18 Oct 2013Working Paper Summaries

Monetary Policy Drivers of Bond and Equity Risks

by John Y. Campbell, Carolin E. Pflueger and Luis M. Viceira

Given the importance of nominal bonds in investment portfolios, and in the design and execution of fiscal and monetary policy, financial economists and macroeconomists need to understand the determinants of nominal bond risks. This is particularly challenging because the risk characteristics of nominal bonds are not stable over time. In this paper the authors ask how monetary policy has contributed to these changes in bond risks. They propose a model that integrates the building blocks of a New Keynesian model into an asset pricing framework in which risk and consequently risk premia can vary in response to macroeconomic conditions. The model is calibrated to US data between 1960 and 2011, a period in which macroeconomic conditions, monetary policy, and bond risks have experienced significant changes. Findings show that two elements of monetary policy have been especially important drivers of bond risks during the last half century. First, a strong reaction of monetary policy to inflation shocks increases both the beta of nominal bonds and the volatility of nominal bond returns. Positive inflation shocks depress bond prices, while the increase in the Fed funds rate depresses output and stock prices. Second, an accommodating monetary policy that smooths nominal interest rates over time implies that positive shocks to long-term target inflation cause real interest rates to fall, driving up output and equity prices, and nominal long-term interest rates to increase, decreasing bond prices. The paper shows empirical evidence that the Fed monetary policy followed an anti-inflationary stance after 1979, but it has moved to a more accommodating, nominal interest rate smoothing policy since the mid 1990's. Consistent with the predictions of the model, the first period corresponds to a period of average positive Treasury-bond beta and stock-bond correlation, and the second period to a period of average negative bond beta and stock-bond correlation. Overall, results imply that it is particularly important to take account of changing risk premia. Key concepts include:

This paper contributes to scholarship on monetary policy regime shifts exploring the implications of monetary policy regimes for asset values and the co-movement of stock and bond returns.
In different periods of history, long-term Treasury bonds have played very different roles in investors' portfolios. During the 1970s and particularly the 1980s, for example, Treasury bonds added to investors' macroeconomic risk exposure by moving in the same direction as the stock market and real output growth, while since the mid-1990's Treasury bonds have provided investors with protection against deflation risk by moving in the opposite direction as the stock market and output growth.
These authors' model allows for a detailed exploration of the monetary policy drivers of bond and equity risks.
The increase in bond risks after 1979 is attributed primarily to a shift in monetary policy towards a more anti-inflationary stance.
The more recent decrease in bond risks after 1997 is attributed primarily to an increase in the persistence of monetary policy interacting with continued shocks to the central bank's inflation target.

Author Abstract

The exposure of U.S. Treasury bonds to the stock market has moved considerably over time. While it was slightly positive on average in the period 1960-2011, it was unusually high in the 1980s and negative in the 2000s, a period during which Treasury bonds enabled investors to hedge macroeconomic risks. This paper explores the effects of monetary policy parameters and macroeconomic shocks on nominal bond risks, using a New Keynesian model with habit formation and discrete regime shifts in 1979 and 1997. The increase in bond risks after 1979 is attributed primarily to a shift in monetary policy towards a more anti-inflationary stance, while the more recent decrease in bond risks after 1997 is attributed primarily to an increase in the persistence of monetary policy interacting with continued shocks to the central bank's inflation target. Endogenous responses of bond risk premia amplify these effects of monetary policy on bond risks.