There does not seem to be a clear relationship between interest rates and equity risk premiums. Damodaran (2019) has a great paper that goes into details of equity risk premiums. In this work, he writes:
In much of valuation and corporate finance practice, we assume that
the equity risk premium that we compute and use is unrelated to
the level of interest rates ... But is this a reasonable assumption?
How much of the variation in the premium over time can be explained by
changes in interest rates? Put differently, do equity risk premiums
increase as the risk free rate increases or are they unaffected? To
answer this question, we looked at the relationship between the
implied equity risk premium and the treasury bond rate (risk free
rate). As can be seen in figure 13, the implied equity risk premiums were
highest in the 1970s, when interest rates and inflation were also
high. However, there is contradictory evidence between 2008 and 2018,
when high equity risk premiums accompanied low risk free rates.
Duarte and Rosa (2015) have discussed multiple variants of equity risk premiums, including the DDM framework. While their main objective was to compare and contrast the models, they also highlight that:
The ERP in 2012 and 2013 reached heightened levels—of around 12
percent—not seen since the 1970s.
This is in line with the previous study. Furthermore,
There are two reasons why the ERP can be high: low discount rates and
high current or expected future cash flows ...
We conclude the ERP is high because Treasury yields are unusually low.
Current and expected future dividend and earnings growth play a
smaller role. In fact, expected stock returns are close to their
I looked at Ang and Bekaert (2007) and thought that they were looking at interest rate predictability by dividend:
Table 5 reports that the long sample for the U.S. shows a positive
effect of the dividend yield on future interest rates. The effect is
economically small ... we view the relationship between dividend
yields and future interest rates as economically important because
interest rates are a crucial component of a present value relation.
From the present value relation (5), we expect a positive relation
between dividend yields and future discount rates. The interest rate
enters the discount rate in two ways. The discount rate is the sum of
the risk free rate and the risk premium and enters these two
components with opposite signs. It is the first component that gives
rise to the positive relation.Although not statistically
significant, the positive sign of interest rate predictability by
dividend yields is robust.
I wonder if the reverse is true.
Overall though, I do not think that the relationship between the interest rates and equity risk premiums is straightforward to capture. This is more an art than a science and involves lots of subjective judgement. Hope you will find the papers useful and let us know your thoughts!