Inflation bets or deflation hedges?

The covariance between US Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953 - 2005, it was particularly high in the early 1980's and negative in the early 2000's. This paper specifies and estimates a model in which the nominal term structure of interest rates is driven by five state variables: the real interest rate, risk aversion, temporary and permanent components of expected inflation, and the covariance between nominal variables and the real economy. The last of these state variables enables the model to fit the changing covariance of bond and stock returns. Log nominal bond yields and term premia are quadratic in these state variables, with term premia determined mainly by the product of risk aversion and the nominal-real covariance. The concavity of the yield curve-the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields-is a good proxy for the level of term premia. The nominal-real covariance has declined since the early 1980's, driving down term premia.