Asset Allocation and Monetary Policy: Evidence from the Eurozone

The eurozone has a single short-term nominal interest rate, but monetary policy conditions measured by either real short-term interest rates or Taylor rule residuals varied substantially across countries in the period from 2003-2010. We use this cross-country variation in the (local) tightness of monetary policy to examine its influence on equity and money market flows. In line with a powerful risk-shifting channel, we find that fund investors in countries with decreased real interest rates shift their portfolio investment out of the money market and into the riskier equity market. A ten-basis-point lower real short-term interest rate is associated with a 0.8% incremental money market outflow and a 1% incremental equity market inflow by local investors relative to asset under management. The latter produces the strongest equity price increase in countries where domestic institutional investors represent a large share of the countries' stock market capitalization.