Co-movements Between the Real Economy and Financial Markets

The long-term relationship between financial markets and economic conditions is unclear. This paper aims to investigate how movements in the financial markets interact with the broader economy in the long term. Dynamic factor models are implemented to capture unobserved factors—common factor and sector factors. The common factor represents the co-movement between the real economy and the financial markets, and the sector factors indicate co-movements within the economy or within the financial markets. Variance decomposition is performed to show how much of variation in each variable can be explained by the co-movements. The results show that bond indexes are highly co-moved with money/credit related economic indicators, but stock indexes seem only to co-move with one another, and a big portion of variation in the stock market remains unexplained.