Expectation-Driven Term Structure of Equity and Bond Yields

The fundamental question in asset-pricing research is what drives the movements of equity and bond prices—risk premiums or cash flow expectations. Leading asset-pricing models are based on risk premiums; however, recent empirical findings pose serious challenges to existing equilibrium models.

This paper presents a new equilibrium model where equity and bond yield movements are mainly driven by subjective expectations. Short-term equity yields are more volatile because the expected short-term dividend growth returns to its less volatile long-term average level. The procyclical slope of equity yields is due to the countercyclical slope of dividend growth expectations. The correlation between equity yields and nominal bond yields switched from positive to negative after the late 1990s because of a stronger correlation between real GDP and dividend expectations. Long- and short-term equity returns are predictable, and the strength of predictability decreases with maturity due to underreaction to dividend news.

We extend the literature by providing a unified framework of equity and bond pricing under subjective expectations. The model is consistent with recent empirical findings on survey expectations, term structure of equity and bond yields, and aggregate market puzzles.