The Yield Curve and the Stock Market: Mind the Long Run

Abstract

We extract cycles from the term spread and study their role for predicting the equity premium using linear models. When properly extracted, the trend of the term spread is a strong and robust out-of-sample equity premium predictor, both from a statistical and an economic point of view. It outperforms several variables recently proposed as good equity premium predictors. Our results support recent Findings in the asset pricing literature that the low-frequency components of macroeconomic variables play a crucial role in shaping the dynamics of equity markets. Hence, for policymakers and financial market participants interested in gauging equity market developments, the trend of the term spread is a promising variable to look at.

Keywords: equity premium, term spread, predictability, frequency domain

JEL Classification: C58, G11, G12, G17