Borel Ahonon

I examine the effects of domestic and U.S. inflation on sovereign credit risk. Using monthly data for twenty-three advanced economies between 2001 and 2022, I document that domestic inflation raises sovereign CDS spreads, whereas U.S. inflation lowers them. These opposite effects operate mainly through investors’ expectations of sovereign default rather than risk premia. The negative association between U.S. inflation and sovereign credit risk reflects a “good inflation” channel, where price increases arise during periods of stronger economic activity and lower default probabilities. In contrast, domestic inflation signals tighter monetary policy and weaker fiscal prospects, heightening concerns about debt sustainability.

This paper assesses the informativeness of the Treasury yield curve about the long-run real interest rate, r-star, when bond investors are uncertain about its value. We propose a macro-finance model where inflation, growth, and the monetary policy rate are driven by a combination of persistent trends and transitory cycles. Investors only observe the aggregate macroeconomic variables but infers trends and cycles to price bonds. In spite of imperfect information, our model preserves the simplicity of standard affine term structure models. Our estimation reveals wide investors uncertainty about r-star that does not disappear over time, and an increasing r-star trend before the Volcker era, largely contrasting with perfect information estimates. Because investors confuse trends with cycles, the yield curve can under or overreact to structural monetary policy shocks.

How are sovereign credit risk and exchange rate related? How does the difference in credit default swaps (CDS) spreads on the same entity but denominated in different currencies, i.e. quanto spread, arise? I empirically document a negative contemporaneous relationship between sovereign credit risk and exchange rate and a positive predictability of exchange rates by quanto CDS spreads. I then propose an international macrofinance model in which the level, volatility, and term structure of quanto spread are driven by a rare disaster risk with time-varying probability and its contagion effect. These features of quanto spread depend on the correlation of cross-country expected consumption volatilities and present a trade-off: an upward term structure of quanto spread and a strong negative contemporaneous relationship lead to a negative predictability relationship and exceedingly high exchange rate volatility.