Stock Returns and the Term Structure

It is well known that in the postwar period stock returns have tended to be low when the short term nominal interest rate is high. In this paper I show that more generally the state of the term structure of interest rates predicts stock returns. Risk premia on stocks appear to move closely together with those on 20—year Treasury bonds, while risk premia on Treasury bills move somewhat independently. Average returns on 20—year bonds have been very low relative to average returns on stocks. I use these observations to test some simple asset pricing models. First I consider latent variable models in which betas are constant and risk premia vary with expected returns on a small number of unobservable hedge portfolios. The data strongly reject a single—latent—variable model. The last part of the paper examines the relationship between conditional means and variances of returns on bills, bonds and stocks. Bill returns tend to be high when their conditional variance is high, but there is a perverse negative relationship between stock returns and their conditional variance. A model is estimated which assumes that asset returns are determined by their time—varying betas with a fixed—weight "benchmark" portfolio of bills, bonds and stocks, whose return is proportional to its conditional variance. This portfolio is estimated to place almost all its weight on bills, indicating that uncertainty about nominal interest rates is important in pricing both short— and long—term assets. John Y. Campbell Department of Economics Dickinson Hall Princeton University Princeton, NJ 08544 (609) 452—4011 In recent years a great deal of effort has been expended in testing rational expectations models of long-term asset prices. Such models state that the rationally expected returns on some set of assets, measured over some time interval, differ across assets only by a constant. Typically one asset in the set has a (nominal) return which is known in advance, so the model implies that expected returns on all the other assets are equal to this known return, plus a constant. The difference between two expected returns is often called a "risk premium", and expectations models state that risk premia are constant through time.' Two particularly well-known expectations models concern the term structure of interest rates, and the relationship between stock returns and interest rates. The expectations theory of the term structure states that expected returns on bonds and bills of all maturities are equal except for a constant. The expectations theory for stock returns and interest rates, as described informally by Fama and Schwert [1977], states that expected nominal stock returns equal the nominal Treasury bill rate, plus a constant. Fama and Schwert showed that in postwar U.S. data the expectations theory for stock returns and interest rates is strongly rejected. When monthly stock returns are regressed on the 1-month Treasury bill rate, the estimated coefficient is about -5 rather than +1 as predicted by the theory. Fama and Schwert attributed their results to a negative impact of inflation on stock returns.2 1 Expectations models as defined here are less restrictive than the models considered by Cox, Ingersoll and Ross [1981] and LeRoy [l982a], which state that risk premia are constant at zero.