Global financial cycles and risk premiums

Òscar Jordà, Moritz Schularick, Alan Taylor, Felix Ward 25 June 2018



The Global Crisis highlighted the need for an evolution in macroeconomic thinking. In addition to the urgency to integrate banking and finance into the basic architecture of macroeconomic models, one could add that there is also fundamental need to understand the financial cycle and its interplay with the business cycle. But is there a financial cycle at all? And if so, how has its operation in the global economy evolved?

Although the comovement of real variables has been extensively studied in the literature, attention has increasingly shifted toward studying the financial cycle. More specifically, Bruno and Shin (2014), Cerutti et al. (2014), and Obstfeld 2014 document a sharp increase in global financial synchronizstion over the past two decades.

In a recent paper (Jordà et al. 2018) we analyse global financial cycles over the past 150 years across a sample of 17 advanced economies. An important innovation in our analysis is that, for the first time, we now have long-run data on credit growth, as well as house and equity prices. These data have been made only recently available by Jordà et al. (2017) and Jordà et al. (2016).

Financial comovement: The facts

A simple way to assess common movements in credit, house prices, and equity prices internationally is to calculate 15-year rolling window correlation coefficients. Figure 1 shows that harmonisation in financial cycles has risen substantially over time. The comovement of credit and equity markets is at a historical peak today, with correlation coefficients of about 0.4 and 0.8 respectively. Our findings complement recent research by Bruno and Shin (2014), Cerutti et al. (2014), and Obstfeld (2014) by using a much longer time series. Particularly notable is the rise in equity price correlation. Since the 1990s, this correlation has continued to increase, now reaching near perfect global integration, and far exceeding the correlation in equity prices during the declines associated with the Great Depression.

Abstracting from bouts of house price comovement associated with WWI and WWII housing busts, international house prices are also generally more correlated today than in previous decades. However, since the Global Crisis, global house prices have increasingly diverged, slowing down the increasing synchronisation of recent years. Overall and to varying degrees, the comovement in credit, house prices, and equity prices is higher now than in previous decades. In this sense it is possible to speak about a global financial cycle among developed economies.

Figure 1 Average bilateral financial cycle correlation

Note: Spearman rank correlation coefficients based on 15-year rolling windows. 2 to 32-year period Baxter-King detrended series. Bars – 95% cross-sectionally block-bootstrapped confidence bands.

Understanding global equity market comovements

Why have equity prices become increasingly correlated across markets starting in the 1990s? We investigate the mechanisms that may explain this phenomenon by decomposing equity prices into two components. The first component describes how a risk-neutral investor would value equities based on the stream of future dividends discounted by future risk-free rates.1What remains primarily describes an investor’s ability and willingness to hold risk. These two components are useful approximations based on traditional asset pricing concepts. Thus, we label the first component the ‘risk-neutral price’,and the second component ‘risk appetite’.Obviously, riskappetiteis a summary term that comprises a diverse range of forces, such as risk aversion, consumption habits, the ability of intermediaries to supply credit, as well as investor sentiment, to cite a few. Using each of these two components, we then ask how much of the comovement in equity prices is due to comovements in dividends and risk-free rates, and how much is due to the synchronisation of riskappetite based on our broad definition.

Figure 2 shows that until the 1990s the comovement in equity prices was mostly accounted for by the comovement in the risk-neutral price component. Starting in the 1990s, however, it is the synchronisation in the riskappetite component that increasingly binds together equity prices among advanced economies.And it is difficult to overstate how dramatic that increase is when seen against the last 150 years of the history of modern finance.

Figure 2 Average bilateral equity price correlation

Note: Spearman rank correlation coefficients based on 15-year rolling windows. 2 to 32-year period Baxter-King detrended series. Bars – 95% cross-sectionally block-bootstrapped confidence bands.

Monetary policy and the synchronisation of risk taking

What might explain the increasing synchronisation of risk appetite across global equity markets? A popular view, often embraced by practitioners in financial markets, is that monetary policy in global financial centres (in particular the US Federal Reserve) plays an important role in explaining risk-taking in international financial markets. 

One way to assess this view is to examine how global equity prices react to a +1 percentage point (ppt) innovation in financial centre policy rates. We again distinguish between the risk-neutral price response of dividends and risk-free rates versus the response of equity prices themselves. The difference between these two responses measures the degree to which global risk appetite responds to financial centre monetary policy. Our measure for the financial centre policy rate is the US short-term rate after 1947, and the UK short-term rate prior to 1914. Between WWI and WWII, we use the average of US and UK short-term rates instead.

Does financial centre monetary policy act as a driver of global risk appetite? Figure 3 provides the answer. The left panel shows the full sample results, while the middle and right panels focus on the two eras of financial globalisation: before 1914, and after 1980. 

Our first result is that the response of equity prices has become stronger over time. The international response to a +1 ppt interest rate hike in the financial centre has almost doubled from the full sample average of about -4% to the post-1980 trough of -8%. Furthermore, the negative response has grown more persistent. Importantly, the implied risk-neutral equity price, calculated from the dividend and risk-free rate responses, suggests that dividend and risk-free rate responses explain only about 25% of the post-1980 equity price response over four years. Fluctuations in risk appetite are by far the most important driver, accounting for three quarters of the response.

By contrast, before 1914, equity markets reacted to rate changes much as would be expected from a risk-neutral investor perspective. Equity prices declined in response to a +1 ppt increase of the policy rate of the Bank of England, but there is no major impact above and beyond the risk-neutral path. Thus, monetary policy in financial centres have become an important driver of global risk taking and this is a new and recent phenomenon. Possible explanations for why this is the case include changes in monetary policy practices, a more prominent role of leveraged financial intermediaries, dollar funding markets, and global banks in the world economy today.

Figure 3 Response of global equity markets to +1 ppt centre rate hike

Note: Cumulative impulse response functions to +1ppt increase in financial centre interest rates. Risk-neutral – risk neutral price. Centre rate – financial centre (UK and/or US) short-term risk-free rate. Confidence bands calculated on the basis of Driscoll-Kraay standard errors.

Flexible exchange rates are not a perfect insulator 

Risk-appetite spillovers of US monetary policy are substantial. Do floating exchange rates help countries avoid such spillovers? Floating exchange rates are thought to insulate domestic interest rates from foreign interest rates (Obstfeld et al. 2004, 2005). But it is unclear whether this insulation generalises to risk premiums and risk appetite more generally (Rey 2015). It is natural to ask the extent to which floating exchange rates effectively decouple domestic financial conditions from substantial comovements in risk appetite. To address this question, we analyse the response of global equity prices to financial centre policy rate innovations conditional on a country’s exchange rate regime.

The top half of Table 1 shows the international responses of equity prices for the full sample. The equity price response tends to be stronger for countries whose exchange rate is pegged to the USD, or pegs. Over the full sample, equity prices are down by 3% in year 1, while there is no significant response among economies that allow their exchange rate to freely float, or floats. A test for equality of the impulse responses confirms that historically, the response to centre-country monetary policy changes has been significantly more pronounced for pegs.

The bottom half of Table 1 shows the post-WWII subsample results. As our previous results show, this is the period when risk premium spillovers were strongest. We find that for the post-WWII sample the peg-float dichotomy is somewhat less stark. Equity prices for floats now also show a response to centre-country interest rate changes, but on a smaller scale. Pegs on average still exhibit a much stronger response, based on point estimates. However, in this smaller sample, the precision of these estimates is weaker, and the difference between the two responses is no longer statistically significant. In sum, the transmission effects are stronger for fixed exchange rate regimes, but they are still sizable for floats.

Table 1 Exchange rate regime and equity price response

Note: Standard errors in parentheses. * p < 0.10, ** p < 0.05, *** p < 0.01. Wald test for equality of peg and float responses.


Based on our long-run analysis of financial cycle synchronisation among advanced economies, we find that the comovement in total lending, house prices, and equity prices has reached historical highs over the past few decades. The post-1980 increase in equity price comovement is particularly notable. Importantly, the post-1980 synchronisation of equity prices cannot be easily accounted for by the behaviour of dividends or risk-free rates, but instead must be attributed to other factors. Here we have summarised such other factors under the label risk appetite, which includes factors, such as time variation in investor sentiment, or financial frictions.

What explains these evolving patterns? Monetary policy in financial centre countries is one of the common drivers of global financial conditions, and thus one of the potential explanations for international financial comovement. Our analysis of the international spillover effects of financial centre monetary policy shows that the influence of US monetary policy on international equity markets has increased over the 20th century to levels never before experienced. Furthermore, a large part of the increasing influence of US monetary policy on international equity markets cannot be accounted for by its increasing influence on international dividends and risk-free rates, but instead must be attributed to the other factors summarised here as risk appetite. Although the transmission of financial centre monetary policy is more muted in floating rate regimes, floating exchange rate regimes do not fully insulate an economy from fluctuations in riskappetite across global equity markets.


Bruno, V, and H S Shin (2014), “Cross-border banking and global liquidity”, Review of Economic Studies 82(2): 535–564. 

Cerutti, E, S Claessens, and L Ratnovski (2014), “Global liquidity and drivers of cross-border bank flows”, IMF Working Paper 14/69.

Jordà, O, M Schularick, A M Taylor, and F Ward (2018), “Global financial cycles and risk premiums”, CEPR Discussion Paper 12969

Jordà, O, K Knoll, D Kuvshinov, M Schularick, and A M Taylor (2017), “The rate of return on everything, 1870-2015”, CEPR Discussion Paper 12509.

Jordà, O, M Schularick, and A M Taylor (2016), “Macro financial history and the new business cycle facts”, NBER Macroeconomics Annual 31(1): 213–263.

Obstfeld, M (2014), “Trilemmas and trade-offs: Living with financial globalization”, BIS Working Paper 480.

Obstfeld, M, J C Shambaugh, and A M Taylor (2004), “Monetary sovereignty, exchange rates, and capital controls: The trilemma in the interwar period”, IMF Staff Papers 51(1): 75–108. 

Obstfeld, M, J C Shambaugh, and A M Taylor (2005), “The trilemma in history: Tradeoffs among exchange rates, monetary policies, and capital mobility”, Review of Economics and Statistics 87(3): 423–438.

Rey, H (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, Proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyo., August 23–24, 2013, pp. 285–333.




Topics:  Financial markets Macroeconomic policy

Tags:  global financial cycles, risk premiums, asset markets

Federal Reserve Bank of San Francisco and UC Davis

Professor of Economics, University of Bonn and CEPR Research Fellow

Professor of Economics and Finance, University of California, Davis; Research Fellow, CEPR

PhD student, Department of Economics, University of Bonn


CEPR Policy Research