Monetary Policy Drivers Of Bond And Equity Risks

John Y. Campbell

Harvard University – Department of Economics; National Bureau of Economic Research (NBER)

Carolin E. Pflueger

University of British Columbia (UBC) – Division of Finance

Luis M. Viceira

Harvard Business School – Finance Unit; National Bureau of Economic Research (NBER)

June 15, 2015

Harvard Business School Finance Working Paper No. 14-031


How do monetary policy rules, monetary policy uncertainty, and macroeconomic shocks affect the risk properties of US Treasury bonds? The exposure of US Treasury bonds to the stock market has moved considerably over time. While it was slightly positive on average over 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 develops a New Keynesian macroeconomic model with habit formation preferences that prices both bonds and stocks. The model attributes the increase in bond risks in the 1980s to a shift towards strongly anti-inflationary monetary policy, while the decrease in bond risks after 2000 is attributed to a renewed focus on output fluctuations, and a shift from transitory to persistent monetary policy shocks. Endogenous responses of bond risk premia amplify these effects of monetary policy on bond risks.

Monetary Policy Drivers Of Bond And Equity Risks – Introduction

In different periods of history, long-term US Treasury bonds have played very different roles in investors’ portfolios. During the Great Depression of the 1930s, and once again in the first decade of the 21st Century, Treasury bonds served to hedge other risks that investors were exposed to: the risk of a stock market decline, and more generally the risk of a weak macroeconomy, with low output and high unemployment. Treasuries performed well both in the Great Depression and in the two recessions of the early and late 2000s. During the 1970s and especially the 1980s, however, Treasury bonds added to investors’ macroeconomic risk exposure by moving in the same direction as the stock market and the macroeconomy. A number of recent papers including Baele, Bekaert, and Inghelbrecht (2010), Campbell, Sunderam, and Viceira (2013), Christiansen and Ranaldo (2007), David and Veronesi (2013), Guidolin and Timmermann (2006), and Viceira (2012) have documented these developments. These stylized facts raise the question what macroeconomic forces determine the risk properties of US Treasury bonds, and particularly their changes over time.

The contribution of this paper is twofold. First, we develop a model combining a standard New Keynesian macroeconomy with habit formation preferences. Bonds and stocks in the model can be priced from assumptions about their payoffs. Second, we use the model to relate changes in bond risks to periodic regime changes in the parameters of the central bank’s monetary policy rule and the volatilities of macroeconomic shocks, including a regime shift that we identify in the early 2000s. Since monetary policy in our model affects macroeconomic and risk premium dynamics, we capture both the direct and indirect effects of monetary policy changes.

Macroeconomic dynamics in our model follow a standard three-equation New Keynesian model. An investment-saving curve (IS) describes real equilibrium in the goods market based on the Euler equation of a representative consumer, a Phillips curve (PC) describes the effects of nominal frictions on inflation, and a monetary policy reaction function (MP) embodies a Taylor rule as in Clarida, Gali, and Gertler (1999), Taylor (1993), and Woodford (2001). A time-varying inflation target in the monetary policy rule captures investors’ long-term perceived policy target and volatility in long-term bond yields.

While we model macroeconomic dynamics as loglinear, preferences in our model are nonlinear to capture time-varying risk premia in bonds and stocks. As in Campbell and Cochrane (1999), habit formation preferences generate highly volatile equity returns and address the “equity volatility puzzle” one of the leading puzzles in consumption-based asset pricing (Campbell, 2003). In contrast to Campbell and Cochrane (1999), our preferences are consistent with an exactly loglinear consumption Euler equation, time-varying conditionally homoskedastic real interest rates, and endogenous macroeconomic dynamics. The model is overall successful at matching the comovement of bond and stock returns, while generating time-varying bond and equity risk premia.

By using a New Keynesian macroeconomic framework, in which price stickiness allows monetary policy to have real effects, we overcome some of the limitations of affine term structure and real business cycle approaches. One common approach to studying macroeconomic bond risks is to use identities that link bond returns to movements in bond yields, and that link nominal bond yields to expectations of future short-term real interest rates, expectations of future inflation rates, and time-varying risk premia on longer-term bonds over short-term bonds. Barsky (1989), Shiller and Beltratti (1992), and Campbell and Ammer (1993) were early examples of this approach. A more recent literature has proceeded in a similar spirit, building on the no-arbitrage restrictions of affine term structure models (Duffee and Kan 1996, Dai and Singleton 2000, 2002, Duffee 2002) to estimate multifactor term structure models with both macroeconomic and latent factors (Ang and Piazzesi 2003, Ang, Dong, and Piazzesi 2007, Rudebusch and Wu 2007). Although these exercises can be informative, they are based on a reduced-form econometric representation of the stochastic discount factor and the process driving inflation. This limits the insights they can deliver about the underlying macroeconomic determinants of bond risks.

Monetary Policy

Monetary Policy

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