Paper.pdf

Interest rates on safe assets fell sharply during the 2008 financial crisis and remained low even after financial markets calmed down, with government bond yields showing no sign of rebounding by 2017. The decline in interest rates is attributed to a persistent increase in perceived "tail risk" - the risk of rare, extreme events - which makes safe liquid assets more valuable and keeps their rates of return depressed. A simple theory of belief formation, where agents use macro data to estimate the distribution of shocks, is proposed to explain this phenomenon. The model shows that transitory shocks have persistent effects on beliefs, leading to a decline in government bond yields. The link between heightened tail risk and rates of return comes from two mechanisms: the increase in consumption risk making safe assets more valuable, and government bonds providing liquidity services that are particularly valuable in bad states. The explanation is consistent with other evidence of heightened tail risk, including changes in the value of safety and liquidity, and option-implied measures of tail risk in equity markets.