Pricing Catastrophe: How Extreme Political Shocks Reprice Sovereign Risk, Beliefs, and Growth Expectations

TL;DR

This paper examines how extreme political shocks, like the 2023 Israel attack, cause persistent changes in sovereign risk, beliefs, and growth expectations, revealing belief-driven macro-financial dynamics.

Contribution

It introduces a novel empirical approach to quantify belief shifts and macroeconomic impacts following political shocks using advanced econometric methods.

Findings

Long-term sovereign risk of Israel is persistently repriced.

Household welfare beliefs decline durably after the shock.

Medium-term economic momentum improves despite increased tail-risk premia.

Abstract

Extreme political shocks may reshape economies not only through contemporaneous disruption but by altering beliefs about the distribution of future states. We study how such belief ruptures affect the cost of capital, expectations, and macroeconomic dynamics, using the October 7, 2023 attack on Israel as a precisely timed shock. Leveraging monthly data from 2008 to 2025 and a donor pool of advanced economies, we estimate counterfactual paths using a matrix completion design with rolling-window cross-validation and placebo-based inference, corroborated by synthetic difference-in-differences. We document three core findings. First, long-horizon sovereign risk of Israel is persistently repriced. Ten-year yields and spreads relative to the United States rise sharply and remain elevated. Second, household welfare beliefs deteriorate durably, as reflected in consumer confidence. Third, medium-run momentum improves, captured by a strong rise in the OECD composite leading indicator. These patterns reveal risk-growth decoupling where tail-risk premia rise even as medium-horizon activity expectations strengthen. Our results highlight belief-driven channels as a central mechanism through which extreme ruptures shape macro-financial outcomes.