38 Pages Posted: 6 Sep 2017
Date Written: September 1, 2017
The term spread has long been of interest to monetary policymakers and to financial markets participants. Despite being a strong business cycle leading indicator, it is known to be a poor out-of-sample predictor of the equity risk premium. In this paper we show that its low-frequency component, when properly extracted from the data, is effectively a very strong equity risk premium out-of-sample predictor. The economic source of this predictability power is found to come from the discount rate channel. The out performance of the low-frequency component of the term spread (versus the historical mean benchmark) is surprisingly very strong at one-month horizon, increases with the forecasting horizon and is consistently stable throughout an out-of-sample period comprising more than 20 years of monthly data. Remarkably, it also forecasts well in expansions. It outperforms several predictors that have recently been proposed in the literature.
Keywords: equity risk premium, term spread, predictability, frequency domain
JEL Classification: C58, G11, G12, G17
Suggested Citation: Suggested Citation
Faria, Gonçalo and Verona, Fabio, The Equity Risk Premium and the Low Frequency of the Term Spread (September 1, 2017). Available at SSRN: https://ssrn.com/abstract=3030760