Macroeconomic Drivers of Bond and Equity Risks

Abstract

Our new model of consumption-based habit generates time-varying risk premia on bonds and stocks from loglinear, homoskedastic macroeconomic dynamics. Consumers' first-order condition for the real risk-free bond generates an exactly loglinear consumption Euler equation, commonly assumed in New Keynesian models. We estimate that the correlation between inflation and the output gap switched from negative to positive in 2001. Higher inflation lowers real bond returns and higher output raises stock returns, explaining why the bond-stock return correlation changed from positive to negative. In the model risk premia amplify this change in bond-stock return comovement, and are crucial for a quantitative explanation.

Keywords: consumption-based habit formation; consumption Euler equation; time-varying risk premia; inflation dynamics; bond-stock correlation

JEL Classification: E3, E4, G12