Asset safety switches: macroeconomic consequences
A Banca d'Italia working paper develops a model-based definition of time-varying sovereign bond safety and applies it empirically. The study constructs a news-based index (FLY) to measure global safe-asset demand and identifies 'safety switches' in bond classifications.
The shifting safety landscape
The paper introduces a novel concept of time-varying sovereign bond safety, arguing that an asset's perceived safety can fluctuate with significant macroeconomic implications.
It constructs a news-based 'flight-to-safety index' (FLY) to empirically measure global demand for safe assets.
This index captures flight-to-safety episodes, the global savings glut, and declines in natural interest rates.
The study finds that the global set of safe assets has shrunk since the Great Recession, while the safety of US assets has increased.
The research detects regime switches in FLY loadings, classifying bonds as safe, neutral, or risky.
Positive switches, where an asset becomes safe, align with economic expansions, higher government spending, lower debt, and credit upgrades.
Conversely, negative switches, indicating an asset becoming risky, are associated with contractions, reduced spending, higher debt, and credit downgrades.
These findings highlight the dynamic nature of asset safety and its profound impact on fiscal policy and financial conditions.
Measuring demand, identifying switches
The theoretical framework defines safe assets as those with low risk and high liquidity, sought after during turmoil.
It posits that safety is time-varying, driven by country fundamentals, non-pecuniary benefits (liquidity, collateral), and risk volatilities.
The empirical procedure involves two steps: first, constructing the FLY index by counting safe-assets-related terms in financial newspapers, building on methods from Baker, Bloom, and Davis (2016).
This index effectively captures major flight-to-safety events like the Russian debt default, the subprime crisis, and the European debt crisis.
Second, the paper estimates correlations of bond returns with the FLY index to identify 'safety switches.'
A positive switch occurs when a bond's correlation with FLY becomes positive and significant, indicating it has become safe.
A negative switch signifies a bond becoming risky, with a negative and significant correlation.
The analysis reveals that the set of global safe assets was larger pre-global financial crisis, but post-crisis, many countries lost their safe-asset status, and US bonds emerged as the dominant global safe asset.
A dynamic view of sovereign safety
This paper offers a crucial empirical tool for understanding the fluid nature of safe assets, moving beyond static classifications.
The FLY index and the concept of safety switches provide a robust framework for policymakers to assess financial stability and fiscal space.
Its findings underscore that perceived safety is not immutable, demanding continuous monitoring and adaptive policy responses.
For governments, the ability to maintain or achieve safe-asset status directly impacts their capacity to manage economic cycles and crises.