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«MONETARY POLICY DRIVERS OF BOND AND EQUITY RISKS John Y. Campbell Carolin Pflueger Luis M. Viceira Working Paper 20070 ...»

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John Y. Campbell

Carolin Pflueger

Luis M. Viceira

Working Paper 20070



1050 Massachusetts Avenue

Cambridge, MA 02138

April 2014

We are grateful to Alberto Alesina, Fernando Alvarez, Yakov Amihud, Gadi Barlevy, Robert Barro, Charlie Bean, Paul Beaudry, Philip Bond, Mikhail Chernov, George Constantinides, Alexander David, Ian Dew-Becker, Adlai Fisher, Ben Friedman, Lorenzo Garlappi, Joao Gomes, Joshua Gottlieb, Gita Gopinath, Robin Greenwood, Lars Hansen, Christian Julliard, Anil Kashyap, Ralph Koijen, Howard Kung, Leonid Kogan, Deborah Lucas, Greg Mankiw, Lubos Pastor, Harald Uhlig, Pietro Veronesi, Michael Woodford, conference and seminar participants at the University of British Columbia, the Bank of Canada, Universidad Carlos III, the University of Calgary, the University of Chicago, the Chicago Booth Finance Lunch Seminar, the Federal Reserve Bank of Chicago, the Federal Reserve Bank of New York, the Harvard Monetary Economics Seminar, the 2013 HBS Finance Research Retreat, IESE, LSE, LBS, the University of Miami, MIT Sloan, NYU Stern School, the Vienna Graduate School of Finance, ECWFC 2013, PNWCF 2014, the Jackson Hole Finance Conference 2014, the ASU Sonoran Winter Finance Conference 2014, the Duke/UNC Asset Pricing Workshop, the Monetary Policy and Financial Markets Conference at the Federal Reserve Bank of San Francisco, the Adam Smith Asset Pricing Workshop, the SFS Cavalcade 2014, and especially our discussants Jules van Binsbergen, Olivier Coibion, Gregory Duffee, Martin Lettau, Francisco Palomino, Monika Piazzesi, Rossen Valkanov, and Stanley Zin for helpful comments and suggestions. We thank Jiri Knesl and Alex Zhu for able research assistance. This material is based upon work supported by Harvard Business School Research Funding and the PH&N Centre for Financial Research at UBC. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.

NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

© 2014 by John Y. Campbell, Carolin Pflueger, and Luis M. Viceira. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Monetary Policy Drivers of Bond and Equity Risks John Y. Campbell, Carolin Pflueger, and Luis M. Viceira NBER Working Paper No. 20070 April 2014, Revised April 2015 JEL No. E43,E44,E52,G12

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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.

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Carolin Pflueger Sauder School of Business University of British Columbia 2053 Main Mall Vancouver, BC, V6T 1Z2 Canada carolin.pflueger@sauder.ubc.ca

A data appendix is available at:

http://www.nber.org/data-appendix/w20070 1 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 1 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 2 (Duffie 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.

A more ambitious approach is to build a general equilibrium model of bond pricing. Real business cycle models have an exogenous real economy, driven by shocks to either goods endowments or production, and an inflation process that is either exogenous or driven by monetary policy reactions to the real economy. Papers in the real business cycle tradition often assume a representative agent with Epstein-Zin preferences, and generate time-varying bond risk premia from stochastic volatility in the real economy and/or the inflation process (Song 2014, Bansal and Shaliastovich 2013, Buraschi and Jiltsov 2005, Burkhardt and Hasseltoft 2012, Gallmeyer et al 2007, Piazzesi and Schneider 2006). Some papers instead derive time-varying risk premia from habit formation in preferences, with or without stochastic macroeconomic volatility (Ermolov 2015, Bekaert, Engstrom, and Grenadier 2010, Bekaert, Engstrom, and Xing 2009, Buraschi and Jiltsov 2007, Dew-Becker 2013, Wachter 2006). Under either set of assumptions, this work allows only a more limited role for monetary policy, which determines inflation (at least in the long run) but has no influence on the real economy.2 Our model is most closely related to a recent literature exploring the asset pricing implications of New Keynesian models. Recent papers in this literature include Andreasen (2012), Bekaert, Cho, and Moreno (2010), Van Binsbergen et al (2012), Dew-Becker (2014), Kung 2 A qualification to this statement is that in some models, such as Buraschi and Jiltsov (2005), a nominal tax system allows monetary policy to affect fiscal policy and, through this indirect channel, the real economy.

3 (2015), Li and Palomino (2014), Palomino (2012), Rudebusch and Wu (2008), and Rudebusch and Swanson (2012). While this literature has begun to focus on the term structure of interest rates, an integrated treatment of bonds and stocks, especially with risk premia not driven by counterfactually extreme heteroskedasticity in macroeconomic fundamentals, has so far proved elusive.3 We use our model to quantitatively investigate two candidate explanations for the empirical instability in bonds’ risk properties: changes in monetary policy or changes in macroeconomic shocks. In this way we contribute to the literature on monetary policy regime shifts (Andreasen 2012, Ang, Boivin, Dong, and Kung 2011, Bikbov and Chernov 2013, Boivin and Giannoni 2006, Chib, Kang, and Ramamurthy 2010, Clarida, Gali, and Gertler 1999, Palomino 2012, Rudebusch and Wu 2007, Smith and Taylor 2009). While this literature has begun to focus on the implications of monetary regime shifts for the term structure of interest rates, previous papers have not looked at the implications for the comovements of bonds and equities as we do here. Our structural analysis takes account of various channels by which the monetary policy regime affects the sensitivities of bond and stock returns to macroeconomic shocks, including endogenous responses of risk premia.4 Both US monetary policy and the magnitude of macroeconomic shocks have changed substantially over our sample from 1960 to 2011. Testing for break dates in the relation between the Federal Funds rate, output, and inflation, we determine three distinct monetary policy regimes. The first regime comprises the period of rising inflation in the 1960s and 3 In contrast, several papers have used reduced-form affine or real business cycle models to provide an integrated treatment of bonds and stocks (Ang and Ulrich 2012, Bansal and Shaliastovich 2013, Bekaert, Engstrom, and Grenadier 2010, Ermolov 2015, Koijen, Lustig, and Van Nieuwerburgh 2010, Campbell 1986, Campbell, Sunderam, and Viceira 2013, d’Addona and Kind 2006, Dew-Becker 2013, Eraker 2008, Hasseltoft 2009, Lettau and Wachter 2011, Wachter 2006).

4 Song (2014), in a paper circulated after the first version of this paper, considers bond-stock comovements in a model with exogenous real dynamics.

4 1970s, while the second one covers the inflation-fighting period under Federal Reserve Board chairmen Paul Volcker and Alan Greenspan. The third regime is characterized by renewed attention to output stabilization and smaller, but more persistent, shocks to the monetary policy rule. If central bank policy affects the macroeconomy through nominal interest rates, it is natural to think that these significant changes in monetary policy should change the risks of bonds and stocks.

The nature of economic shocks has also changed over time, with potentially important implications for bond risks. While oil supply shocks were prominent during the 1970s and early 1980s, they became less important during the subsequent Great Moderation. In our model, Phillips curve shocks act as supply shocks, leading to high inflation recessions. Nominal bond prices fall with rising inflation expectations, while stock prices fall with recessions, so Phillips curve shocks move bonds and stocks in the same direction and give rise to positive nominal bond betas. In contrast, credible shocks to the central bank’s long-term inflation target, or equivalently persistent shocks to the monetary policy rule, reduce the beta of nominal bonds. A downward drift in the perceived target drives down inflation and induces firms with nominal rigidities to reduce output. Consequently, a negative target shock raises the value of nominal bonds just as equity prices fall, decreasing the stock-market beta of nominal bonds.

Figure 1 shows a timeline of changing US bond risks, together with estimated monetary policy regimes, and oil price shocks from Hamilton (2009). We estimate monetary policy break dates using data on the Federal Funds rate, the output gap (the gap between real output and potential output under flexible prices), and inflation.5 The statistically determined dates 1977Q2 and 2001Q1 line up remarkably closely with changes in bond betas and institu


5 For details on the econometric procedure, see Section 3.

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