Low risk premiums - watch out

History has not dealt kindly with the aftermath of protracted periods of low risk premiums.
- Alan Greenspan, 2005

Risk premia and volatilities are unusually low precisely when risk is highest. What looks like low risk is, in fact, a sign of aggressive risk-taking.
-Claudio Borio

Risk premiums are low and that should be a concern for anyone who invests in financial markets. For that matter, Main Street will also be affected by low risk premiums because we know that declines in financial markets will have spill-over wealth effects on the rest of the economy. The one thing that has been clear since the Financial Crisis is that liquidity and market frictions will hit the real economy. The financial channel affects real growth. The assumptions of most macro models prior to the Financial Crisis were that banking and finance constraints did not play a strong role. We now know differently.

Risk premiums are time varying and mean reverting. Greater risk premium will only be received through prices adjusting downward to make assets more attractive. Risk premiums will rise in response to higher volatility and bad consumption states. As the lower volatility state moves higher, price will react. Of course, we cannot predict when this will happen or what will be the catalyst. We do know that transitions in states are painful.