The Conventional Wisdom on Rate Cuts May Be Wrong
A new explanation for what drives the market after a Fed surprise.
- By
- December 30, 2024
- CBR - Monetary Policy
For almost two decades, the conventional wisdom has been that when the US Federal Reserve makes a surprise rate decision, the resulting moves in the stock market are driven by the projected equity premium, or the extra return that investors expect from holding stocks rather than risk-free bonds such as Treasurys. This belief is based on a seminal 2005 study by Nobel laureate Ben Bernanke, who was Fed chairman from 2006 to 2014, and Williams College’s Kenneth N. Kuttner.
But that thinking may be wrong, according to Chicago Booth’s Stefan Nagel and City University of Hong Kong’s Zhengyang Xu. Using data that was unavailable to Bernanke and Kuttner, they find that market moves following interest-rate policy surprises instead grow out of changes in the estimated yields on risk-free debt. This suggests that monetary policy may directly influence the stock market and economy in a more conventional way than Bernanke and Kuttner found—which could help policymakers better understand and anticipate how their decisions will play out.
Until now, the process by which rate changes get transmitted to the market has been somewhat mysterious. The hypothesis was that a rate hike raised the risk premium that investors demanded from stocks, but it wasn’t clear why.
Nagel and Xu took another look at this transmission question using a new, model-free methodology. They first analyzed how Treasury yields reacted on days that the Federal Open Market Committee issued a surprise announcement about the federal funds rate, finding that the biggest response was in bonds maturing in less than five years.
Watch the bond market
After an unexpected hike in the federal funds rate, bond yields typically rise and stock prices fall. The study finds that most of the decline in stock prices is likely due to the change in bond yields, leaving little room for other factors.
Changes in bond yields affect stock prices, but calculating the effects of those changes requires knowing how much investors expect to receive from dividends at any particular point in time. Nagel and Xu extracted that expectation from the prices of dividend futures contracts—and were ultimately able to compare the actual price of the S&P 500 index on the day of a Fed announcement with the price that had been anticipated and might have been realized if not for the rate surprise. In short, they isolated the market impact of the announcement.
The changes in bond yields accounted for nearly all of that impact, according to the researchers. The portion of stock-price movements left unaccounted for by yield curve changes was so small, they add, that it rendered the effects of equity-premium changes statistically insignificant. This result held for different definitions of so-called monetary-policy surprises, Nagel and Xu write.
“The channel we find at work is a straightforward discount rate effect,” says Nagel. He and Xu surmise that after a surprise rate hike, Treasury yields rise. This pushes up corporate discount rates, which reflect the rate of return a company requires on any investment. Higher discount rates in turn lower the present value of corporate cash flows—and thus stock prices.
This more direct take may help Fed bankers—who are currently moving from an era of interest rate tightening to easing—when they’re planning surprise announcements with an end goal in mind.
- Ben Bernanke and Kenneth N. Kuttner, “What Explains the Stock Market’s Reaction to Federal Reserve Policy?” Journal of Finance, May 2005.
- Stefan Nagel and Zhengyang Xu, “Movements in Yields, Not the Equity Premium: Bernanke-Kuttner Redux,” Working paper, August 2024.
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