On the economic link between asset prices and real activity

This paper presents a model linking two financial markets (stocks and bonds) with real business cycle, in the framework of the Consumption Capital Asset Pricing Model with Generalized Isoelastic Preferences. Besides interest rate term spread, the model includes a new variable to forecast economic activity: stock market term spread. This is the slope of expected stock market returns. The empirical evidence documented in this paper suggests systematic relationships between business cycle’s state and the shapes of two yield curves (interest rates and expected stock returns). Results are robust to changes in measures of economic growth, stock prices, interest rates and expectations generating mechanisms.The authors are from Universidad Carlos III de Madrid. Partial financial support was provided by DGICYT grants PB98-0030, BEC2002-0279 and SEC2003-06457. Seminar participants at various universities and conferences provided useful comments. The authors thank the anonymous referee who provided astute comments that considerably improved the study. The usual disclaimer applies. (Paper received March 2005, revised version accepted August 2006. Online publication December 2006)Publicad