Precautionary Savings and the Stock-Bond Covariance

Abstract

I show that the precautionary savings motive can account for high-frequency variation in the stock-bond covariance. An increase in the price of risk lowers risky asset prices on account of an increase in risk premia; it lowers bond yields on account of the precautionary savings component. Consequently, a price of risk shock moves risky and safe asset prices in the opposite direction. Times when the price of risk is volatile see a more negative stock-bond covariance. I demonstrate that a model calibrated to match the equity risk premium fits well the recent evidence on stock-bond covariance. Empirically, I show that stock-bond covariance co-moves with credit spreads and can predict excess returns on risky bonds and on bond-like stocks. The calibrated model underlines the first-order effect of risk compensation on safe rates.