Interactive effect of changes in the shape of the yield curve and conditional term spread on expected equity returns

Abstract

Recent research has noted that the change in the shape of the yield curve can serve as a proxy for economic activity and contains economic information not present in other explanatory variables. This article extends previous research by examining the combined effect of changes in the shape of the yield curve (yield pattern) and term spread on ex ante equity returns. We find specific yield patterns do affect future equity returns, that changes in the expected long rate is a significant factor, and that, when conditioned on the change in yield curve, the term spread is time variant and significant in specific yield pattern environments and insignificant in others. Specifically, we find that average ex ante equity returns are significant and positive when the yield pattern shows signs of the expected long rate declining. In addition, we find the efficacy of the conditional term spread to predict future equity returns increased after 1980. Our results are consistent with the Expectation Theory of interest rates and robust across capitalization and industry classification.

Keywords:

• term spread
• yield curve
• term structure
• expectations hypothesis

JEL Classification:

• G12
• G19

Notes

¹ The five quarterly returns that were dropped are as follows: July 1932 (43%), August 1932 (66%), April 1933 (52%), May 1933 (60.5%) and September 1939 (39%).