Is Fed Policy Still Relevant for Investors?

Thirty-eight years of U.S. data indicate that U.S. monetary policy continues to have a strong relationship with security returns. U.S. stock returns are consistently higher and less volatile when the Federal Reserve is following an expansive monetary policy. Furthermore, the monetary policy–related return patterns of companies considered to be most sensitive to changes in monetary conditions are much more pronounced than average patterns. Finally, the influence of U.S. monetary policy is global; international indexes have return patterns similar to those for the U.S. market. Overall, the evidence suggests that investment professionals should continue to consider monetary conditions when performing fundamental analysis of U.S. and international securities. Numerous studies have documented the relationship between monetary policy and security returns, but the relevance of monetary conditions in investment analysis is still debated. In particular, questions have been raised about the continued importance of U.S. monetary policy in recent periods. To study this issue, we analyzed stock returns following changes in the U.S. Federal Reserve’s monetary policy in 21 separate monetary policy environments that occurred from the middle of July 1963 to early 2001. We considered U.S. stocks in general, U.S. stocks grouped according to size and along the value–growth dimension, U.S. stocks by industrial sector, and international stocks. We identified a change in Fed monetary policy as a directional change in the Fed discount rate. We used daily returns (rather than monthly returns) to provide an accurate assessment of returns. To the cross-sectional study, we added an exploration of the time-series consistency of all the relationships.Our findings support the following claims: First, monetary conditions have had and continue to have a strong relationship with security returns. In particular, periods of expansive monetary policy are associated with strong stock performance (higher-than-average returns and lower-than-average risk), whereas periods of restrictive monetary policy generally coincide with weak stock performance (lower-than-average returns and higher-than-average risk). Second, a highly consistent relationship between monetary conditions and stock returns is evident over time. Although initial analysis suggests the relationship has diminished, a more thorough investigation indicates that a single monetary period that occurred in the mid-1990s is largely responsible for this conclusion. Third, small-cap companies are more sensitive than large-cap companies to changes in monetary conditions. Portfolios of small-cap stocks have economically and statistically significant monetary policy–related return patterns that are consistent over time. Fourth, cyclical stocks have a much higher sensitivity to changes in monetary conditions than defensive stocks. For example, stocks in the cyclical consumer goods, cyclical financial services, and information technology sectors had expansive-period returns that were more than 26 percentage points a year higher than the returns they earned during restrictive periods. Finally, U.S. monetary policy has an important influence on global markets. We found significant return patterns related to U.S. monetary policy for five international stock indexes. This evidence is consistent with the prominent role U.S. economic conditions play in the prospects of foreign companies.Overall, our evidence strongly suggests that practitioners should devote considerable attention to monetary conditions as part of a thorough economic analysis. Furthermore, because sensitivity to changes in monetary conditions deviates considerably among sectors, a rigorous industry analysis is also essential. Finally, investment professionals who are attempting a sector or industry rotation strategy should carefully monitor changes in Fed monetary policy.