Zeroing In: Asset Pricing Near the Zero Lower Bound

Abstract

This paper analyzes the effect of the Zero Lower Bound (ZLB) on asset prices, risk premia, and the co-movement of asset returns using a New Keynesian framework with nominal rigidities. I find that the presence of the ZLB generates a new source of macroeconomic risk: the risk that the ZLB will be binding in the future. When the monetary policy rate is high, stocks and bonds are both risky, and bond risk premia are high. In contrast, at the ZLB, stock market risk increases but bond risk decreases. When the probability of the ZLB binding in the near future increases, investors cut spending to increase savings. This lowers current and future output and dividends. Lower expected dividends and higher equity risk premia lower current stock prices. Simultaneously, investors expect future short rates and bond risk premia to drop which raise long-term bond prices. These opposite exposures to the same ZLB risk sharply lower the correlation between stock and bond returns. In fact, the stock-bond correlation turns negative. I develop and calibrate a model that endogenously generates these observed changes while respecting unconditional macroeconomic and asset pricing moments.