The stock return predictability of treasury bond yield in China

We provide empirical evidence that the average treasury bond yield across one- to ten-year maturities can negatively predict stock returns in the Chinese stock market. The substantial predictive power of bond yield underscores that the flight-to-safety effect associated with treasury bonds plays a predominant role in driving this predictive relationship. However, we find that bond yield does not operate as a systematic risk factor that explains cross-sectional variations in average stock returns, suggesting that it does not qualify as a state variable within the intertemporal capital asset pricing model framework proposed by Merton (1973). Using an affine market price of risk model, we demonstrate that the average bond yield serves as a pivotal determinant of the time-varying pattern of market prices for the market excess return factor, thereby establishing the theoretical foundation for its predictive power regarding stock returns.