What Moves the Stock and Bond Markets? A Variance Decomposition for Long‐Term Asset Returns

Abstract

The Harvard community has made this article openly available. Please share how this access benefits you. Your story matters This paper uses a log-linear asset pricing framework and a vector autoregressive model to break down movements in stock and bond returns into changes in expectations of future stock dividends, inflation, short-term real interest rates, and excess returns on stocks and bonds. In monthly postwar U.S. data, excess stock returns are found to be driven largely by news about future excess stock returns, while excess 10-year bond returns are driven largely by news about future inflation. Real interest rate changes have little impact on either stock or 10-year bond returns, although they do affect the short-term nominal interest rate and the slope of the term structure. These findings help to explain why postwar excess stock and bond returns have been almost uncorrelated.

Macro-Finance Determinants of the Long-Run Stock-Bond Correlation: The DCC-MIDAS Specification

“…The forecasting ability of the inflation is consistent with Ilmanen (2003) who finds that changes in discount rates dominate the cash flow expectations during periods of high inflation, thereby inducing a positive stock-bond correlation. This is, however, in contrast with Campbell and Ammer (1993) who report that variations in expected inflation promote a negative correlation since an increase in inflation is bad news for bonds and ambiguous news for stocks. The authors also find that variation in interest rates promotes a positive correlation since the prices of both stocks and bonds are negatively related to the discount rate.…”

“…Viceira (2012) finds that the yield spread and the short rate are important determinants of the stock-bond comovement. Campbell and Ammer (1993) decompose the bond and stock returns into unexpected components of future cash flows and future discount rates and employ a vector autoregression model with asset returns and 3 macro variables. They show that stock and bond returns are influenced by different factors, which might be the reason why stock and bond returns are not strongly correlated.…”

Market fundamentals versus rational bubbles in stock prices: a Bayesian perspective

“…The posterior distributions of variances to shocks to dividend growth and required returns (see Table III) also suggest that the required returns component is relatively more important than dividend growth-the variance of shocks to returns is substantially larger than the variance of shocks to dividend growth. This is consistent with previous variance decomposition studies that assumed dividend growth and returns to be stationary, for example Campbell and Shiller (1988), Cochrane (1992), and Campbell and Ammer (1993). Note that the covariance between innovations in dividend and required returns is positive.…”

“…Required returns are time varying but only temporary components are present for both returns and dividend growth. This corresponds to the specification of market fundamentals employed by Campbell and Shiller (1987), Campbell and Ammer (1993), and Cochrane (1992).…”

International fund investment and local market returns

“…Earlier studies on the comovements of bond and equity prices, e.g., Campbell and Ammer (1993) for the US, focus on countryspecific experiences. Hong et al (2009) find in the cases of Canada, Germany, Japan, the UK and the US that the correlations between stock and bond returns are related to the size of the financial market and the growth and volatility of the economy.…”