What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns

Mainstream research in empirical asset pricing has traditionally treated variances and covariances of asset returns as being exogenous. A number of authors have challenged this approach. In the present analysis, a vector autoregressive model is used to decompose stock and 10-year bond returns into changes in expectations of future stock dividends, inflation, short-term real interest rates, and excess stock and bond returns. In monthly postwar US data, stock and bond returns are driven largely by news about future excess stock returns and inflation. Real interest rates have little impact on returns, although they do affect short-term mominal interest rate and the slope of the term stucture. These findings help to explain the low correlation between excess stock and bond returns.