Regime Shifts in a Long-run Risks Model of U.S. Stock and Treasury Bond Markets

We study the joint determinants of stock and bond returns in a long-run risks model framework with regime shifts in consumption and inflation dynamics. In particular, the means, volatilities, and the correlation structure between consumption growth and inflation are regime-dependent. This general equilibrium framework can not only generate sign-switching stock-bond correlations and bond risk premium, but also quantitatively reproduce various other salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curves, the violation of the expectations hypothesis of bond returns. Our model shows that the term structure of interest rates and stock-bond correlation are intimately related to business cycles, while long-run risks play a more important role in accounting for high equity premium than do business cycle risks