THE "FED-MODEL"AND THE CHANGINGCORRELATION OF STOCK AND BONDRETURNS: AN EQUILIBRIUM APPROACH

This paper presents an equilibrium model that provides a rational explanation for twofeatures of data that have been considered puzzling: The positive relation between USdividend yields and nominal interest rates, often called the Fed-model, and the time-varying correlation of US stock and bond returns. Key ingredients are time-varyingrst and second moments of consumption growth, ination, and dividend growth inconjunction with Epstein-Zin and Weil recursive preferences. Historically in the US,ination has signalled low future consumption growth. The representative agent there-fore dislikes positive ination shocks and demands a positive risk premium for holdingassets that are poor ination hedges, such as equity and nominal bonds. As a result,risk premiums on equity and nominal bonds comove positively through their exposureto macroeconomic volatility. This generates a positive correlation between dividendyields and nominal yields and between stock and bond returns. High levels of macrovolatility in the late 1970s and early 1980s caused stock and bond returns to comovestrongly. The subsequent moderation in aggregate economic risk has brought correla-tions lower. The model is able to produce correlations that can switch sign by includingthe covariances between consumption growth, ination, and dividend growth as statevariables.