Risk, Asset Pricing and Monetary Policy Transmission in Europe: Evidence from a Threshold-VAR approach

This paper investigates in how far monetary policy shocks impact European asset markets, conditional on different risk states. It focuses on four different asset classes: equity of industrial firms, equity of banks, high-grade corporate bonds, and high-yielding corporate bonds. We distinguish between macroeconomic risk, political risk, and financial risk. In a first step, we separately extract three factors via principal component analysis from a set of candidate variables that are assumed to be driven by these latent types of risk. Next, these factors augment a threshold-VAR model that contains assets and a short-rate. Our model is estimated with Bayesian techniques and identified recursively. We illustrate that during periods of severe crisis, different risk regimes coincide. This impedes a clear delimitation among these three types of risk. Further on, impulse responses show that we indeed see state-dependency in the reaction of asset prices to monetary policy shocks. AA-rated corporate bond yields only show minor state-dependency if we distinguish between states of high and macroeconomic or financial risk, but show very pronounced state-dependency for political risk. Their sensitivity to monetary policy shocks is highest if political risk is . Non-investment-grade corporate bond yields as well as equity of industrial firms face the strongest state-dependency when we differentiate between macroeconomic or financial risk. If these risks are high, junk bond yields are very sensitive to monetary policy shocks while the opposite holds for equity of industrial corporations. Surprisingly, financial equity in general reacts positively or insignificant to hikes in short-rates. The positive reaction is most pronounced for states of high financial risk. As a consequence, monetary policy transmission via distinct asset markets highly depends on the degree of these different kinds of risk inherent in European asset markets. This also has strong implications for investors: they have to be aware of this varying degree of sensitivity of asset prices to changes in policy rates as they highly depend on the respective prevailing risk-regime.