Investor sentiment, volatility and cross-market illiquidity dynamics: A threshold vector autoregression approach

This paper discusses the role that stock market volatility plays in the linkages between the U.S. stock and Treasury bond markets through liquidity under different regimes of investor sentiment in a threshold vector autoregression model. The baseline analysis shows that the interaction between volatility and illiquidity dynamics coincides with the flight-to-safety phenomenon. Moreover, the empirical evidence in the high investor sentiment regime points to the potential existence of flight-from-maturity where market participants tend to shorten their lending maturities for precautionary purposes. This result is robust under either an exogenously or an endogenously chosen investor sentiment threshold value. Further analysis verifies this relationship in the period after the Global Financial Crisis (GFC) and finds evidence of flight-from-maturity in the medium-term and the short-term bond markets. Finally, this paper finds that an adverse stock market volatility shock increases the probability of moving from a high sentiment to a low sentiment regime. This probability gets higher in the post-GFC era.