Does the Fed model provide a switching signal?

PurposeThe Fed model implies a stable relation between equity and bond yields such that movement in one particular direction provides a trading signal for an investor to move between the two assets. As such, the Fed model should provide predictive power not only for stock returns as previously considered, but also for bond returns and the difference between the two assets. However, a complicating factor is that the mean value of the Fed series, over the full sample period, may not be constant. This paper aims to examine these questions.Design/methodology/approachUsing monthly US data from 1952 to 2023, the paper estimates predictive regressions for stock and bond returns and the difference between them. Two definitions of the Fed ratio are considered, using both current and forward earnings. Breaks in the ratio are allowed for using both a breakpoint test and forward recursions. Two trading-based strategies are considered, including an in-sample portfolio where investors move into stocks or bonds once the Fed series is sufficiently far from its mean and an out-of-sample exercise.FindingsResults supports predictive power of the Fed model for the two asset returns and their difference. This supportive evidence remains consistent over two definitions of the Fed model and two adjustments for mean shifts. Further evidence is provided through the two-trading strategy-based approaches. Firstly, the in-sample portfolio where investors move between stocks or bonds. This active portfolio is compared against two passive, fixed asset allocation portfolios. Secondly, the out-of-sample forecast exercise for the return difference where the outcome of the forecasts determine trading signals and is compared to a baseline forecast.Originality/valueThe predictive regression results and both exercises provide continued support for the Fed model in its ability to aid investors in switching between stocks and bonds. Overall, while debate continues within the literature, the evidence provided here supports the Fed model as containing information for investors, and that stock and bond yield do exhibit a relation over time, although with mean level shifts.