Investor Sentiment, Sovereign Debt Mispricing, and Economic Outcomes

Ramzy Al-Amine and Tim Willems

The Economic Journal, 2023, vol. 133, issue 650, 613-636

Abstract: We find that countries able to borrow at spreads that seem low given fundamentals (e.g., because investors are bullish regarding the country’s future) are more likely to develop medium-term difficulties. We establish this by regressing spreads on fundamentals. Subsequently deploying first-stage residuals in a second-stage regression suggests that an optimistic sentiment reduces growth in the medium term while increasing odds of fiscal crises. Incorporating information from our mispricing estimate reduces the root-mean-square error of out-of-sample growth forecasts by 15%. This supports theories of sentiment affecting the business cycle and suggests that countries should not solely rely on spreads when setting fiscal policy.

Date: 2023
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