Riksbank studies link between equity prices and interest rates

Equity price ratios that do not directly take into account interest rates provide a better explanation for historical stock prices, says research conducted by Sveriges Riksbank.

The cyclically-adjusted price-to-earnings (Cape) ratio, a valuation measure that uses real earnings per share over a 10-year period, is a good guide to the evolution of prices, the paper finds. But the excess Cape yield, a measure of the relative return of equities over bonds that directly takes into account the level of interest rates, is not suited for all jurisdictions.

“The extent to which excess Cape yield can explain historical stock price developments varies between different stock markets and the time periods used in the estimations,” the paper says.

More specifically, this model works well for the US stock market, “though not as well for Sweden and other countries”, it adds.

Because it focuses on the relative returns of equities to bonds, excess Cape yield could be a better gauge of excess returns, point out the authors.

Sustained equity price increases worldwide over the past decade have increased the focus of financial stability analysts on stock markets. From this point of view, studies are analysing to what extent low interest rates, and government bond purchases, have boosted equity prices. Risks could also be triggered if central banks start increasing rates to tame rising inflation.