Sticky prices and twin habits explain equity and bond yield curves
Nominal price rigidities combined with market and home consumption habits reconcile macroeconomic quantities with equity and bond yield curves, according to research by Pierlauro Lopez, Francisco Vázquez-Grande and David López-Salido.
Operating leverage and dividend slopes
The model replicates a downward-sloping equity curve at short maturities alongside upward-sloping bond yield curves.
In the baseline simulation, the one-year dividend strip carries an average risk premium of 6.9 percent compared with 5.5 percent in the 2003-2019 data, while the two-minus-one-year equity yield spread averages minus 1.2 percent.
Aggregate equities yield an annualized excess return of 5.6 percent, closely matching the 6.5 percent empirical benchmark.
Sticky prices create operating leverage by forcing firms to absorb productivity shocks through countercyclical labor shares.
Consequently, dividends drop sharply in downturns before recovering, which generates highly procyclical near-term cash flows.
Twin habits unlock macro-finance separation
Standard production models with Campbell-Cochrane habits typically generate severe distortions in labor supply and investment volatility.
The authors resolve this quantity puzzle by introducing a second habit in home consumption, achieving macro-finance separation.
In bad states, marginal utilities of market and home consumption drop symmetrically, neutralizing distortions to hours worked.
While short-horizon equity yields reflect cash flow mean reversion, slow-moving external habits produce rising risk premia at longer horizons, generating an overall U-shaped equity term structure.
A clever patch with policy limits
The model elegantly links macroeconomic business cycles with asset pricing term structures.
Yet relying on home-production habits acts more as a mathematical patch than a convincing economic driver.
Policy models still need richer shock structures before applying these pricing insights.