Members of the NBER's Asset Pricing Program met April 10 on Zoom. Research Associates Andrea L. Eisfeldt of University of California, Los Angeles and Stijn Van Nieuwerburgh of Columbia University organized the meeting. These researchers' papers were presented and discussed:
Anna Cieslak and Hao Pang, Duke University
Common Shocks in Stocks and Bonds
Cieslak and Pang propose a new approach to identifying economic shocks from asset prices. Their identification disentangles monetary news, growth news as well as pure risk-premium shocks on any day from the variation in the stock market and the Treasury yield curve. The researchers use this approach to analyze news content of macroeconomic announcements and channels through which the Fed affects asset prices. Cieslak and Pang document a pronounced effect of the Fed on risk premiums that dominates the conventional monetary news channel. About 70% of the average positive stock returns earned over the FOMC cycle stem from the Fed-induced reductions in risk premiums. They further explain the puzzling fact that stocks but not bonds earn high returns on FOMC days. As bonds hedge growth risk in stocks, Fed-induced reductions in the value of the bond insurance premium offset any gains, making overall bond returns on FOMC days economically small. Overall, since the early 1980s, conventional monetary news accounts for less than 10% and 20% of the variation in the ten-year yield and the aggregate stock market, respectively. The results suggest that the Fed has a significant effect on long-term assets through its ability to directly affect the risk premiums.
Itamar Drechsler, University of Pennsylvania and NBER, and Alexi Savov and Philipp Schnabl, New York University and NBER
The Financial Origins of the Rise and Fall of American Inflation
Drechsler, Savov, and Schnabl propose and test a new, entirely different explanation for the defining macroeconomic event of the post-war era, the Great Inflation of the 1970s. Their theory is that inflation rose (fell) because of the imposition (repeal) of hard ceilings on bank deposit rates under the law known as Regulation Q. Deposits were a critical form of household savings, so their ceilings kept the real return earned by savers very low even as the Fed raised the funds rate. This spurred demand, driving up inflation, and further decreasing the real deposit rate. The upwards spiral was broken, and monetary transmission restored, when the ceilings were finally lifted at the end of the 1970s. Consistent with their theory, Drechsler, Savov, and Schnabl document that the timing of the rise and fall in national inflation lines up closely with changes in Regulation Q and their enormous impact on deposit rates and quantities. Using detailed local data on deposit markets and inflation they also analyze the cross-sectional relationship between deposit ceilings and local inflation during four time periods in which there is geographic variation in the degree to which Regulation Q was binding. The researchers find that the imposition and repeal of Regulation Q can fully explain the magnitude and timing of the rise and fall of the Great Inflation. Drechsler, Savov, and Schnabl conclude that a severe friction in the financial system--not the particulars of the Fed's policy rule--was responsible for the rise and fall of American inflation.
Yang Liu, University of Hong Kong; Lukas Schmid, Duke University; and Amir Yaron, University of Pennsylvania and NBER
The Risks of Safe Assets
US government bonds exhibit characteristics often attributed to safe assets. A long literature documents significant convenience yields in scarce US Treasuries, suggesting that rising Treasury supply and government debt comes with a declining liquidity premium and a fall in firms' relative cost of debt financing. Liu, Schmid, and Yaron empirically document and theoretically identify a dual role for government debt and novel fiscal cost. Through a liquidity channel an increase in government debt improves liquidity and lowers liquidity premia by facilitating debt rollover, thereby reducing credit spreads. Through an uncertainty channel, however, rising government debt creates policy uncertainty, raising default risk premia. They interpret and quantitatively evaluate these two channels through the lens of a general equilibrium asset pricing model with risk-sensitive agents subject to liquidity shocks, in which firms issue defaultable bonds and the government issues tax-financed bonds that endogenously enjoy liquidity benefits. The calibrated model generates quantitatively realistic liquidity spreads and default risk premia, and suggests that rising government debt reduces liquidity premia, but crowds out corporate debt financing and investment, and creates endogenous tax volatility, reflected in higher credit spreads, risk premia, and consumption volatility. Therefore, increasing safe asset supply can be risky, and come at a significant fiscal cost.
Lubos Pastor, University of Chicago and NBER; Robert F. Stambaugh, University of Pennsylvania and NBER; and Lucian A. Taylor, University of Pennsylvania
Sustainable Investing in Equilibrium (NBER Working Paper 26549)
Pastor, Stambaugh, and Taylor present a model of investing based on environmental, social, and governance (ESG) criteria. In equilibrium, green assets have negative CAPM alphas, whereas brown assets have positive alphas. Green assets' negative alphas stem from investors' preference for green holdings and from green stocks' ability to hedge climate risk. Green assets can nevertheless outperform brown ones during good performance of the ESG factor, which captures shifts in customers' tastes for green products and investors' tastes for green holdings. The latter tastes produce positive social impact by making firms greener and shifting real investment from brown to green firms. The ESG investment industry is at its largest, and the alphas of ESG-motivated investors are at their lowest, when there is large dispersion in investors' ESG preferences.
Mathias Kruttli and Brigitte Roth Tran, Federal Reserve Board, and Sumudu W. Watugala, Cornell University
Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics
In this paper, Kruttli, Roth Tran, and Watugala isolate and estimate extreme weather uncertainty. Their framework identifies market responses to the uncertainty regarding both potential hurricane landfall and subsequent economic impact. Stock options of firms with establishments exposed to the landfall region exhibit large increases in implied volatility of up to 30 percent, reflecting impact uncertainty, which persists up to four months after landfall. Using hurricane forecasts, Kruttli, Roth Tran, and Watugala find both landfall uncertainty and expected impact uncertainty are reflected in option prices before landfall. Their findings show the significant costs to hedging extreme weather uncertainty and have important implications for assessing the economic effects of extreme weather.
Antonio Coppola, Harvard University; Matteo Maggiori, Stanford University and NBER; Brent Neiman, University of Chicago and NBER; and Jesse Schreger, Columbia University and NBER
Redrawing the Map of Global Capital Flows: The Role of Cross-Border Financing and Tax Havens (NBER Working Paper 26855)
Global firms finance themselves through foreign subsidiaries, often shell companies in tax havens, which obscures their nationality in aggregate statistics. Coppola, Maggiori, Neiman, and Schreger associate the universe of traded securities with their issuer's ultimate parent and restate bilateral investment positions to better reflect the true financial linkages connecting countries around the world. They find that private capital flows from developed countries to firms in large emerging markets are dramatically larger than previously thought. The national accounts of the United States, for example, understate the U.S. position in Chinese firms by nearly $600 billion, while China's official net creditor position to the rest of the world may be overstated by as much as 50 percent. Coppola, Maggiori, Neiman, and Schreger additionally show how taking account of offshore issuance is important for their understanding of the currency composition of external liabilities, the nature of foreign direct investment, and the growth of financial globalization.