International interest rates and US monetary policy announcements: Evidence from Hong Kong and Singapore

This paper investigates the responses of market interest rates to US monetary policy announcements for the US and two emerging economies, Hong Kong and Singapore which are similar on many respects but have experienced opposite exchange rate regimes in the last twenty years. Our results, based on market expectations extracted from federal fund futures rates, document that FOMC announcements significantly affect the term structure of interest rate in the US and both Asian countries. Further, international interest rate differentials around FOMC meeting dates tend to be negative for short maturities with the impact gradually dissipating as bond maturity increases. Finally, for the case of Singapore, we find that domestic interest rates react to both external and domestic monetary policy announcements with a magnitude that is larger over the full bond maturity spectrum for domestic announcements. These results are robust to time-varying futures risk premia and alternative measures of interest rates expectations.     

U.S. monetary policy indicators and international stock returns: 1970-2001

It is documented in the literature that U.S. and many international stock returns series are sensitive to U.S. monetary policy. Using monthly data, this empirical study examines the short-term sensitivity of six international stock indices (the Standard & Poor 500 [S&P] Stock Index, the Morgan Stanley Capital International [MSCI] European Stock Index, the MSCI Pacific Stock Index, and three MSCI country stock indices: Germany, Japan, and the United Kingdom) to two major groups of U.S. monetary policy indicators. These two groups, which have been suggested by recent research to influence stock returns, are based on the U.S. discount rate and the federal funds rate. The first group focuses on two binary variables designed to indicate the stance in monetary policy. The second group of monetary indicators involves the federal funds rate and includes the average federal funds rate, the change in the federal funds rate, and the spread of the federal funds rate to 10-year Treasury note yield. Dividing the sample period (1970-2001) into three monetary operating regimes, we find that not all policy indicators influence international stock returns during all U.S. monetary operating periods or regimes. Our results imply that the operating procedure and/or target vehicle used by the Federal Reserve Board (Fed) influences the efficacy of the policy indicator. We suggest caution in using any monetary policy variable to explain and possibly forecast U.S. and international stock returns in all monetary conditions.     

Stock Return Predictability and The Role of Monetary Policy

This article examines whether shifts in the stance of monetary policy can account for the observed predictability in excess stock returns. Using long-horizon regressions and short-horizon vector autoregressions, the article concludes that monetary policy variables are significant predictors of future returns, although they cannot fully account for observed stock return predictability. I undertake variance decompositions to investigate how monetary policy affects the individual components of excess returns (risk-free discount rates, risk premia, or cash flows).     

Credit risk dynamics in response to changes in the federal funds target: The implication for firm short-term debt

The recent credit crisis has raised a number of interesting questions regarding the role of the Federal Reserve Bank and the effectiveness of its expected and unexpected interventions in financial markets, especially during the crisis, given its mandate. This paper reviews and evaluates the impact of expected and unexpected changes in the federal funds rate target on credit risk premia. The paper's main innovation is the use of an ACH-VAR (autoregressive conditional hazard VAR) model to generate the Fed's expected and unexpected monetary policy shocks which are then used to determine the effects of a Federal Reserve policy change on counterparty credit risk and more importantly short-term firm debt financing. The findings answer a longstanding question sought by researchers on the effect of policy makers' announcements on firm debt financing. The results clearly show that the Federal Reserve influences short-term debt financing through the credit channel for both expansionary and contractionary monetary policies. In particular, we find that the growth in counterparty risk appears less responsive to anticipated responses in the Fed funds rate that fail to materialize than to an unanticipated increase in the federal funds rate. Finally, we also document that the results appear to validate the Feds interventions in financial markets to stem counterparty risk and to make liquidity more readily available to firms.     

Financial conditions,macroeconomic factors and disaggregated bond excess returns

Bond excess returns can be predicted by macro factors, however, large parts remain still unexplained. We apply a novel term structure model to decompose bond excess returns into expected excess returns (risk premia) and the innovation part. In order to explore these risk premia and innovations, we complement macro variables by financial condition variables as possible determinants of bond excess returns. We find that the expected part of bond excess returns is driven by macro factors, whereas innovations seem to be mainly influenced by financial conditions, before and after the financial crisis. Thus, financial conditions, such as financial stress, deserve attention when analyzing bond excess returns.     

STATE DEPENDENCY OF BANK STOCK REACTION TO FEDERAL FUNDS RATE TARGET CHANGES

We investigate the effects of changes in the federal funds target rate on bank stock returns through an event‐study analysis. We examine the state dependency of such effects and focus on the surprise elements of policy changes derived from the federal funds futures market. Although we confirm an inverse relation between bank stock returns and changes in the federal funds target rate previously supported in the literature, we find that bank stock returns only respond to surprise or unexpected changes in the federal funds target rate. We also find that such responses are conditional on the context in which policy changes take place.     

Money Market Integration

We use transaction-level data and detailed modeling of the high-frequency behavior of federal funds–Eurodollar spreads to provide evidence of strong integration of the U.S. markets for federal funds and Eurodollars, the two core components of the dollar money market. Our evidence of negligible federal funds–Eurodollar premia contrasts with previous findings of large and predictable premia, which have been interpreted as evidence of segmentation between the markets for federal funds and Eurodollars. Our results, however, are consistent with possible persistent segmentation within the global Eurodollar market. We document several patterns in the behavior of federal funds–Eurodollar spreads, including liquidity effects from trading volume to yield spreads' volatility.     

Risk premia in crude oil futures prices

If commercial producers or financial investors use futures contracts to hedge against commodity price risk, the arbitrageurs who take the other side of the contracts may receive compensation for their assumption of nondiversifiable risk in the form of positive expected returns from their positions. We show that this interaction can produce an affine factor structure to commodity futures prices, and develop new algorithms for estimation of such models using unbalanced data sets in which the duration of observed contracts changes with each observation. We document significant changes in oil futures risk premia since 2005, with the compensation to the long position smaller on average in more recent data. This observation is consistent with the claim that index-fund investing has become more important relative to commerical hedging in determining the structure of crude oil futures risk premia over time.     

THE EFFECT OF MONETARY POLICY ON CREDIT SPREADS

We analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions.     

UK Stock Returns and the Impact of Domestic Monetary Policy Shocks

Abstract:  We investigate the influence of changes in UK monetary policy on UK stock returns and the possible reasons behind such a response. Firstly, we conduct an event study to assess the impact of unexpected changes in monetary policy on aggregate and sectoral stock returns. The decomposition of unexpected changes in the policy rate is based on futures markets data. Secondly, using a variance decomposition in the spirit of Campbell (1991) we attempt to identity the channels behind the response of stock returns to monetary policy surprises. The variance decomposition results indicate that the monetary policy shock leads to a persistent negative response in terms of future excess returns for a number of sectors.     

The Pre‐FOMC Announcement Drift

We document large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the Federal Open Market Committee (FOMC) in the past few decades. These pre‐FOMC returns have increased over time and account for sizable fractions of total annual realized stock returns. While other major international equity indices experienced similar pre‐FOMC returns, we find no such effect in U.S. Treasury securities and money market futures. Other major U.S. macroeconomic news announcements also do not give rise to preannouncement excess equity returns. We discuss challenges in explaining these returns with standard asset pricing theory.     

Perfecting the Market's Knowledge of Monetary Policy

The rational expectations revolution made clear that a complete macro model requires a specification of the government's economic policy. We argue that monetary policy should be conducted in such a way that the market can predict policy actions. An implication of market success in predicting policy actions is that interest rates move ahead of the policy actions, and such a timing relationship may appear to some as the central bank following the market instead of leading it. Another implication of the market predicting policy actions is that nominal interest rate changes provide no useful information to the central bank about the strength of aggregate demand or inflationary expectations. Finally, failure of the market to predict policy actions reflects a problem that needs to be addressed.We explore the theoretical implications of a monetary policy that is completely specified and perfectly understood by the market. We construct a bare-bones model to illustrate the key concepts. Finally, we conduct an empirical investigation of these issues, especially in the context of monetary policy since 1988, when the establishment of the federal funds future market made available well-defined market information on expectations about Fed policy actions. We find that when the intended funds rate is changed, interest rates over the maturity spectrum respond to news measured by changes in the one-month-ahead funds futures yield but do not respond to the anticipated component of the change in the intended funds rate.     

Exchange Rates and Monetary Policy Uncertainty

We document that a trading strategy that is short the U.S. dollar and long other currencies exhibits significantly larger excess returns on days with scheduled Federal Open Market Committee (FOMC) announcements. We show that these excess returns (i) are higher for currencies with higher interest rate differentials vis‐à‐vis the United States, (ii) increase with uncertainty about monetary policy, and (iii) increase further when the Federal Reserve adopts a policy of monetary easing. We interpret these excess returns as compensation for monetary policy uncertainty within a parsimonious model of constrained financiers who intermediate global demand for currencies.     

Using Survey Data to Correct the Bias in Policy Expectations Extracted from Fed Funds Futures

Many studies estimate risk premiums on federal funds futures to extract monetary policy expectations by assuming that average forecast errors of the expectations are zero or that survey forecasts are good proxies for the expectations. These assumptions, however, may fail due to an unanticipated declining trend in the federal funds rate and to survey respondents' strategic behavior. Consequently, the premiums estimated under these assumptions may be biased. We propose a new method to estimate the premiums and find that the premiums have been often negative since 2000, which is generally consistent with the negative betas observed in the 2000s.     

Treasury return predictability and investor sentiment

We document that the Treasury market investor sentiment (TSENT) of institutional investors is a powerful predictor of bond risk premia. Specifically, TSENT positively predicts Treasury bond excess returns in and out of sample. The forecasting gains of TSENT are incremental to those in conventional bond return predictors: Fama–Bliss forward spreads, Cochrane–Piazzesi forward rate factor, and Ludvigson–Ng macro factor, as well as equity market sentiment proxies such as the investor sentiment index and the partial least squares sentiment index. Asset allocation analysis indicates the forecasting power of TSENT is economically valuable to investors. Finally, we show that the time-series bond risk premia predictability associated with TSENT relates to its predictive power for macroeconomic performance, such as payroll employment, unemployment rate, and industrial production.     

Macroeconomic cycles and the stock market’s reaction to monetary policy

This paper examines cyclical variation in the effect of Fed policy on the stock market. We find a much stronger response of stock returns to unexpected changes in the federal funds target rate in recession and in tight credit market conditions. Using firm-level data, we also show that firms that face financial constraints are more affected by monetary shocks in tight credit conditions than the relatively unconstrained firms. Overall, the results are consistent with the credit channel of monetary policy transmission.     

Identifying VARS based on high frequency futures data

Using the prices of federal funds futures contracts, we measure the impact of the surprise component of Federal Reserve policy decisions on the expected future trajectory of interest rates. We show how this information can be used to identify the effects of a monetary policy shock in a standard VAR. This alternative approach to identification is quite different, and, we argue, more plausible, than the conventional identifying restrictions. We find that a usual recursive identification of the model is rejected, as is any identification that insists on a monetary policy shock having an exactly zero effect on prices contemporaneously. We nevertheless agree with the conclusion of much of the VAR literature that only a small fraction of the variance of output can be attributed to monetary policy shocks.     

Asset volatility

We examine whether fundamental measures of volatility are incremental to market-based measures of volatility in (i) predicting bankruptcies (out of sample), (ii) explaining cross-sectional variation in credit spreads, and (iii) explaining future credit excess returns. Our fundamental measures of volatility include (i) historical volatility in profitability, margins, turnover, operating income growth, and sales growth; (ii) dispersion in analyst forecasts of future earnings; and (iii) quantile regression forecasts of the interquartile range of the distribution of profitability. We find robust evidence that these fundamental measures of volatility improve out-of-sample forecasts of bankruptcy and help explain cross-sectional variation in credit spreads. This suggests that an analysis of credit risk can be enhanced with a detailed analysis of fundamental information. As a test case of the benefit of volatility forecasting, we document an improved ability to forecast future credit excess returns, particularly when using fundamental measures of volatility.     

Monetary policy and financial stability: What role for the futures market?

This paper examines interactions between monetary policy and financial stability. There is a general view that central banks smooth interest rate changes to enhance the stability of financial markets. But might this induce a moral hazard problem, and induce financial institutions to maintain riskier portfolios, the presence of which would further inhibit active monetary policy? Hedging activities of financial institutions, such as the use of interest rate futures and swap markets to reduce risk, should further protect markets against consequences of unforeseen interest rate changes. Thus, smoothing may be both unnecessary and undesirable. The paper shows by a theoretical argument that smoothing interest rates may lead to indeterminacy of the economy's rational expectations equilibrium. Nevertheless, our empirical analysis supports the view that the Federal Reserve smoothes interest rates and reacts to interest rate futures. We add new evidence on the importance for policy of alternative indicators of financial markets stress.     

Hedging Pressure Effects in Futures Markets

We present a simple model implying that futures risk premia depend on both own-market and cross-market hedging pressures. Empirical evidence from 20 futures markets, divided into four groups (financial, agricultural, mineral, and currency) indicates that, after controlling for systematic risk, both the futures own hedging pressure and cross-hedging pressures from within the group significantly affect futures returns. These effects remain significant after controlling for a measure of price pressure. Finally, we show that hedging pressure also contains explanatory power for returns on the underlying asset, as predicted by the model.