Expectation-Driven Term Structure of Equity and Bond Yields

Abstract: This paper develops a noisy-information equilibrium model to study how subjective expectations shape the joint dynamics of equity and bond yields. In our framework, movements in asset yields are driven by subjective expectations of dividend and GDP growth, rather than time-varying risk premia. A dual-component dividend structure, together with belief distortions, generates key asset-pricing facts: short-term equity yields are more volatile than long-term yields because short-run dividend growth expectations mean-revert to their stable long-run counterpart; the equity yield slope is procyclical due to countercyclical term structure of expected dividend growth; and the bond-stock correlation changes from positive to negative after the late 1990s, reflecting a shift in the correlation between expected GDP and dividend growth. The model also implies predictable dividend strip returns, with predictability declining with maturity due to dividend forecast revisions, and it successfully replicates the observed dynamics of equity yields and some aggregate moments.