Seminar by Quentin Vandeweyer (London Business School)

The fiscal foundation of safe assets

Abstract: Government bonds hedge equities in some countries and periods and not in others. We show that the difference depends systematically on the government's fiscal position. In a consumption-based model with sovereign default risk, a heavier fiscal burden raises stock-bond comovement, because bad news then raises default risk more than it lowers the risk-free rate. In a panel of 44 advanced and emerging economies since 1960, stock-bond comovement rises with a country's forward interest expense, our measure of its fiscal burden. It accounts for a quarter of the cross-country variation in average correlations and predicts the correlation within countries. A quasi-experiment in the euro area, where countries share one monetary policy, corroborates this result: after the Greek deficit revision in 2009, correlations in the periphery rose by 0.44 relative to the core. Two text-based measures of fiscal news predict the correlation in the same direction. Within countries, the relationship runs through the credit component of the yield. The safe-asset status of government bonds therefore has fiscal foundations: it is not acquired once and for all and can be lost when the fiscal burden rises.