Blog - Investing Notes

November 4, 2008 - Update: The Federal Funds Rate and the Stock Market

Media commentators and expert advisors generally focus on the Federal Funds Rate (FFR) as an indicator of stock market behavior. Does the overall U.S. stock market respond systematically to loosening and tightening of credit via cuts and boosts in FFR? To investigate, we compare the behaviors of FFR and the S&P 500 index over the period January 1990 through October 2008, encompassing 76 changes in FFR (45 cuts and 31 boosts). We find that...

The following chart compares the behaviors of FFR and the S&P 500 index over the entire sample period. FFR cuts and boosts appear to cluster in loosening and tightening regimes. The average (median) interval between FFR changes is 89 (46) calendar days. The Federal Reserve is active in the credit market. No consistent relationship between FFR and stocks is apparent visually. For example:

• During 1990-1992, stocks advance while FFR falls dramatically.
• During 1995-2000, stocks rise dramatically while FFR changes little.
• During 2000-2002, stocks and FFR fall sharply together.
• During 2003, stocks rise while FFR changes little.
• During 2004-2006, stocks and FFR generally rise together.
• During 2007-2008, stocks and FFR fall dramatically together.

Does the real FFR (adjusted for inflation) interact differently with stocks?

The next chart compares the behaviors of the real FFR (FFR minus the 12-month trailing inflation rate) and the S&P 500 index over the entire sample period. The general subperiod relationships noted above still hold. Again, no consistent relationship is apparent visually.

Are changes in FFR predictive for stock market returns over intervals of a week to six months?

The next chart summarizes average stock market returns over several intervals after increases and decreases in FFR. Since the Federal Reserve announces FFR changes during the trading day, we calculate S&P 500 index returns from the close on the day before an FFR change to the close on the last day of the interval. Results suggest that:

• Cuts in FFR (subsample size 45) are modestly bullish over the next week, month and quarter but not over the next six months.
• Boosts in FFR (subsample size 31) are somewhat bearish over the next week and month, but inconsequential over the longer intervals.

The volatilities (standard deviations) of returns over all intervals are generally quite a bit larger than the average returns, so outcomes from trading FFR changes would vary considerably. Stock return volatilities are noticeably higher (lower) than normal after FFR cuts (boosts). Also, sample/subsample sizes are modest. Therefore, a few more observations might significantly alter the average returns, and trading on FFR changes is very risky.

Note that changes in FFR sometimes occur more frequently than 126, 63 or even 21 trading days, resulting in overlapping (non-independent) measurement intervals for subsequent stock returns. Overlap of measurement intervals reduces effective sample/subsample sizes and may overweight periods of very frequent changes in FFR. In other words, results for longer intervals are not as reliable as even the fairly small sample/subsample sizes and volatilities imply.

Might the stock market lead FFR changes?

The final chart summarizes average stock market behavior over several intervals before increases and decreases in FFR. Since the Federal Reserve announces FFR changes during the trading day, we calculate all S&P 500 index returns from the close on the first day of each interval to the close on the day before the FFR change. Results suggest that:

• Cuts in FFR tend to follow intermediate-term periods of stock market weakness.
• There is no relationship between boosts in FFR and prior stock market behavior.

A possible interpretation is that investors and the Federal Reserve focus on similar indicators of economic weakness, but that investors act more quickly on bad news than do the central bankers. Again, relatively large standard deviations of returns, modest sample/subsample sizes and overlap of measurement intervals limit confidence in the conclusion.

In summary, simple tests of data since 1990 do not support beliefs that the level of the Federal Funds Rate and changes in the rate are reliable indicators of future U.S. stock market behavior.

See Blog Synthesis: The Economy and the Stock Market for other research on relationships between macroeconomic indicators and stock market behavior.