Market-based short-rate uncertainty and time-varying expected returns

We show that the cyclical component of market-based short-term interest rate uncertainty (SRU) is a robust predictor of aggregate stock market returns, whereas the slow-moving trend component obscures this predictability. In real-time out-of-sample forecasting, the cyclical component of SRU achieves an R2 of up to 14.22%, significantly outperforming the historical average and a broad set of standard financial and macroeconomic predictors. This predictive performance translates into substantial economic value for mean-variance investors. Mechanistically, the cyclical component captures transient uncertainty shocks that are strongly linked to interest rates, real economic activity, and investor sentiment. A present-value decomposition reveals that the predictive power of cyclical component operates primarily through the cash-flow channel rather than the discount-rate channel.