The Fiscal Foundations of Safe Assets
Why do some government bonds hedge equity risk while others do not? We argue that the answer lies in sovereign fiscal sustainability. A simple model of fiscal limits points to interest expense relative to GDP as the relevant statistic. When it is low, bonds appreciate in equity downturns; when high, sovereign credit risk links stocks and bonds, and both decline together. We test this in a panel of 44 countries from 1960 to 2025: a one-standard-deviation increase in interest expense (2.2 percentage points) raises the stock-bond correlation by 0.10. The mechanism runs through sovereign credit risk, not the inflation regime emphasized in prior work: the credit-risk component of the fiscal burden dominates the default-free component. In the euro area, monetary policy and the inflation target are common across countries, and stock-bond correlations diverge with fiscal positions.
