Long-run growth shocks steepen equity yield curve, boost dividends
A Federal Reserve study finds that positive long-run growth shocks steepen the equity yield curve by increasing expected dividend growth. This effect leaves discount rates largely unchanged and is more pronounced for growth firms.
Dividend growth drives yield curve steepening
Researchers analyzed the response of equity yields to a well-identified long-run growth shock, specifically the total factor productivity (TFP) news shock.
Using synthetic equity yield data from Giglio et al. (2024), the study demonstrates that a positive long-run shock significantly steepens the equity yield curve.
This steepening is primarily driven by an increase in expected dividend growth, particularly for short-term claims (over 1% for 1-year claims), while discount rates remain largely unaffected.
The analysis further reveals that growth-firm yields respond more strongly than value-firm yields, reflecting larger changes in their expected dividend growth.
The modified model by Ai et al. (2018), which separates cash dividends from total payout, best matches these empirical responses compared to other benchmark equity term structure models.
The 10-1 year equity yield slope rises by about 1% in the first few quarters, with effects dissipating over two years.
Beyond benchmark models
The study evaluates three benchmark equity term structure models—Bansal and Yaron (2004), Lettau and Wachter (2007), and Gormsen (2021)—against the empirical findings.
While all models predict higher expected growth, the effects in Bansal and Yaron and Lettau and Wachter are quantitatively too small.
Gormsen's model matches market equity yields but incorrectly attributes too large a share to the risk-premium component.
The modified Ai et al. (2018) model, by contrast, correctly assigns the yield response to expected growth, aligning with the data.
The research also investigates how investment driving this growth is financed.
It finds that aggregate cash and total payout respond with opposite signs, implying a large negative response of net repurchases (around -0.6%).
This indicates new issuance is the main source of funding for increased investment following a long-run growth shock, supporting the ACDL model's payout process modification.
A new lens on asset pricing
This study offers a more granular understanding of how macroeconomic shocks transmit to asset prices, moving beyond aggregate stock prices to the equity term structure.
Its findings challenge existing models by highlighting the critical role of expected dividend growth and the financing of investment through new issuance.
This detailed decomposition provides valuable insights for both academic research and practical asset pricing strategies.