IDEAS home Printed from https://ideas.repec.org/a/eee/jimfin/v128y2022ics0261560622001103.html
   My bibliography  Save this article

The Fed and the stock market: A tale of sentiment states

Author

Listed:
  • Guo, Haifeng
  • Hung, Chi-Hsiou D.
  • Kontonikas, Alexandros

Abstract

We analyze the period before the zero lower bound and show that the state of investor sentiment strongly affects the transmission of monetary policy to the stock market. The impact of Federal funds rate (FFR) surprises is mostly potent when sentiment-driven overvaluation is followed by a correction, whereby the stock market increases by 0.8% in response to an unexpected FFR cut of 10 basis points. Our findings suggest that monetary easing surprises during sentiment-waning phases boost the stock market by alleviating investors’ fear. The ability of sentiment to drive the observed state dependence is hard to reconcile with rational pricing.

Suggested Citation

  • Guo, Haifeng & Hung, Chi-Hsiou D. & Kontonikas, Alexandros, 2022. "The Fed and the stock market: A tale of sentiment states," Journal of International Money and Finance, Elsevier, vol. 128(C).
    • Handle: RePEc:eee:jimfin:v:128:y:2022:i:c:s0261560622001103
    DOI: 10.1016/j.jimonfin.2022.102707
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0261560622001103
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jimonfin.2022.102707?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Ben S. Bernanke & Kenneth N. Kuttner, 2005. "What Explains the Stock Market's Reaction to Federal Reserve Policy?," Journal of Finance, American Finance Association, vol. 60(3), pages 1221-1257, June.
    2. Antoniou, Constantinos & Doukas, John A. & Subrahmanyam, Avanidhar, 2013. "Cognitive Dissonance, Sentiment, and Momentum," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 48(1), pages 245-275, February.
    3. Gabriel Perez‐Quiros & Allan Timmermann, 2000. "Firm Size and Cyclical Variations in Stock Returns," Journal of Finance, American Finance Association, vol. 55(3), pages 1229-1262, June.
    4. Silvia Miranda-Agrippino & Giovanni Ricco, 2021. "The Transmission of Monetary Policy Shocks," American Economic Journal: Macroeconomics, American Economic Association, vol. 13(3), pages 74-107, July.
    5. Bekaert, Geert & Hoerova, Marie & Lo Duca, Marco, 2013. "Risk, uncertainty and monetary policy," Journal of Monetary Economics, Elsevier, vol. 60(7), pages 771-788.
    6. Itamar Drechsler & Alexi Savov & Philipp Schnabl, 2018. "A Model of Monetary Policy and Risk Premia," Journal of Finance, American Finance Association, vol. 73(1), pages 317-373, February.
    7. Gervais, Simon & Odean, Terrance, 2001. "Learning to be Overconfident," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 1-27.
    8. Balvers, Ronald J. & Huang, Dayong, 2009. "Money and the C-CAPM," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(2), pages 337-368, April.
    9. Tim Bollerslev & George Tauchen & Hao Zhou, 2009. "Expected Stock Returns and Variance Risk Premia," The Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4463-4492, November.
    10. Paulo Maio, 2014. "Another Look at the Stock Return Response to Monetary Policy Actions," Review of Finance, European Finance Association, vol. 18(1), pages 321-371.
    11. Giovanni Dell'Ariccia & Luc Laeven & Gustavo A. Suarez, 2017. "Bank Leverage and Monetary Policy's Risk-Taking Channel: Evidence from the United States," Journal of Finance, American Finance Association, vol. 72(2), pages 613-654, April.
    12. Shleifer, Andrei & Summers, Lawrence H, 1990. "The Noise Trader Approach to Finance," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 19-33, Spring.
    13. Kuttner, Kenneth N., 2001. "Monetary policy surprises and interest rates: Evidence from the Fed funds futures market," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 523-544, June.
    14. Kurov, Alexander & Sancetta, Alessio & Strasser, Georg & Wolfe, Marketa Halova, 2019. "Price Drift Before U.S. Macroeconomic News: Private Information about Public Announcements?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 54(1), pages 449-479, February.
    15. Dashan Huang & Fuwei Jiang & Jun Tu & Guofu Zhou, 2015. "Investor Sentiment Aligned: A Powerful Predictor of Stock Returns," The Review of Financial Studies, Society for Financial Studies, vol. 28(3), pages 791-837.
    16. Malcolm Baker & Jeffrey Wurgler, 2006. "Investor Sentiment and the Cross‐Section of Stock Returns," Journal of Finance, American Finance Association, vol. 61(4), pages 1645-1680, August.
    17. Gurkaynak, Refet S. & Sack, Brian T. & Swanson, Eric P., 2007. "Market-Based Measures of Monetary Policy Expectations," Journal of Business & Economic Statistics, American Statistical Association, vol. 25, pages 201-212, April.
    18. Piazzesi, Monika & Swanson, Eric T., 2008. "Futures prices as risk-adjusted forecasts of monetary policy," Journal of Monetary Economics, Elsevier, vol. 55(4), pages 677-691, May.
    19. Tim Bollerslev & Viktor Todorov, 2011. "Tails, Fears, and Risk Premia," Journal of Finance, American Finance Association, vol. 66(6), pages 2165-2211, December.
    20. Kontonikas, Alexandros & MacDonald, Ronald & Saggu, Aman, 2013. "Stock market reaction to fed funds rate surprises: State dependence and the financial crisis," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4025-4037.
    21. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    22. Bekaert, Geert & Hoerova, Marie, 2014. "The VIX, the variance premium and stock market volatility," Journal of Econometrics, Elsevier, vol. 183(2), pages 181-192.
    23. Daniel L. Thornton, 2014. "The identification of the response of interest rates to monetary policy actions using market-based measures of monetary policy shocks," Oxford Economic Papers, Oxford University Press, vol. 66(1), pages 67-87, January.
    24. Emi Nakamura & Jón Steinsson, 2018. "High-Frequency Identification of Monetary Non-Neutrality: The Information Effect," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 133(3), pages 1283-1330.
    25. Ben S. Bernanke & Ilian Mihov, 1998. "Measuring Monetary Policy," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 113(3), pages 869-902.
    26. Marek Jarociński & Peter Karadi, 2020. "Deconstructing Monetary Policy Surprises—The Role of Information Shocks," American Economic Journal: Macroeconomics, American Economic Association, vol. 12(2), pages 1-43, April.
    27. Malcolm Baker & Jeffrey Wurgler, 2007. "Investor Sentiment in the Stock Market," Journal of Economic Perspectives, American Economic Association, vol. 21(2), pages 129-152, Spring.
    28. Stambaugh, Robert F. & Yu, Jianfeng & Yuan, Yu, 2012. "The short of it: Investor sentiment and anomalies," Journal of Financial Economics, Elsevier, vol. 104(2), pages 288-302.
    29. David O. Lucca & Emanuel Moench, 2015. "The Pre-FOMC Announcement Drift," Journal of Finance, American Finance Association, vol. 70(1), pages 329-371, February.
    30. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
    31. Diego García, 2013. "Sentiment during Recessions," Journal of Finance, American Finance Association, vol. 68(3), pages 1267-1300, June.
    32. Lutz, Chandler, 2015. "The impact of conventional and unconventional monetary policy on investor sentiment," Journal of Banking & Finance, Elsevier, vol. 61(C), pages 89-105.
    33. Michael Weber & Ali Ozdagli, 2016. "Monetary Policy Through Production Networks: Evidence from the Stock Market," 2016 Meeting Papers 148, Society for Economic Dynamics.
    34. Di Maggio, Marco & Kacperczyk, Marcin, 2017. "The unintended consequences of the zero lower bound policy," Journal of Financial Economics, Elsevier, vol. 123(1), pages 59-80.
    35. Baker, Malcolm & Wurgler, Jeffrey & Yuan, Yu, 2012. "Global, local, and contagious investor sentiment," Journal of Financial Economics, Elsevier, vol. 104(2), pages 272-287.
    36. Mark Gertler & Peter Karadi, 2015. "Monetary Policy Surprises, Credit Costs, and Economic Activity," American Economic Journal: Macroeconomics, American Economic Association, vol. 7(1), pages 44-76, January.
    37. Shiu‐Sheng Chen, 2007. "Does Monetary Policy Have Asymmetric Effects on Stock Returns?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(2‐3), pages 667-688, March.
    38. Michael Weber & Ali Ozdagli, 2016. "Monetary Policy Through Production Networks: Evidence from the Stock Market," 2016 Meeting Papers 148, Society for Economic Dynamics.
    39. Kurt G. Lunsford, 2020. "Policy Language and Information Effects in the Early Days of Federal Reserve Forward Guidance," American Economic Review, American Economic Association, vol. 110(9), pages 2899-2934, September.
    40. Refet S Gürkaynak & Brian Sack & Eric Swanson, 2005. "Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements," International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), May.
    41. Shleifer, Andrei & Vishny, Robert W, 1997. "The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
    42. Lioui, Abraham & Maio, Paulo, 2014. "Interest Rate Risk and the Cross Section of Stock Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 49(2), pages 483-511, April.
    43. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
    44. Roy E. Welsch & Edwin Kuh, 1977. "Linear Regression Diagnostics," NBER Working Papers 0173, National Bureau of Economic Research, Inc.
    45. Adrian, Tobias & Song Shin, Hyun, 2010. "Financial Intermediaries and Monetary Economics," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 12, pages 601-650, Elsevier.
    46. Basistha, Arabinda & Kurov, Alexander, 2008. "Macroeconomic cycles and the stock market's reaction to monetary policy," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2606-2616, December.
    47. Chauvet, Marcelle & Piger, Jeremy, 2008. "A Comparison of the Real-Time Performance of Business Cycle Dating Methods," Journal of Business & Economic Statistics, American Statistical Association, vol. 26, pages 42-49, January.
    48. R. David Mclean & Mengxin Zhao, 2014. "The Business Cycle, Investor Sentiment, and Costly External Finance," Journal of Finance, American Finance Association, vol. 69(3), pages 1377-1409, June.
    49. Kurov, Alexander, 2010. "Investor sentiment and the stock market's reaction to monetary policy," Journal of Banking & Finance, Elsevier, vol. 34(1), pages 139-149, January.
    50. Chung, San-Lin & Hung, Chi-Hsiou & Yeh, Chung-Ying, 2012. "When does investor sentiment predict stock returns?," Journal of Empirical Finance, Elsevier, vol. 19(2), pages 217-240.
    51. Ho, Chienwei & Hung, Chi-Hsiou, 2009. "Investor sentiment as conditioning information in asset pricing," Journal of Banking & Finance, Elsevier, vol. 33(5), pages 892-903, May.
    52. Jinfang Li, 2015. "The asymmetric effects of investor sentiment and monetary policy on stock prices," Applied Economics, Taylor & Francis Journals, vol. 47(24), pages 2514-2522, May.
    53. Acharya, Viral & Naqvi, Hassan, 2019. "On reaching for yield and the coexistence of bubbles and negative bubbles," Journal of Financial Intermediation, Elsevier, vol. 38(C), pages 1-10.
    54. Alok Kumar & Charles M.C. Lee, 2006. "Retail Investor Sentiment and Return Comovements," Journal of Finance, American Finance Association, vol. 61(5), pages 2451-2486, October.
    55. Michael Lemmon & Evgenia Portniaguina, 2006. "Consumer Confidence and Asset Prices: Some Empirical Evidence," The Review of Financial Studies, Society for Financial Studies, vol. 19(4), pages 1499-1529.
    56. Bernile, Gennaro & Hu, Jianfeng & Tang, Yuehua, 2016. "Can information be locked up? Informed trading ahead of macro-news announcements," Journal of Financial Economics, Elsevier, vol. 121(3), pages 496-520.
    57. Jansen, Dennis W. & Tsai, Chun-Li, 2010. "Monetary policy and stock returns: Financing constraints and asymmetries in bull and bear markets," Journal of Empirical Finance, Elsevier, vol. 17(5), pages 981-990, December.
    58. Charles L. Evans, 1998. "Real-time Taylor rules and the federal funds futures market," Economic Perspectives, Federal Reserve Bank of Chicago, vol. 22(Q III), pages 44-55.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Xu, Yongdeng & Guan, Bo & Lu, Wenna & Heravi, Saeed, 2024. "Macroeconomic shocks and volatility spillovers between stock, bond, gold and crude oil markets," Energy Economics, Elsevier, vol. 136(C).
    2. Benchimol, Jonathan & Saadon, Yossi & Segev, Nimrod, 2023. "Stock market reactions to monetary policy surprises under uncertainty," International Review of Financial Analysis, Elsevier, vol. 89(C).
    3. Ahmed, Walid M.A. & Sleem, Mohamed A.E., 2023. "Short- and long-run determinants of the price behavior of US clean energy stocks: A dynamic ARDL simulations approach," Energy Economics, Elsevier, vol. 124(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Ozdagli, Ali & Velikov, Mihail, 2020. "Show me the money: The monetary policy risk premium," Journal of Financial Economics, Elsevier, vol. 135(2), pages 320-339.
    2. Wang, Wenzhao & Su, Chen & Duxbury, Darren, 2022. "The conditional impact of investor sentiment in global stock markets: A two-channel examination," Journal of Banking & Finance, Elsevier, vol. 138(C).
    3. Lutz, Chandler, 2015. "The impact of conventional and unconventional monetary policy on investor sentiment," Journal of Banking & Finance, Elsevier, vol. 61(C), pages 89-105.
    4. Oguzhan Cepni & Rangan Gupta & Qiang Ji, 2023. "Sentiment Regimes and Reaction of Stock Markets to Conventional and Unconventional Monetary Policies: Evidence from OECD Countries," Journal of Behavioral Finance, Taylor & Francis Journals, vol. 24(3), pages 365-381, July.
    5. Cepni, Oguzhan & Gupta, Rangan, 2021. "Time-varying impact of monetary policy shocks on US stock returns: The role of investor sentiment," The North American Journal of Economics and Finance, Elsevier, vol. 58(C).
    6. Niko Hauzenberger & Michael Pfarrhofer, 2021. "Bayesian State‐Space Modeling for Analyzing Heterogeneous Network Effects of US Monetary Policy," Scandinavian Journal of Economics, Wiley Blackwell, vol. 123(4), pages 1261-1291, October.
    7. Lakdawala, Aeimit & Schaffer, Matthew, 2019. "Federal reserve private information and the stock market," Journal of Banking & Finance, Elsevier, vol. 106(C), pages 34-49.
    8. Kurov, Alexander & Olson, Eric & Zaynutdinova, Gulnara R., 2022. "When does the fed care about stock prices?," Journal of Banking & Finance, Elsevier, vol. 142(C).
    9. Alexander Kurov, 2012. "What determines the stock market's reaction to monetary policy statements?," Review of Financial Economics, John Wiley & Sons, vol. 21(4), pages 175-187, November.
    10. Benchimol, Jonathan & Saadon, Yossi & Segev, Nimrod, 2023. "Stock market reactions to monetary policy surprises under uncertainty," International Review of Financial Analysis, Elsevier, vol. 89(C).
    11. Szymon Lis, 2022. "Investor Sentiment in Asset Pricing Models: A Review," Working Papers 2022-14, Faculty of Economic Sciences, University of Warsaw.
    12. Szymon Lis, 2024. "Investor Sentiment in Asset Pricing Models: A Review of Empirical Evidence," Papers 2411.13180, arXiv.org.
    13. Wang, Wenzhao & Su, Chen & Duxbury, Darren, 2021. "Investor sentiment and stock returns: Global evidence," Journal of Empirical Finance, Elsevier, vol. 63(C), pages 365-391.
    14. Mariano González-Sánchez & M. Encina Morales de Vega, 2021. "Influence of Bloomberg’s Investor Sentiment Index: Evidence from European Union Financial Sector," Mathematics, MDPI, vol. 9(4), pages 1-21, February.
    15. Andreas Neuhierl & Michael Weber & Michael Weber, 2017. "Monetary Momentum," CESifo Working Paper Series 6648, CESifo.
    16. Kroencke, Tim A. & Schmeling, Maik & Schrimpf, Andreas, 2021. "The FOMC Risk Shift," Journal of Monetary Economics, Elsevier, vol. 120(C), pages 21-39.
    17. Dahmene, Meriam & Boughrara, Adel & Slim, Skander, 2021. "Nonlinearity in stock returns: Do risk aversion, investor sentiment and, monetary policy shocks matter?," International Review of Economics & Finance, Elsevier, vol. 71(C), pages 676-699.
    18. Alexandros Kontonikas & Paulo Maio & Zivile Zekaite, 2016. "Monetary Policy and Corporate Bond Returns," Working Papers 2016_05, Business School - Economics, University of Glasgow.
    19. Seo, Sung Won & Kim, Jun Sik, 2015. "The information content of option-implied information for volatility forecasting with investor sentiment," Journal of Banking & Finance, Elsevier, vol. 50(C), pages 106-120.
    20. Shen, Junyan & Yu, Jianfeng & Zhao, Shen, 2017. "Investor sentiment and economic forces," Journal of Monetary Economics, Elsevier, vol. 86(C), pages 1-21.

    More about this item

    Keywords

    Investor Sentiment; Monetary Policy Surprises; Event Study;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jimfin:v:128:y:2022:i:c:s0261560622001103. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/30443 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.