The reaction of international stock markets to Federal Reserve policy

This paper investigates how changes in Federal Reserve policy impact international stock returns, with the three objectives of measuring the reaction of international stock markets, understanding the transmission channels of that reaction, and explaining the economic sources of that reaction. We find that unanticipated Federal Reserve policy actions exert a significant and robust influence on international stock prices. However, the influence of unanticipated monetary policy actions is not strong enough to change the correlation structure of international equity returns. We also find that international stock return co-movements play an important role in the transmission of monetary policy. Finally, the variance decomposition analysis indicates that the effects of monetary policy surprises on future excess returns or dividend returns account for the largest portion of the equity price response.     

Show me the money: The monetary policy risk premium

We create a parsimonious monetary policy exposure (MPE) index based on observable firm characteristics that previous studies link to how stocks react to monetary policy. Our index successfully captures stocks’ responses to both conventional and unconventional monetary policy. Stocks whose prices react more positively to expansionary monetary policy (high-MPE stocks) earn lower average returns. This result is consistent with the notion that high-MPE stocks provide a hedge against bad economic shocks, to which the Federal Reserve responds with expansionary monetary policy. A long-short trading strategy designed to exploit this effect achieves an annualized Sharpe Ratio of 0.77.     

On Stock Market Returns and Monetary Policy

Financial economists have long debated whether monetary policy is neutral. This article addresses this question by examining how stock return data respond to monetary policy shocks. Monetary policy is measured by innovations in the federal funds rate and nonborrowed reserves, by narrative indicators, and by an event study of Federal Reserve policy changes. In every case the evidence indicates that expansionary policy increases ex-post stock returns. Results from estimating a multi-factor model also indicate that exposure to monetary policy increases an asset's ex-ante return.     

Discount rate changes,stock market returns,volatility, and trading volume: Evidence from intraday data and implications for market efficiency

We examine the effect of discount rate changes on stock market returns, volatility, and trading volume using intraday data. Equity returns generally respond negatively and significantly to the unexpected announcements; however, the effect of expected changes on equity returns is insignificant. Furthermore, our results indicate that equity prices respond to announcements within the trading period/hour after the information release. An indication of a return reversal is too small to cover the full transaction costs. Unexpected discount rate changes also contribute to higher market volatility although the volatility is short-lived. Similarly, unexpected changes in discount rates induce larger trading volume while expected changes do not. Abnormal trading volume occurs only in period t. Our results also support the notion that unexpected changes in the discount rates impact market returns irrespective of the Federal Reserve operating procedures.     

How do oil supply and demand shocks affect Asian stock markets?

This paper examines how oil market shocks affect Asian stock prices using the structural vector autoregression (VAR) approach. Global oil supply and demand shocks are disentangled using sign restrictions and elasticity bounds. Oil price increases are bad news only if the source is from oil-market-specific demand shifts. Northeast Asian stock markets are more resilient as investors’ expectation of continued economic growth outweighs the adverse effect of higher oil prices. Increased global economic activity also stimulates stock prices. Global oil shocks are more important in explaining variability in Asian stock returns compared with the United States, suggesting different dynamics in Asia.     

U.S. Monetary Policy Surprises and International Securitized Real Estate Markets

This paper examines the impact of U.S. monetary policy surprises on securitized real estate markets in 18 countries. The policy surprises are measured by both the surprise changes to the target federal funds rate (the target factor) and surprises in the future direction of the Federal Reserve monetary policy (the path factor). The results show that most international securitized real estate markets have significantly positive responses to surprise decrease in current or future expected federal funds rates, though such responses vary greatly across countries. Also, while the U.S. securitized real estate market reacts mainly to the target factor, foreign securitized real estate markets react to the path factor. Furthermore, we find that the cross-country variation in the response to the target factor is correlated with the country’s exchange rate regime and its degree of real economic and particularly financial integration, while the cross-country variation in the response to the path factor is mainly related to the country’s degree of financial integration.     

The shortage of safe assets in the US investment portfolio: Some international evidence

This paper develops a Bayesian Global VAR (GVAR) model to track the international transmission dynamics of two stylized shocks, namely a supply and demand shock to US-based safe assets. Our main findings can be summarized as follows. First, we find that (positive) supply-sided shocks lead to pronounced increases in economic activity which spills over to foreign countries. The impact of supply-sided shocks can also be seen for other quantities of interest, most notably equity prices and exchange rates in Europe. Second, a demand-sided shock leads to an appreciation of the US dollar and generally lower yields on US securities, forcing investors to shift their portfolios towards foreign fixed income securities. This yields sizable positive effects on US output, equity prices and a general decrease in financial market volatility.     

The Fiscal and Monetary Linkage between Stock Returns and Inflation

Contrary to economic theory and common sense, stock returns are negatively related to both expected and unexpected inflation. We argue that this puzzling empirical phenomenon does not indicate causality. Instead, stock returns are negatively related to contemporaneous changes in expected inflation because they signal a chain of events which results in a higher rate of monetary expansion. Exogenous shocks in real output, signalled by the stock market, induce changes in tax revenue, in the deficit, in Treasury borrowing and in Federal Reserve “monetization” of the increased debt. Rational bond and stock market investors realize this will happen. They adjust prices (and interest rates) accordingly and without delay. Although expected inflation seems to have a negative effect on subsequent stock returns, this could be an empirical illusion, since a spurious causality is induced by a combination of: (a) a reversed adaptive inflation expectations model and (b) a reversed money growth/stock returns model. If the real interest rate is not a constant, using nominal interest proxies for expected inflation is dangerous, since small changes in real rates can cause large and opposite percentage changes in stock prices.     

Asymmetric effects of oil shocks on stock market returns in Saudi Arabia: evidence from industry level analysis

We examine the impact of oil price shocks on stock market returns in Saudi Arabia using the country-level as well as the industry-level stock market data. We find that the relation between changes in oil prices and equity returns is positive and significant at the country-level and at the industry level. Our results show that oil prices have asymmetric effects on equity returns for 4 out of 15 industrial sectors (e.g., hotel and tourism, insurance, multi-investment, and petrochemicals). These results have significant implications for investors, portfolio managers, policymakers, and corporate finance managers.     

What Explains the Stock Market's Reaction to Federal Reserve Policy?

This paper analyzes the impact of changes in monetary policy on equity prices, with the objectives of both measuring the average reaction of the stock market and understanding the economic sources of that reaction. We find that, on average, a hypothetical unanticipated 25‐basis‐point cut in the Federal funds rate target is associated with about a 1% increase in broad stock indexes. Adapting a methodology due to Campbell and Ammer, we find that the effects of unanticipated monetary policy actions on expected excess returns account for the largest part of the response of stock prices.     

Credit market shocks and economic fluctuations: Evidence from corporate bond and stock markets

To identify disruptions in credit markets, research on the role of asset prices in economic fluctuations has focused on the information content of various corporate credit spreads. We re-examine this evidence using a broad array of credit spreads constructed directly from the secondary bond prices on outstanding senior unsecured debt issued by a large panel of nonfinancial firms. An advantage of our “ground-up” approach is that we are able to construct matched portfolios of equity returns, which allows us to examine the information content of bond spreads that is orthogonal to the information contained in stock prices of the same set of firms, as well as in macroeconomic variables measuring economic activity, inflation, interest rates, and other financial indicators. Our portfolio-based bond spreads contain substantial predictive power for economic activity and outperform—especially at longer horizons—standard default-risk indicators. Much of the predictive power of bond spreads for economic activity is embedded in securities issued by intermediate-risk rather than high-risk firms. According to impulse responses from a structural factor-augmented vector autoregression, unexpected increases in bond spreads cause large and persistent contractions in economic activity. Indeed, shocks emanating from the corporate bond market account for more than 30 percent of the forecast error variance in economic activity at the two- to four-year horizon. Overall, our results imply that credit market shocks have contributed significantly to US economic fluctuations during the 1990-2008 period.     

Assessing the effects of unconventional monetary policy and low interest rates on pension fund risk incentives

This study quantifies the effects of persistently low interest rates near to the zero lower bound and unconventional monetary policy on pension fund risk incentives in the United States. Using two structural vector autoregressive (VAR) models and a counterfactual scenario analysis, the results show that monetary policy shocks, as identified by changes in Treasury yields following changes in the central bank's target interest rates, lead to a substantial increase in pension funds’ allocation to equity assets. Notably, the shift from bonds to equity securities is greater during the period where the US Federal Reserve launched unconventional monetary policy measures. Additional findings show a positive correlation between pension fund risk-taking, low interest rates and the decline in Treasury yields across both well-funded and underfunded public pension plans, which is thus consistent with a structural risk-shifting incentive.     

Oil and the Stock Markets

We test whether the reaction of international stock markets to oil shocks can be justified by current and future changes in real cash flows and/or changes in expected returns. We find that in the postwar period, the reaction of United States and Canadian stock prices to oil shocks can be completely accounted for by the impact of these shocks on real cash flows alone. In contrast, in both the United Kingdom and Japan, innovations in oil prices appear to cause larger changes in stock prices than can be justified by subsequent changes in real cash flows or by changing expected returns.     

The monetary origins of asymmetric information in international equity markets

Existing studies using low-frequency data have found that macroeconomic shocks contribute little to international stock market covariation. However, these papers have not accounted for the presence of asymmetric information where sophisticated investors generate private information about the fundamentals that drive returns in many countries. In this paper, we use a new microstructure data set to better identify the effects of private and public information shocks about U.S. interest rates and equity returns. High-frequency private and public information shocks help forecast domestic money and equity returns over daily and weekly intervals. In addition, these shocks are components of factors that are priced in a model of the cross-section of international returns. Linking private information to U.S. macroeconomic factors is useful for many domestic and international asset-pricing tests.     

EFFECT OF FEDERAL RESERVE POLICIES ON BANK EQUITY RETURNS

We investigate the reaction of bank equity returns to changes in the relevant Federal Reserve (Fed) policy tool, which is the federal funds rate during periods of interest rate targeting and the discount rate during periods of reserves targeting. Three policy periods from 1974 to 1996 are investigated. We find that bank equity returns are inversely related to changes in the relevant Fed policy tool and that the degree of sensitivity of bank equity returns is conditioned on the direction of the change in the Fed policy tool. Also, we find that values of larger commercial banks and low‐capital‐ratio commercial banks are more exposed to changes in the relevant Fed policy tool. JEL classification: G11, G12, G14.     

The Importance of Cash-Flow News for Financially Distressed Firms

Previous studies have shown that stock prices are moved primarily by news about discount rates (expected returns). I argue that when a firm experiences financial distress, news about cashflows becomes more dominant in driving its stock returns. Applying Campbell's (1991) variance decomposition framework to financially distressed firms supports this argument. Furthermore, I find that more bankruptcies occur after negative shocks to expected cashflows than after positive shocks to discount rates; and that stock prices of distressed firms are less sensitive than those of sound firms to changes in equity risk.     

Oil and stock market activity when prices go up and down: the case of the oil and gas industry

We examine the asymmetric effects of daily oil price changes on equity returns, market betas, oil betas, return variances, and trading volumes for the US oil and gas industry. The responses of stock returns associated with negative changes in oil prices are higher than that associated with positive changes in oil prices. Stock risk measured by market beta is influenced more due to oil price decreases than due to oil price increases. On the other hand, oil risk exposures (oil betas) and return variances are more influenced by oil price increases than oil price decreases. The results of our study indicate that oil and gas firm returns, market betas, oil betas, return variances respond asymmetrically to oil price changes. We also find that relative changes in oil prices along with firm-specific factors such as firm size, ROA, leverage, market-to-book ratio (MBR) are important in determining the effects of oil price changes on oil and gas firms’ returns, risks, and trading volumes.     

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.     

A Model of Monetary Policy Shocks for Financial Crises and Normal Conditions

Deteriorating economic conditions in late 2008 led the Federal Reserve to lower the target federal funds rate to near zero, inject liquidity through novel facilities, and engage in large‐scale asset purchases. The combination of conventional and unconventional policy measures prevents using the effective federal funds rate to assess the effects of monetary policy beyond 2008. We employ a broad monetary aggregate to elicit the effects of monetary policy shocks both before and after 2008. Our estimates align well with major changes in the Fed's asset purchase programs and yield responses that are free from price, output, and liquidity puzzles that plague other approaches.     

Expectations and the Treasury Bill-Federal Funds Rate Spread over Recent Monetary Policy Regimes

This paper shows that the spread between the 3–month Treasury bill and the federal funds rate has significant predictive power for the future change in the federal funds rate during the volatile nonborrowed reserves operating regime, but it has less and no predictive power during the borrowed reserves regime and the federal funds targeting regime, respectively. These findings suggest that Treasury bill rates forecast future federal funds rates most accurately when the Federal Reserve follows a well-defined rule that does not smooth the impact of shocks on the federal funds rate.