Nominal Bonds, Real Bonds, and Equity
We explain the prices of nominal bonds, real bonds, and equity in a unified model with only observable macro variables. We decompose the term structure of expected equity returns into (1) the real short rate, (2) a premium for holding real
long-term bonds, or the real duration premium, the excess returns of nominal long-term bonds over real bonds which reflects (3) expected inflation and (4) inflation risk, and (5) a real cashflow risk premium. The
shape of the nominal and real yield curves are upward-sloping due to increasing duration and inflation risk premiums, while the downward-sloping term structure of expected equity returns is
due to the decreasing trend, or short-term expected, inflation component. Around 70% of the variation of expected equity returns at the 10-year horizon is due to variation in the output gap and trend inflation.
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