Thinking about the yield curve (term spread) and the equity premium

The yield curve (term premium) is a powerful tool for predicting behavior in the macroeconomy. An inverted yield curve is a strong predictor of recessions, albeit the relationship has a long lead time. The term spread can tell us about bond and equity risk premium as a response to business cycle fluctuations. Nevertheless, the link between the term spread and equity returns may be hard to use over the short-run out-of-sample.

Recent research suggests that the term premium can be decomposed into different frequencies as wavelets to provide useful information. See "The yield curve and the stock market: mind the long run". Using wavelet analysis on the 10-year / 3-month term premium, the authors isolate three free frequencies, a short-term (less than a year), business cycle (a few years) and long-term wave (approximately a decade).  Get rid of short-term noise and the term premium is a good predictor of equity premium. The low frequency term premium provides useful information on the future discount rate which supports equity premium predictions. The long-term shape of the yield curve does matter for making long-term equity allocations.