Sandy LaiHong Kong University

http://www.sandylai-research.com1

Asset Allocation and Monetary Policy: Evidence from the Eurozone

Harald HauUniversity of Geneva and SFI

http://www.haraldhau.com

Motivation

Did low real interest rates contribute to the build-up of risk leading up to the financial crisis?

Rajan (2006, 2010); Borio and Zhu (2008); Adrian and Shin (2010)

Risk-Taking Channel of Monetary Policy Banks: lowering credit standards at low real short rates (e.g.,

Maddaloni and Peydro, 2011) Household risk taking in real estate (e.g., Taylor, 2008) Investor risk taking in the stock market (our focus)

Asset price inflation as a side effect of an excessively accommodating monetary policy

© Harald Hau, University of Geneva and Swiss Finance Institute 2

Identification Challenges

Hypothesis: A decrease in the real rate (nominal rate minus inflation) creates more risk seeking and inflates asset prices

Endogeneity of monetary policy: Use deviations of the real rate from eurozone average to identify local monetary policy conditions

Endogeneity of inflation rate: Use instruments, use controls and segment local fund flows by investment destination of the fund

Risk seeking measurement: Interpret fund flow as revealed change about firm cash flow expectations or risk tolerance

Quantification of the asset price effect: Compare flow sensitive stocks to non-investable stock

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Eliminate Endogeneity of Nominal Rate

Both monetary policy and portfolio investment react to changing economic conditions

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Examine real rate variations orthogonal to monetary policy: Cross-sectional real rate variations within a currency union are (by construction) exogenous to monetary policy

Follows Maddaloni and Peydro (2011)

Fund Flows as Revealed Preference Change

How to measuring local investor risk choices? Home bias in fund investment: German investors mostly invest

through German funds, etc. Inflow into equity fund and outflow from money market fund represent increase in

investor risk taking

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Use Lipper fund data: Eliminate Belgium,

Ireland, and Luxemburg (large share of non-local investors)

Aggregate Analysis: 8 countries with fund in- outfows using data from 4,939 equity funds and 1,441 money market funds

Investable and Non-Investable Stocks

How to measure effect on equity prices? Identify equity fund inflows and use flow-return relationship.

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Study return effect relative to a local benchmark of the 20% most flow-insensitive stocks (LFHI =Low Fund Holding Index)

LFHI stocks should still be subject to discount rate changes, but not to local risk shifting into stocks.

Econometric Digression

Dynamic Panel Problem: Fund flows have serial correlation; Country fixed effects for flows

LSDV estimator: Fitting fixed effects does not give a consistent estimator for small T.

“Difference” GMM: Use lag 2 or higher for y, lag 1 or higher for x.

“System” GMM: add eq. Use differenced instruments orthogonal to the fixed effect, Δy, Δx. More efficient, but Δy, Δx ┴ θ.

Source: David Roodman: “How to do xtabond2”

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Equity Fund Flows (Table 3)

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LSDV: Biased in small T samples

GMM: Use lagged values as instruments.

Results for DGMM and SGMM similar

Lowering the real short rate SR by 10 bps implies a 1% higher contemporaneous local equity fund inflows (and 1.4% permanent effect).

Money Market Fund Flows (Table 4)

© Harald Hau, University of Geneva and Swiss Finance Institute 9

Same aggregate flow persistence as for equity funds

Weaker evidence that looser monetary policy conditions (ΔSR<0) correlates with money market fund outflows

Causality Issues: Is ΔSR the Flow Trigger?

Local short rate decrease ΔSR (= local inflation ΔP>0) is a result of positive AD and negative AS shocks

Equity flows could directly react to the positive AD shocks that also increase GDP and firm profitability.

© Harald Hau, University of Geneva and Swiss Finance Institute 10

AD Price A S

GDP

Causality Issues: Is ΔSR the Flow Trigger?

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TEST 1: Control for GDP growth and ΔROA directly.

Both variables are better proxies for macroeconomic shocks than ΔSR under nominal rigidities

TEST 2: Use only funds that invest mostly in foreign equity.

Cash flow shocks of foreign stocks are less likely to correlate with the inflation rate (and real short rate) of the fund’s domicile.

Base Model

With Add. Controls

Foreign Focus

Similar Flow Sensitivity to Real Rate Changes

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Cash flow channel: Fund flows into fund with different investment destination should show different real rate sensitivity

Risk seeking channel: Similar real rate sensitivities are predicted for flows across investment destinations

Robustness to Expected Short Rate Proxy

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More Robustness

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Low real rates impact stock returns through A lower discount rate (discount rate effect) Additional equity inflows (flow effect)

Estimated flow effect in a simultaneous equation model: Eq.1: Identify equity flows that are triggered by ΔSR.

We can further relate to lagged changes of short term real interest rates. Small terms in with k>1 are ignored.

Equity Return Impact of Flows

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Equity Return Impact of Flows

Eq.2: Estimate flow effect on the return difference between flow sensitive and flow insensitive stocks:

(Assume constant flow impact γ)

Substitution gives second equation:

with constraints:

© Harald Hau, University of Geneva and Swiss Finance Institute 16

Equity Return Impact of Flows

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Results for the flow equation are not much changed simultaneous equation approach

Differential return effect (flow effect) is economically large: 10bp lower SR implies a 2% return increase

Equity Return Impact of Flows

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Home bias re-enforces link between local monetary policy conditions and equity return impact.

The equity flow effect more than doubles: 10bp lower SR implies a 4% return increase

Summary

Lower real short rates are associated with investor reallocation from money market funds to equity funds.

Fund flows reflect either changing firm cash flow expectations (cash flow channel) or change in risk aversion (risk seeking channel); identical flow sensitivity across investment destinations is evidence for the latter

Equity flows from loose monetary policy conditions have a large return effect, particularly in countries with greater home equity bias

Risk seeking channel is Archilles’ heel of the currency union

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