Stock-Bond Return Correlation, Bond Risk Premium Fundamentals, and Fiscal-Monetary Policy Regime

54 Pages Posted: 20 Apr 2021

See all articles by Erica X. N. Li

Erica X. N. Li

Cheung Kong Graduate School of Business

Tao A. Zha

Federal Reserve Bank of Atlanta; Emory University

Ji Zhang

Tsinghua University - PBC School of Finance

Hao Zhou

SUSTech Business School; Tsinghua University - PBC School of Finance

Date Written: October 2020

Abstract

We incorporate regime switching between monetary and fiscal policies in a general equilibrium model to explain three stylized facts: (1) the positive stock-bond return correlation from 1971 to 2000 and the negative one after 2000, (2) the negative correlation between consumption and inflation from 1971 to 2000 and the positive one after 2000, and (3) the coexistence of positive bond risk premiums and the negative stock-bond return correlation. We show that two distinctive shocks—the technology and investment shocks—drive positive and negative stock-bond return correlations under two policy regimes, but positive bond risk premiums are driven by the same technology shock.

Keywords: stock-bond return correlation, consumption-inflation correlation, fiscal-monetary policy regime, bond risk premium, technology shock, investment shock

JEL Classification: G12, G18, E52, E62

Suggested Citation

Li, Erica X. N. and Zha, Tao A. and Zhang, Ji and Zhou, Hao, Stock-Bond Return Correlation, Bond Risk Premium Fundamentals, and Fiscal-Monetary Policy Regime (October 2020). Available at SSRN: https://ssrn.com/abstract=3829908 or http://dx.doi.org/10.2139/ssrn.3829908

Erica X. N. Li (Contact Author)

Cheung Kong Graduate School of Business ( email )

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One East Chang An Avenue
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Tao A. Zha

Federal Reserve Bank of Atlanta ( email )

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United States
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Emory University ( email )

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Ji Zhang

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

Hao Zhou

SUSTech Business School ( email )

1088 Xueyuan Avenue, Nanshan District
Southern University of Science and Technology
Shenzhen, Guangdong
China
+86-0755-88010464 (Phone)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengfu Road
Haidian District
Beijing, 100083
China
+86-10-62790655 (Phone)

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