Dynamic interaction among stock returns, short-term interest rates, spread and expected inflation

Financial researchers and economists have made many attempts to explain the influence of macroeconomic variables on asset pricing. This study uses spread as a measure of real activity and examines the dynamic interaction and causal linkages among stock returns, interest rates, spread and expected inflation. The dynamic interaction is examined using vector autoregression model and innovation accounting methodology. The analysis shows that there is a strong bi-causal relationship between spread and stock returns, and spread is a significant factor influencing stock returns than the interest rates such as Treasury Bill Yield (TBY) and Commercial Paper Rate, while the overnight interest rates explain much of the variance in stock returns, than spread. Stock market returns signal changes in real activity while it does not signal changes in expected inflation and interest rates and there is no significant relationship between expected inflation and spread. In contrast to the studies in the US market, interest rates do not explain substantial portion of variation in inflation, but the overnight interest rates significantly influence stock returns and have a bi-causal relationship with expected inflation.