Borel Ahonon

Federal Reserve Bank of New York Staff Reports no. 1187

We propose a macro-finance model in which inflation, growth, and the policy rate are driven by unobservable long-run trends and transitory cycles that investors must infer from aggregate data. Their subjective estimates of these trends, and the uncertainty surrounding them, are priced into the Treasury yield curve in a tractable way through both interest rate expectations and bond risk premia. Empirical estimates reveal an upward smooth trend in the long-run real interest rate (r-star) until the 1980s, and large investor uncertainty with confidence bands as wide as 3.4 percentage points, contrasting with the volatile rate implied by perfect information models.

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.

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.