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Given the nominal bond yield and the inflation index bond yield (earning yield), how would one calculate the discounted inflation rate (discounted earning growth rates)?

These two factor seems to explain a lot of the return of asset classes which I like to explore more.

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From an article that I couldn't find anymore, here is a a simple chart that shows the discounted growth rate index. A small quote I saved "...by comparing nominal Treasury bond yields with inflation indexed bond yields, we can see the discounted inflation rates...by comparing nominal bond yield to earnings yield, we can calculate the discounted earnings growth rate; by looking at credit spreads, we can calculate the discounted rate of credit problem"

enter image description here

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The problem is more that the article you read uses language that is not consistent with the way most people in finance talk. People typically call the difference between the nominal Treasury yield and an inflation-linked bond the breakeven inflation rate. When people look at the difference between the earnings yield and the nominal interest rate, they might say they are drawing conclusions based on the fed model. I don't think this difference necessarily deserves its own name, but people are familiar with the term fed model. Similarly when comparing the earnings yield to credit spreads, this is also similar to a different type of fed model, see the paper by Asness called "Fight the Fed Model."

In general, these approaches are about identifying long-run relationships and investigating how they impact other variables (like stock or bond returns). The more general approach is to apply the Error Correction methodology (or VAR in levels). This approach will extract the long-run trends and account for mean-reversion, whereas using these differences is like imposing constraints on the regression coefficients.

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Fisher's equation is what you need. http://en.wikipedia.org/wiki/Fisher_equation

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  • $\begingroup$ Could you give an overview of how to apply this to the question? $\endgroup$
    – chrisaycock
    Dec 7, 2012 at 19:17

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