Essays in Monetary Economics and International Finance
The rapid rise of U.S. interest rates over the past year has important implications for firms' borrowing costs and investment decisions, for global financial stability and the U.S. dollar exchange rate, and for investors' pricing of the U.S. safety premium across asset classes. These three themes are, respectively, the subject of the three chapters of this thesis. They are bound together by a focus on the role of (U.S.) monetary policy for financial intermediation and asset pricing.
Chapter 1, Firm Financial Conditions and the Transmission of Monetary Policy, is co-authored with Thiago Ferreira and John Rogers. We investigate how a firm's investment response to monetary policy depends on its financial conditions, finding a major role for its excess bond premium (EBP)--the component of its credit spread in excess of default risk. Strikingly, while monetary policy easings compress credit spreads more for firms with higher EBPs--i.e. for firms faced with tighter financial conditions--it is lower-EBP firms that invest more. We rationalize these findings with a model in which lower-EBP firms have flatter marginal benefit curves for capital, reflecting their more-resilient investment prospects. Consistent with our model, we show that the pass-through of monetary policy to aggregate investment depends on the distribution of firm EBPs, which varies over time.
Chapters 2 and 3 study different aspects of the relationship between monetary policy and the U.S. dollar's safe-haven status. In Chapter 2, entitled Tails of Foreign Exchange at Risk (FEaR), I investigate this relationship during periods of severe stress in global financial markets (disasters). I first develop a model in which the unwinding of carry trades by speculators and a flight-to-liquidity by hedgers jointly determine exchange rate dynamics in disasters. Reflecting these two forces, the dollar experiences an amplified appreciation against high-interest-rate currencies in disasters, and a dampened depreciation, or even an appreciation, against low-interest-rate ones. I then test these predictions by assessing the relative importance of interest differentials and Treasury liquidity premia for explaining the tails of both the exchange rate distribution and the distribution of speculators' and hedgers' portfolio positions. Overall, my analysis quantifies the extent of, and substantiates a mechanism for, the dollar's safe-haven status in disasters.
In Chapter 3, U.S. Risk and Treasury Convenience, which is co-authored with Giancarlo Corsetti, Simon Lloyd and Emile Marin, we investigate whether U.S. monetary policy has eroded the U.S.'s safety premium over time and across asset classes. We first document that, over the past two decades, investors in equity markets revised-up their assessment of U.S. risk relative to other advanced economies, driven by perceptions of greater long-run risk. Analytically, we use a no-arbitrage framework to link U.S. relative long-run risk, which we infer from bond and equity premia, to long-run exchange-rate risk and the convenience (liquidity) premium on long-maturity U.S. Treasuries. Taking theory to the data, we find that an increase in U.S. long-run risk leads to a persistent fall in the long-run convenience of U.S. Treasuries, in line with a (perceived) worsening of U.S. fundamentals. Further, we show that expansionary (unconventional) U.S. monetary policy induces both an increase in U.S. long-run risk and a decrease in the Treasury premium. Overall, our results suggest that the rise and fall, respectively, of U.S. long-run risk and long-maturity Treasury convenience yields over the past 20 years may be two sides of the same coin and may be the consequence of easy U.S. monetary policy.