Short Rates and Expected Asset Returns

Author contact info: Kenneth A. Froot Graduate School of Business Harvard University Soldiers Field Boston, MA 02163 Tel: 617/495-6677 Fax: 617/496-7357 E-Mail: kfroot@hbs.edu We present evidence that short-term interest rates forecast excess returns on many alternative assets: foreign exchange, stocks, bonds, and commodities. On average, a one percentage-point increase in short rates is associated with three percent lower annualized excess returns. To test whether this predictability is attributable to time-varying risk, independent measures of excess returns are formed using survey data on expected returns. We find similar predictability in these measures, too. Since the surveys don't include risk premia, the predictable components cannot be attributed to risk. We suggest that when short rates are high (low) investors are excessively optimistic (pessimistic) about alternative-asset returns.