Abstract: We show that the stock market index price reaction to monetary policy announcements by the Federal Open Market Committee (FOMC) is explained mostly by changes in the default-free term structure of yields, not by changes in the equity premium. We reach this conclusion based on a new model-free method that uses dividend futures prices to obtain the counterfactual stock market index price change that results purely from the change in the default-free yield curve induced by the monetary policy surprise. The yield curve change in turn partly reflects a change in expected future short-term interest rates, as measured by changes in professional forecasts, and partly a change in the term premium. We further find that the even/odd week FOMC cycle in stock index returns is also largely due to an FOMC cycle in the yield curve rather than the equity premium.
Abstract: Macroeconomic data releases drive US bond yields primarily through the term premium instead of the expectation channel. The evidence exploits a monthly specification for yields embedding the impacts of news identified from high-frequency data. To match the facts, we develop and calibrate a no-arbitrage model where investors use data releases with imperfect information to learn about future monetary policy. If macro news carry perfect information, the model predicts that the bonds’ Sharpe ratio decreases and the term premium declines by half for every maturity, suggesting that central bank’s communication can lower the term premium and financing costs across the economy.
Abstract: I show that pre-FOMC drift and FOMC announcement premium are realized only on the small subset of FOMC days preceded by key macro data releases. On the other two-thirds of all FOMC days, there is neither drift nor announcement premium. These equity returns are thus not unconditionally high around FOMC statements. Instead, they predominantly reflect reactions to new information, in particular to expectations regarding the path of monetary policy that are updated on key macro announcements. More broadly, financial market movements around FOMC statements strongly differ when key macro announcements immediately precede FOMC announcements. On this subset of FOMC days, conventional monetary policy shocks are predictable with past data, the Fed information effect can be observed, the secular decline in interest rates phenomenon around FOMC statements can be seen and the security market line slopes upwards. On all other FOMC days not preceded by macro news, the Fed information effect is absent, monetary policy shocks are not as predictable, there is no decline in interest rates around FOMC statements and the security market line is flat.
