Title: The yield curve and the stock market: Mind the long run
Authors: Fabio Verona - Bank of Finland (Finland) [presenting]
Abstract: Central banks' monetary policy actions affect a broad spectrum of interest rates, which in turn have an impact on stock markets and, ultimately, on stockholders' wealth. It is thus important for central banks to better understand the effects of interest rates movements on the stock market. A variable of interest to policymakers and financial markets participants alike is the slope of the yield curve, also known as the term spread of interest rates. We extract cycles from the term spread and study their role for predicting the equity premium using linear models. When properly computed, 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. Properly means that it is crucial the way the higher-frequency fluctuations are eliminated, as certain filtering methods (namely wavelet filters) enable the extraction of a low-frequency component with equity premium forecasting performance clearly superior to that other filters (like band-pass filters). For policymakers and market participants interested in gauging equity market developments, the proper trend of the term spread can thus be a promising variable to look at.