Macquarie Bank's Mark Tierney talks to Michael Pascoe

Mark Tierney: Just in the last two weeks, financial markets have started to show a sense that perhaps they’ve taken it [reducing risk margins] too far. Now a good example of that is in the United States. The swap spread, basically long-term interest rate borrowing for the private sector versus the Government sector, what is the spread between those two interest rates? It’s started widening just two weeks ago and it’s now risen to its highest level since May last year, for example. Now that’s still relatively low but it’s quite a significant turnaround in a relatively short period of time.

Michael Pascoe: Can you put the risk premium in plain English, always a hard question for an economist?

MT: Well basically the risk-free rate is what the governments can borrow at. They’re obviously the most creditworthy borrowers in the world. Then you have the whole spectrum of borrowers above that. You go into important corporates: they can borrow relatively cheaply; up until junk bonds, for example '” corporates that are not rated so highly '” and you have a whole spectrum of what people are prepared to pay. Now the most important thing is the swap spread because that is essentially what banks can borrow at. When you see that moving, this is not something to do with a junk bond or a company that is bankrupt; this is the heart of the financial system: what they can borrow at '” how much they have to pay above what a government can borrow at, and that’s exactly what’s started to move in the past couple of weeks.

MP: Well when that risk premium had virtually disappeared, what was it saying for investors?

MT: It was saying that investors were prepared to take a very small risk for investing, for example, in a security that is not issued by a government. A private sector security, for example, a fixed interest private sector security. And they say that, 'OK, we’re prepared to borrow and just for example to invest at 40 basis points above a 10-year government bond inside the United States. Now that’s extremely low. There have been times where it’s been double that but up until recently it’s been quite clear that investors have been prepared '” because they believe there is so little alternative '” they’ve been prepared to invest at a very low spread above what the government can borrow for.

MP: So they’re really not being paid very much for taking a risk.

MT: No And the main thing is there’s lack of alternatives. When they look around the world, investors have seen that spreads are low everywhere; interest rates are low everywhere. And when you get interest rates so low, it’s amazing how people then will grab any opportunity they can to even get a small increase above what they can get somewhere else for example.

MP: Does it also push them into taking bigger risks to get a decent return?

MT: Well they have to take risk. When you basically push credit spreads down so low you are taking risk because obviously governments are risk free for all intents and purposes. As you go along the risk spectrum, you have to take greater and greater risk. The fact is people are prepared to take that risk, they’re being forced into taking that risk; there’s very little choice. The alternative, of course, is that you are investing in securities, such as government issued securities, which are at 40-year lows and that increases the appetite for risk.

MP: Does that lack of much of a risk premium make any sense?

MT: It does and the reason it makes sense is because it is a by-product of central bank policy of the past five years. I mean it was only just over a year ago, for example, that official interest rates in the United States were at 1%. At the moment in Japan they’re zero. In Europe they’re 2%. The world is being flooded with excess liquidity by the central banks and that’s been going on for many years. This is probably the greatest expansion of central bank liquidity that we’ve seen for decades. There have been very few episodes where we’ve had interest rates at this level and sustained at this level for so long. Investors are basically being forced to invest in assets that they probably would never have considered five years ago, but just the pressure of central banks and the way they’ve conducted monetary policies, has forced investors to accept the risk. And that, of course, is exactly how monetary policy works. Central banks push rates down, they force investors to take risk and that’s how you get economic growth coming back again.

MP: So what happens next?

MT: The central banks are starting to express concern about the risk appetite. In America, for example, the Federal Reserve has expressed some concern about mortgage lending and the type of products now being offered. The European Central Bank has made it very clear they are concerned about the derivative market for example. They’re looking at these issues. The big risk, however, which is now being imposed on them is that all of a sudden they’re no longer certain that rising oil prices necessarily are going to crush economic growth. For the first time I think we’ve seen for several years, central banks are starting to come to the conclusion that perhaps there will be inflationary consequences of a high oil price.

MP: Well what does that do to the average investor’s portfolio?

MT: They’re not going to try and crush economies. No one’s got an interest in slower economic growth. What they want to do is just tell investors that, 'Look you do not want to take so much risk. We are going to lift interest rates'. At some point in time it will slow growth. If you’re investing in risky assets typically they don’t do as well when economic growth slows a little bit.

MP: The risk premium starts to get built back into debt markets, what do you expect to be the kick on for equity markets?

MT: Equity risk premium at the moment is relatively low. By that I mean that if you look at the gap between the earnings in the equity market and what you can get in the risk-free government bond in a number of countries, it’s still quite wide. That’s certainly true inside the United States. It's less true in Australia, but in the United States if you did a normal calculation of your assumed earnings in the equity market for the next few years and what you can earn in a government bond, the spread is quite wide, which basically says that equities are still cheap on that basis. So I don’t think there’s any reason to expect equity markets to be crushed under those conditions.
However, it’s more important on a sectoral basis, I think, and we’ve seen this since the middle of the year in the United States. Sectors which had been running very very hard '” the home builders, the banks, the retailers, for example '” from July to just recently, they had been hit very hard. Now some of them have started to bounce again. I think that’s partly because the optimism is coming back that, 'OK, while the economy might slow it’s not disastrous. Clearly there was a marked change there, I think, and that’s a sectoral change, whereas other stocks such as the resource and mature companies, had still done very well. I think their conclusion is not so much a general hit to the equity market but a re-allocation between sectors inside the equity market. I think this is the most likely outcome.

MP: So a more rational approach to risk within equities?

MT: I think that’s probably true. Now that’s always difficult for financial markets. Everyone loves the rising tide lifting all boats. Unfortunately, when you’ve got central banks getting a bit nervous, that very rarely happens. No one wants all the boats sinking but there will be a couple that spring leaks.