What Do Interest Rates Reveal About the Stock Market? A Noisy Rational Expectations Model of Stock and Bond Markets

54 Pages Posted: 11 Feb 2021

See all articles by Matthijs Breugem

Matthijs Breugem

University of Turin - Collegio Carlo Alberto

Adrian Buss

Frankfurt School of Finance & Management; Centre for Economic Policy Research (CEPR)

Joel Peress

INSEAD - Finance

Multiple version iconThere are 2 versions of this paper

Date Written: February 2021

Abstract

We propose a novel theory and provide supporting empirical evidence that lower long-term interest rates (e.g., because of ``quantitative easing'') harm informational and allocative efficiency. We develop a noisy rational expectations equilibrium model with an endogenous interest rate that investors use to update their beliefs about economic fundamentals. The interest rate reveals information about discount rates, allowing investors to extract more information about cashflows from stock prices. The precision of the interest-rate signal and, hence, stock-price informativeness increase in the interest rate. As a result, informational and allocative efficiency rise with bond and money supplies and with policy transparency.

JEL Classification: E43, E44, G11, G14

Suggested Citation

Breugem, Matthijs and Buss, Adrian and Peress, Joel, What Do Interest Rates Reveal About the Stock Market? A Noisy Rational Expectations Model of Stock and Bond Markets (February 2021). Available at SSRN: https://ssrn.com/abstract=3783992

Matthijs Breugem (Contact Author)

University of Turin - Collegio Carlo Alberto ( email )

Piazza Albarello 8
Torino, Torino 10122
Italy

Adrian Buss

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt, 60322
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Joel Peress

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France
+33 1 60 72 40 00 (Phone)
+33 1 60 72 40 45 (Fax)

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