perception, as measured by the financial market stress indicator, has gone down substantially and has been hovering at relatively low levels since around the middle of 2014. The message of the chart is, therefore: Risk down, stock valuations up.

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