Flights to Safety, Volatility Risk, and Monetary Policy

Abstract

I propose a novel explanation for the flight to safety in the cross-section of assets, based on volatility risk. I argue that investors seek the safety of Treasuries because they correlate positively with volatility surprises. Conversely, they flee risky assets such as stocks, because they correlate negatively. This dynamic results in a negative stock-bond return correlation. The significant role of volatility is further evidenced through a structural VAR model that interlinks volatility, the real economy, and monetary policy. Consequently, volatility can serve as a valuable instrument in guiding monetary policy during turbulent times, and should be considered a leading economic indicator.

Keywords: Volatility, market stress, flights to safety, monetary policy, cross-section of stocks and Treasuries, structural VAR model

JEL Classification: C21, C22, E52, G12