Working Paper: NBER ID: w3247
Authors: Kenneth A. Froot
Abstract: We present evidence that short-term interest rates forecast excess returns on many alternative assets: foreign exchange, stocks, bonds, and commodities. On average, a one percentage-point increase in short rates is associated with three percent lower annualized excess returns. To test whether this predictability is attributable to time-varying risk, independent measures of excess returns are formed using survey data on expected returns. We find similar predictability in these measures, too. Since the surveys don't include risk premia, the predictable components cannot be attributed to risk. We suggest that when short rates are high (low) investors are excessively optimistic (pessimistic) about alternative-asset returns.
Keywords: short rates; expected returns; asset returns; financial markets
JEL Codes: G12; E43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| short-term interest rates (E43) | excess asset returns (G12) |
| increase in short rates (E43) | lower excess returns (G12) |
| short rates (E43) | market's overall outlook (E66) |
| short rates (E43) | expected returns (G17) |
| short rates (E43) | misjudgment of expected returns (D81) |