The Critical Role of Monetary Policy in the Link between Business Conditions and Security Returns in Taiwan

This study examines the relationship between the business condition proxies and security returns and whether the relationship varies across changing monetary policy environments in Taiwan. We test the explanatory power of business condition proxies, namely, dividend yield (D/P), term spread (TERM), and growth rate of industrial production (GIP), on stock and bond returns in Taiwan and then incorporate monetary policy action into the business condition model to investigate its impact on the ability of business condition proxies in accounting for stock and bond return variation over time. Empirical results suggest that the influence of D/P and TERM on security return behavior varies dramatically with monetary policy. Furthermore, the structural relation between D/P and TERM endures significant changes across monetary environments. These findings underline the importance for central bankers to closely monitor monetary policy. Investors and corporate managers, based on presented evidence, should also take into account monetary policy when modeling security market returns for investment and financing decision-making purpose.