The Capital Asset Pricing Model can be used to help explain the seemingly anomalous behavior of interest rates over the past several years. Specifically, an examination of the covariances between the market returns and real, unexpected rates of return on stocks, bills and bonds of various durations indicates that the variance of return on longer-term bonds increased appreciably between 1977-79 and 1980-81, while their correlations with stock returns rose. The relative risk premiums on these bonds should have risen accordingly.
The calculated real risk premium on bonds of eight years’ duration did increase significantly between June 1979 and December 1981. It is entirely possible that this increase more than offset any decline in the long-term expected inflation rate. Although risk alone cannot account for the increase in the real short-term rate, the timing of the increase suggests a possible correlation with the change in the Federal Reserve’s operating procedures in October 1979. The puzzle of the flat nominal yield curve in the early 1980s may not be a puzzle at all.