We develop a general equilibrium model of government policy choice in which stock prices respond to political news. The model implies that political uncertainty commands a risk premium whose magnitude is larger in weaker economic conditions. Political uncertainty reduces the value of the implicit put protection that the government provides to the market. It also makes stocks more volatile and more correlated, especially when the economy is weak. We find empirical evidence consistent with these predictions.

Stock and Treasury bond comovement, volatilities, and their relations to their price valuations and fundamentals change stochastically over time, in both magnitude and direction. These stochastic changes are explained by a general equilibrium model in which agents learn about composite economic and inflation regimes. We estimate our model using both fundamentals and asset prices and find that inflation news signal either positive or negative future real economic growth depending on the times, thereby affecting the direction of stock-bond comovement. The learning dynamics generate strong nonlinearities between volatilities and price valuations. We find empirical support for numerous predictions of the model.