Investor Sentiment, Sovereign Debt Mispricing, and Economic Outcomes

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