Carolin E. Pflueger Slides

Monetary Policy Drivers of Bond and Equity Risks

John Y. Campbell, Carolin Páueger, and Luis M. Viceira

Harvard Economics, UBC Sauder, and HBS

Q Group, October 2015

Treasuries are Hedges

• We have become used to the idea that US Treasury bonds are hedges:

› Asset class gained in value during global Ã-nancial crisis
› Negative beta with stocks since 2000

• When economy weakes

› Ináation falls
› Real interest rates decline
› Investors ìáee to qualityî into Treasuries and out of stocls

• All three factors drive up prices of Treasuries

› And the last two drive up prices of TIPS

But This is New

• The past 15 years are highly unusual

• In earlier decades, Treasuries had positive beta with stocks

• In the 1980s in particular, when the economy weakened

› Ináation rose
› Real interest rates rose
› Flight to quality was into cash or commodities, and out of both stocks and Treasuries

• All three factors drove down the prices of Treasuries

› And the last two would have driven down TIPS (which had not yet been issued)

Changing Risks of Treasuries Changing Risks of Treasury Bonds


Why Does This Matter? (1)

The ability of Treasuries to hedge economic and equity risks has huge implications for investors

• Treasuries hedge stocks in endowment portfolios

Reduces portfolio volatility for all-long long-term investors

• Equity investing is riskier for pension funds with long-term liabilities

› Stocks will do poorly at the same time as interest rates decline
› The ìperfect stormî of underfunding
› “Over the past decade, the correlation fo stocks and bonds has remained persistently negative (causing big problems for pension funds that are essentially long stock and short bonds)î ñBridgewater Associates LP, 2013

• We should see e§ects on bond risk premia (Campbell, Sunderam, and Viceira 2015)

Why Does this Matter? (2)

The ability fo Treasuries to hedge economic and equity risks has huge implications for investors

• Corporations issuing long-term nominal debt are taking on extra risk (Kang and Páueger,Journal of Finance 2015)

› During recession, ináation declines so real burden of debt increases just as real earnings decrease
› Defaults are likely just when Treasuries are doing particularly well

• We should see e§ects on corporate bond spreads

Ináation Risk and Corporate Bonds (Kang-Páueger)


Ináation Volatility and Corporate Credit Spreads (K-P)


Consequences for Investors Ináation Cyclicality and Corporate Credit Spreads (K-P)


Macroeconomic Sources of Changing Risks

• What has caused this change in bond risks? Two hypotheses:

1 Changes in macroeconomic shocks
2 Changes in monetary policy

Campbell, Páueger, and Viceira (2015) uses a structural macroeconomic model to disentangle these effects

Model Overview

• Expanded version of modern New Keynesian macro model

› Like the standard model, it produces dynamics of di§erence between output and potential output (output gap), ináation, and Fed Funds rate (monetary policy instrument)
› Habit formation as in Campbell and Cochrane (1999) endogenously generates countercyclical asset return volatility and risk premia, needed to Ã-t movements in bond and stock prices

• Why a New Keynesian framework?

› It allows ináation to a§ect the real economy and hence carry a risk premium
› It allows monetary policy to have real e§ects

Building Blocks of New Keynesian Macroeconomics

• A New Keynesian framework has three building blocks:

› A description of consumersíbehavior that links output and real interest rates in equilibrium: the Investment and Savings (IS) curve.
› A description of Ã-rmsíprice-setting behavior that links ináation and output in equilibrium: the Phillips Curve (PC).
› A description of the Fedís procedure for setting interest rates: the Monetary Policy (MP) rule.

• I will spare you the details except for the monetary policy rule.

Fed Behavior: Monetary Policy Rule


Fed Behavior: Long-Run Ináation Target


Fed Behavior: What Do the Parameters Mean?


Monetary Policy Regimes

Break date tests indicate three monetary policy regimes.

• Pre-Volcker period (1960.Q2-1977.Q1):

› Accommodation of ináation.

• Volcker – early Greenspan period (1977.Q2-2000.Q4):

› Aggressive counter-ináationary policy (Clarida, Gali, and Gertler 1999).

• Late Greenspan – Bernanke period (2001.Q1-2011.Q4):

› Coincides with end of great economic expansion of 1990s.
› Renewed focus on Ã-ghting recessions.
› Fed acts much more gradually.
› May be related to new emphasis on transparency and forward guidance.

Monetary Policy Regimes and Bond Beta


Model Modeling Monetary Policy


How the Shocks Move the Economy

• Our model has three shocks and three regimes.
• Shocks are PC (supply), MP (short-term monetary), and ináation target (long-term monetary).
• Regimes are 60.Q2-77.Q1 (blue), 77.Q2-00.Q4 (green), 01.Q4-11.Q4 (red).
• We show ìimpulse responsesî, initial e§ects and subsequent adjustment paths.





Impulse Response Functions: PC and MP Shocks

• Inflationary PC shock has a persistent inflationary and contractionary effect:

› Stock prices fall as a result of a persistent decline in dividends and output and an increase in the equity risk premium.
› Bond prices fall as a result of persistent inflation; an aggressive anti-inflationary central bank reaction (Paul Volcker) adds to this decline.
› Positive impact on nominal bond beta is strongest in the Volcker period.

• MP shock acts raises nominal and real short-term interest rates and causes a recession:

› Stock and bond prices both fall.
› Positive effect on nominal bond beta is largest in the third sub period where MP shocks are persistent.

Impulse Response Functions: Inflation Target Shocks

• Inflation target shocks have a permanent but delayed impact on inflation and create a temporary boom.

• Stock prices rise in response to higher dividends and lower risk premia.

• Nominal bond prices fall due to higher expected inflation.

• Inflation target shocks have a negative effect on the nominal bond beta.

Putting It Together: Monetary Policy Matters


Why Has the Bond Beta Changed Over Time?

• Anti-inflationary US monetary policy stance after 1977 (Paul Volcker) increased nominal bond beta:

› Large increase in Fed funds rate in response to inflation shock.
› Increase in Fed Funds rate depresses output, stock prices, and bond prices.

• Negative nominal bond beta in 2000s due to

› Smaller supply shocks.
› Renewed Fed focus on recessions.
› Inflation target shocks (which may represent changes in investors’ expectations of future Fed actions).

What About Flight to Quality?

• Flight to quality cannot by itself explain the change in bond risks.

• If bonds are seen as risky (moving in the same direction as stocks), then áight to quality hurts bonds and stocks together, amplifying the positive bond beta.

• If bonds are seen as hedges (moving opposite stocks), then áight to quality hurts stocks but helps bonds, amplifying the negative bond beta.

• Flight to quality is an ampliÃ-cation mechanism (built into the CPV model), but cannot be the whole story.

International Bond Betas Implications for International Debt Portfolios

(Du, Páueger, and Schreger 2015)

• Mostly negative bond betas in developed markets, but huge dispersion in bond betas across emerging markets

• Governments with credible monetary policy should be better able to tap local currency (as opposed to USD) bond markets, thereby lowering default risk

• If bond betas indicate central bankís ability to credibly communicate future actions

› We should see international bond-stock betas related to availability of local currency bonds
› We should see international bond-stock betas related to sovereign default risk

International Bond Betas International Bond Betas and CDS Spreads


Asset Class Risks Are Not Stable

• Asset allocation exercises often treat the risks of asset classes as stable, even if the expected returns are thought to vary over time.

› Use of very long-run historical data to estimate these risks.

• In the case of Treasuries, this practice is dangerous.

› Bond risks have moved over time and depend on macroeconomic shocks and the stance of monetary policy.
› While there is no reason to expect any immediate change, investors must keep a careful eye out for a change in the bond beta back towards the historical norm.
› You canít count on Treasuries!

• Similar principles apply to many other asset classes such as commodities and real estate.


Campbell, John Y., Carolin Páueger, and Luis Viceira, 2015, “Monetary Drivers of Bond and Equity Risks”, unpublished paper, Harvard University and University of British Columbia.

Campbell, John Y., Adi Sunderam, and Luis Viceira, 2013, “Ináation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds”, unpublished paper, Harvard University.

Clarida, Richard, Jordi Gali, and Mark Gertler, 1999, “The Science of Monetary Policy: A New Keynesian Perspective”, Journal of Economic Literature 37, 1661-1707.

Du, Wenxin, Carolin Pflueger, and Jesse Schreger, “Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy”, unpublished paper, Federal Reserve Board, University of British Columbia, and Harvard Business School.Kang, Johnny and Carolin Pflueger, 2015, “Inflation Risk in Corporate Bonds”, Journal of Finance 70, 115-162.

Taylor, John B., 1993, “Discretion versus Policy Rules in Practice”, Carnegie-Rochester Conference Series on Public Policy 39, 195-214.