Expectation-Driven Term Structure of Equity and Bond Yields

Recent findings on the term structure of equity and bond yields pose serious challenges to existing equilibrium asset pricing models. This paper presents a new equilibrium model to explain the joint historical dynamics of equity and bond yields (and their yield spreads). Equity/bond yields movements are mainly driven by subjective dividend/GDP growth expectation. Yields on short-term dividend claims are more volatile because short-term dividend growth expectation mean-reverts to its less volatile long-run counterpart. Procyclical slope of equity yields are due to counter-cyclical slope of dividend growth expectations. The correlation between equity returns/yields and nominal bond returns/yields switched from positive to negative after the late 1990s, owing to (1) procyclical inflation and (2) stronger correlation between expectations of real GDP growth and of real dividend growth post-2000. Dividend strip returns are predictable and the predictive power decreases with maturity due to forecast error and revision. The model is also consistent with the data in generating persistent and volatile price-dividend ratios, and excess return volatility