A long-term empirical analysis suggests that faster expected monetary policy tightening in future months leads equity market underperformance. The predictive factor can be modelled as a change in the slope in future implied future policy rates. It has had a meaningful and consistent effect on weekly U.S. equity returns for more than 25 years. Faster future policy tightening can mean either that the central bank has become more hawkish or that it has acted dovishly but thereby fallen behind the curve.
The post ties in with the subject of “best practices for tracking macro trends”, particularly the case for cross-asset perspective, as explained on the summary page on macro trends.
The below are excerpts from the paper. Headings and some other cursive text has been added for context and convenience of reading.
What is a slope factor?
“Changes in the near-term [federal funds] futures contract contain information affecting the level of all future federal funds target rates, whereas changes in the longer-term futures also contain information about the path of future short-term rate changes…We regress changes in the three-month futures-implied rate on the changes in the one-month futures-implied rate to get a purified measure of changes in expectations of the path of future monetary policy. We refer to the residual of this regression as the slope factor. The regression coefficient is close to 1; at a basic level, therefore, we can think of [the slope factor] as a difference in differences [of futures-implied policy rates in three months versus futures-implied policy rates in one month].”
“A positive slope factor reflects market expectations of a faster monetary policy tightening [in future months], or markets assume interest rates three months from now will be higher relative to what the market expected last week and relative to the change in expectations for the federal funds rate in one month.”
“We choose the three-month futures contract because longer-term futures did not trade until 1996 or did not have high trading volume.”
What is the slope factor’s predictive power?
“Stock prices are the present discounted value of future cash flows and should be sensitive to changes in market expectations of the whole path of future short-term interest rates…Slope robustly predicts excess returns of the Center for Research in Security Prices (CRSP) value-weighted index over the following week…The index is an average of all common stocks trading on NYSE, Amex, or Nasdaq…Faster monetary policy easing positively predicts excess returns.”
“The predictive power of the slope factor is large in economic terms…The point estimate of [the sensitivity of future equity returns to the slope factor] is negative and highly statistically significant. Economically, a one-standard-deviation increase in the slope factor (0.04) leads to a drop in weekly returns of 0.3%, which is 1.5 times the average weekly return and 13.5% of a one-standard deviation move in returns (2.19%). The slope factor explains around 2% of the weekly variation in stock returns.”
“Federal funds futures started trading on the Chicago Board of Trade in October 1988…The predictability [of equity returns based on a 1-3 month slope factor] is a robust finding across subsamples from 1988 to 2007…We use longer-dated futures contracts to construct a slope factor during the zero-lower-bound period [after 2007] and find results consistent with our baseline analysis.”
“An investor conditioning on the slope factor can increase his weekly Sharpe ratio by more than 20% compared to a buy-and-hold investor…Trading based on the predictions of the slope factor is feasible and transaction costs are small.”
Why does the slope factor have predictive power?
“Our results are consistent with a delayed market reaction to monetary policy news and short-run monetary policy momentum… Slope predicts changes in future interest rates and forecast revisions of professional forecasters.”
“Consistent with the idea that ‘monetary policy is 98% talk and only two percent action,’ we find that speeches by the chair and vice chair change the slope factor, which predicts future changes in federal funds target rates as well as forecast revisions by professional forecasters.”
“Policymakers attempt to guide financial markets throughout the year and not only during scheduled meetings. We document speeches of the chair or vice chair systematically predicting the slope factor. We use linguistic analysis and find that a more hawkish tone in speeches by the chair or vice chair predicts a faster monetary policy tightening. Our findings are consistent with the idea that monetary policy became more transparent in the 1990s.”