Monetary Policy Shocks and Their Impact on the Equity Term Structure

In financial research, understanding how monetary policy impacts equity markets is essential. Drawing from the foundational work of Bernanke and Kuttner (2005), studies have highlighted the responsiveness of stock markets to unexpected changes in interest rates. Recent advancements in economics have enabled researchers to assess the term structure of equity risk premia and dividend growth expectations across different maturities more effectively. This article delves into how monetary policy surprises (MPS), driven by Federal Reserve announcements, influence both short- and long-term estimates of these financial metrics using insights from the Giglio, Kelly, and Kozak (2024) model.

Understanding Monetary Policy Shocks

Measuring the effects of monetary policy shocks can be complex. Most frameworks rely on the high-frequency identification approach established by Kuttner (2003) and expanded by Bernanke and Kuttner (2005). MPS values emerge from analyzing price movements in interest rate-linked futures contracts immediately surrounding Federal Open Market Committee (FOMC) meetings. A positive MPS indicates a hawkish surprise, suggesting interest rates are expected to rise, while a negative value implies a dovish outlook, anticipating rate cuts.

The Federal Reserve Bank of San Francisco provides a Monetary Policy Surprise Dataset, aggregating these shocks into a monthly series. Analyzing the historical series since February 1988 reveals that the average surprise is near zero. However, during economic downturns, a slight negative mean is evident, while periods of economic strength show a slight positive mean. To better understand these dynamics, we categorize economic episodes into three distinct subsamples: periods of positive MPS, negative MPS, and none—allowing for a clearer analysis of the relationship between MPS and risk premia.

Monetary Policy and Equity Term Structure Connection

Monetary policy not only influences government bond interest rates but also has ramifications for stock prices via equity risk premia and growth expectations—two core components in the valuation of stocks. These elements are crucial for present value calculations, yet discerning them solely through stock prices is challenging. The relationship between stock prices, risk premia, and growth expectations can be articulated through the discounted present value formula:

$\sum _{m=1}^{\infty }\frac{E_t\left[D_{t+m}\right]}{(1+r_{t,m}{)}^m}=P_t$

Here, $E_t\left[D_{t+m}\right]$ denotes expected future dividends, $P_t$ represents the stock's market value, and $r_{t,m}$ is the discount rate for maturity $m$. Economic theory often assumes a constant discount rate across maturities, though models suggest that higher uncertainty associated with long-term cash flows may lead to higher risk premiums. Overall, this analysis aims to understand how these variables, across maturities, respond to different monetary policy shocks.

Disentangling Risk Premia

Using the Giglio, Kelly, and Kozak (2024) model, we can isolate risk premia and dividend growth rates in excess of the risk-free rate. The model computes risk parameters by evaluating the time-series dynamics of stock market and anomaly portfolio returns from 1973 to 2020. This method identifies significant risk factors that shape investor expectations regarding future market dynamics, resulting in monthly series depicting both risk premiums and dividend growth rates across various maturities.

From the comprehensive analysis of the 1988-2020 period, we find that expected dividend growth rates hover around three percent, exhibiting stability over time. More notably, the term structure of risk premia appears upward sloping, beginning slightly negative for short maturities and reaching approximately 3.6 percent for maturities of fifteen years. This pattern reflects investor aversion to long-term risks, leading to heightened risk premiums associated with discounting long-term equity cash flows.

The Dual Nature of Monetary Policy Shocks

The evidence suggests a complex relationship between monetary policy surprises and the associated expectations in equity markets. The monetary policy information channel proposes that interest rate cuts could signal underlying economic weakness, impacting both risk premiums and expected dividend growth rates. Our analysis of different MPS subsamples corroborates some elements of this theory.

Results indicate that negative surprises lead to an average 25-basis-point increase in risk premiums across all maturities, suggesting a uniform upward shift when negative MPS occur. Conversely, positive monetary policy surprises do not correlate with a drop in risk premiums, potentially indicating that rapid interest rate hikes may also reflect bad economic indicators such as inflationary pressures. Although these effects are statistically insignificant, they provide insight into the overall response of equity markets to monetary policy shifts.

On the expectations side, only dovish surprises yield a decline in expected dividend growth rates—reported declines of over 50 basis points for short maturities and 20 basis points for longer maturities. This finding aligns with economic intuition: significant rate cuts generally signal less favorable economic conditions, leading to reduced growth prospects. In contrast, hawkish surprises do not exhibit a similar pattern, suggesting positive economic conditions or inflation may persist despite increasing interest rates.

Conclusions

In summary, the ongoing exploration of the equity term structure's sensitivity to monetary policy shocks reveals nuanced insights into market dynamics. The application of new modeling techniques enhances our understanding of how various monetary policy surprises impact equity risk premiums and dividend growth expectations across differing maturities. Notably, significant interest rate shocks tend to increase equity risk premiums, while negative surprises distinctly lower expectations for future dividend growth. As research continues, these findings underline the need for a deeper examination of the interconnections between monetary policy and equity market behavior.

Henry Dyer holds a master's in finance from MIT Sloan School of Management, while Tomas Jankauskas serves as a financial research economist at the Federal Reserve Bank of New York.