Abstract
Understanding the behaviour of the equity yield and its relation to the bond yield is important for portfolio managers and those engaged in modelling the interaction between asset classes. During the mid-1900s, the equity yield—which was previously greater than the bond yield—declined, while the bond yield rose and became higher. Research, seeking to understand this, put forward the view that stock and bond return volatility is key. Evidence from the 2000s suggest that the relative values of the equity and bond yield have flipped again, with the former now greater. Empirical evidence presented here shows that during such periods, the hypothesised relation between the equity yield and the bond yield and the two volatilities also changes, with the signs reversed. Moreover, there is noticeable variation in the coefficient values. This paper argues that the relative equity and bond yield values are, to a large extent, driven by inflation volatility. High inflation volatility persisted during the first half of the twentieth century when the equity yield was higher. This was followed by more benign inflation volatility when the bond yield became higher. Evidence for a long span of US data, and shorter German, Japanese, and UK data, suggests the recent rise in the equity yield is accompanied by an uptick in inflation volatility relative to its recent tranquillity.
Highlights
The nature of the relation between stocks and bonds remains of important interest to academics, investors, and policy-makers
This paper examines the behaviour of the equity yield with respect to the bond yield, and uses the relative volatility of stock and bond returns, as suggested in Asness (2000), to explain the movements of the yields
Our evidence supports the view that this switch occurred as stock return volatility fell relative to bond return volatility
Summary
The nature of the relation between stocks and bonds remains of important interest to academics, investors, and policy-makers (see, for example, Shiller and Beltratti 1992; Campbell and Ammer 1993; Baele et al 2010; Campbell et al 2017). We use the framework of Asness (2000), who argues that movements in the equity yield (either dividends or earnings) are driven by movements in the bond yield, to which they are positively related, and movements in relative stock and bond return volatility. Asness argues that it is the recent history and experiences of investors with respect to volatility that is important We reconsider this model in trying to understand the current state of the relation between stocks and bonds and, notably, the apparent recent switch in the relative values of equity and bond yields. Inflation has been relatively tranquil over the most recent past, an uptick in volatility, we argue, is consistent with the equity yield again moving higher than the bond yield. In addition to the evidence for a long history of US data, we consider a shorter history for Germany, Japan, and the United Kingdom in seeking to provide robust evidence for this view
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