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What do Interest Rates Reveal about the Stock Market? A Noisy Rational Expectations Model of Stock and Bond Markets

Author

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  • Buss, Adrian
  • Breugem, Matthijs
  • Peress, Joël

Abstract

We propose a novel theory and provide supporting empirical evidence that lower long-term interest rates (e.g., because of ``quantitative easing'') harm informational and allocative efficiency. We develop a noisy rational expectations equilibrium model with an endogenous interest rate that investors use to update their beliefs about economic fundamentals. The interest rate reveals information about discount rates, allowing investors to extract more information about cashflows from stock prices. The precision of the interest-rate signal and, hence, stock-price informativeness increase in the interest rate. As a result, informational and allocative efficiency rise with bond and money supplies and with policy transparency.

Suggested Citation

  • Buss, Adrian & Breugem, Matthijs & Peress, Joël, 2021. "What do Interest Rates Reveal about the Stock Market? A Noisy Rational Expectations Model of Stock and Bond Markets," CEPR Discussion Papers 15766, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:15766
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    References listed on IDEAS

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    1. Bruno Biais & Peter Bossaerts & Chester Spatt, 2010. "Equilibrium Asset Pricing and Portfolio Choice Under Asymmetric Information," Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1503-1543, April.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    (endogenous) interest rates; Informational efficiency; Capital allocation efficiency; Rational expectations; Unconventional monetary policy;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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