The Fiscal Foundations of Safe Assets
Government bonds are often viewed as a hedge against stock market losses. But does weaker fiscal capacity erode this role? Prof. Quentin Vandeweyer, from London Business School, and colleagues examine this question using data from 44 countries from 1960 to 2026.
Why do some government bonds hedge equity risk while others do not? We argue that the answer lies in sovereign fiscal sustainability. A simple model of fiscal limits points to interest expense relative to GDP as the relevant statistic. When it is low, bonds appreciate in equity downturns; when high, sovereign credit risk links stocks and bonds, and both decline together. We test this in a panel of 44 countries from 1960 to 2025: a one-standard-deviation increase in interest expense (2.2 percentage points) raises the stock-bond correlation by 0.10. The mechanism runs through sovereign credit risk, not the inflation regime emphasized in prior work: the credit-risk component of the fiscal burden dominates the default-free component. In the euro area, monetary policy and the inflation target are common across countries, and stock-bond correlations diverge with fiscal positions.
