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All investor eyes focus on Federal Reserve Board of Governors meetings. Will they raise, cut or hold the Federal Funds Rate (FFR)? Experts predict. Commentators comment. Does it really matter for the overall stock market? To check, we examine the relationship between the behaviors of FFR and the S&P 500 index during 1/2/90-3/17/07. There have been 67 changes in FFR over this period. We find that...
The following chart compares the behaviors of FFR and the S&P 500 index over the entire sample period. No consistent relationship is apparent visually. For example:
While there is a hint that sharp stock market declines (plunges) may precede FFR cuts, it seems that FFR is not a good indicator of long-term future stock market behavior.
What if investors focus on real, rather than nominal FFR?
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. The level of real FFR appears not to be useful for predicting future stock market behavior.
But do changes in FFR predict stock market returns over the short and intermediate terms?
The next chart summarizes average stock market behavior over several intervals after 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 day before the change to the close on the last day of the interval. Results suggest that cuts in FFR (sample size 36) are modestly bullish over all four intervals tested, and that increases in FFR (sample size 31) are somewhat bearish over the short term and inconsequential over the intermediate term. However, the standard deviations of returns are generally quite a bit larger than the averages, so the fairly infrequent trading outcomes vary considerably. Also, the sample sizes are modest, such that a few more observations might significantly change the averages. Therefore, FFR changes are not a reliable enough indicator for trading the overall stock market.
Might the stock market lead FFR changes?
The next 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 (sample size 36) tend to follow intermediate-term periods of stock market weakness, and that there is no relationship between increases in FFR (sample size 31) and prior stock market behavior. A possible interpretation is that investors and the Federal Reserve Board of Governors focus on similar indicators of economic weakness, but that investors act more quickly when the news is bad. Again, relatively large standard deviations of returns and modest sample sizes limit confidence in the conclusion.
For what asset is FFR a solid indicator?
The final chart compares the behaviors of FFR and the 90-day Treasury bill (T-bill) over the entire sample period. The relationship is obvious. The Pearson correlation between these two series is 99%.
In summary, neither the level of the Federal Funds Rate nor changes in the rate are of much use in forecasting the behavior of the overall stock market, partly because any relationships are weak and partly because rate changes are infrequent.
See Blog Synthesis: The Economy and the Stock Market for other research on relationships between macroeconomic indicators and stock market behavior.
