The Time-Varying Relation between Stock Returns and Monetary Variables
32 Pages Posted: 18 Nov 2021
Date Written: November 2, 2021
The nature of the relation between stock returns and the three monetary variables of interest rates (bond yields), inflation and money supply growth, while oft studied, is one that remains unclear. We argue that the nature of the relation changes over time and this variation is largely driven by shocks, with a change in risk associated with each variable shifting the pattern of behaviour. We show a change in the correlation between each of the three variables with stock returns. Notably, a predominantly negative correlation with bond yields and inflation becomes positive, while the opposite is true for money supply growth. The shift begins with the bursting of the dotcom bubble but is exacerbated by the financial crisis. Results of predictive regressions for stock returns also indicate a switch in behaviour. Predominantly negative predictive power switches temporarily to positive around economic shocks. This suggests that higher yields, inflation and money growth typically depress returns but support the market during periods of stress. However, after the financial crisis, higher inflation and money growth exhibit persistent positive predictive power and suggests a change in the risk perception of higher values.
Keywords: Stock Returns, Interest Rates, Inflation, Money Supply, Time-Variation, Correlation, Predictability
JEL Classification: C22, G12
Suggested Citation: Suggested Citation