| US Federal Reserve announcements and the implications for the Irish stock market |
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| Don Bredin and Gerard O’Reilly examine the relationship between the ISEQ returns and volatility and U.S. monetary policy. They identify the sensitivity of the Irish economy in general and the Irish stock market in particular to events in the US. |
With increasing global financial integration, returns in markets tend to move in concert, with changes in one market leading to spillovers to other markets, both in terms of returns and uncertainty (volatility). Concomitantly, financial market participants pay close attention to the release of both foreign and domestic economic news which may affect asset returns. Of particular note is the influence of US monetary policy decisions on both returns and volatility of the Irish stock market (ISEQ). In order to identify such an influence, two possible avenues are followed; the news, or new information channel and the behavioural channel.
The first important issue is whether the announcement may impart new information to market participants as it may differ from what they had anticipated. If markets are efficient (stock prices incorporate both current and expected future events), assets should react to the unanticipated element (surprise) of the announcement rather than the announcement itself and hence market returns should not respond to the expected component of announcements. How this US interest rate news effect is likely to influence ISEQ returns and volatility associated with those returns is an important question1. Second, do regularly scheduled meetings of the US Federal Reserve have an influence on the volatility of the ISEQ2? In the financial press, there is anecdotal evidence to suggest that markets enter a lull (lower volatility) prior to the release of important information. In the wake of an announcement, traders react to such information leading to an increase in activity (higher volatility). For example on the morning of an FOMC meeting, CNN news wire noted that the US stock market was ‘…very quiet… amid anticipation that the Federal Reserve would raise interest rates in the afternoon’, August 24th 1999. This pattern has been dubbed the calm before the storm and would represent a behavioural change in the ISEQ around the time that the Federal Reserve makes decisions.
Previous research has found evidence of the influence of large international stock markets on ISEQ returns and ISEQ volatility. However, this begs the question, what is the driving force behind a change in one market leading to a spillover into another? One important and an obvious starting point are US monetary policy announcements. A recent study highlighted the important influence of US monetary policy on ISEQ returns, relative to domestic (Euro area) and other international monetary policy shocks (for example the US and the UK)3. The authors find that the ISEQ is in fact influenced significantly by international monetary surprises, but notably this is only the case for surprises emanating from the US. The ISEQ does not respond to either Euro area or UK monetary policy surprises. Overall, the results suggest that monetary policy conditions in the UK, and Euro area appear to have little influence on ISEQ returns. This result may initially seem surprising. However, recently, Irish economic growth has been more akin to that of the US, rather than any of its European neighbours with growth prospects in the US acting as a good barometer for economic activity in Ireland. This was due in part to the large influx of US multinationals and the concomitant decline in traditional firms who mainly exported to our European neighbours. In addition, there was an increased expansion of the major players in the Irish stock market in the US market4. Viewed in this context, it is less surprising that monetary conditions in the US appear to play a much larger role in determining prospects on the ISEQ than the UK and Euro area monetary policy.
As a result the main focus has been on US monetary policy surprises and their impact on ISEQ returns and volatility. A key issue is an accurate proxy for US monetary policy surprise or put another way, how are expected future policy forecasted. Rather than adopting statistical models to forecast expected future interest rates, a market proxy is adopted, using interest rate futures contracts. With the advent of US federal funds future contracts in the late 1980s researchers have increasingly focused on the information contained in the federal funds futures rate to identify expectations of changes in future monetary policy5. The settlement price of the contract is 100 minus the average of the daily overnight Federal funds rate during the month of the contract. Hence, a forecast of the Federal funds rate is implied by the price of the contract. A number of studies in the US have found that Federal funds futures contract dominates other market instruments at forecasting the federal funds rate over horizons out to several months. The measure of the monetary policy surprise can then be defined as the one day change in the Federal funds futures contract. The markets based measure of the surprise can be used to address the impact on both ISEQ returns and volatility (assumed to vary over time). The impact of US monetary policy surprises is found to reduce ISEQ returns and this finding is statistically significant. Therefore a surprise tightening in US monetary policy leads to a fall in returns on the Irish market. This result is consistent with both anecdotal evidence and economic theory. There is also greater uncertainty (that is, volatility increases) in ISEQ returns, as a result of a surprise tightening of US monetary policy.
Finally, the question of whether there are any behaviour changes and specifically if volatility in ISEQ returns follows a pattern which is consistent with the /calm before the storm/. This is often referred to as a pre-announcement effect in relation to FOMC meetings and so any change in market behaviour occurs before any decision is released publicly. The empirical results find evidence in favour of a calm before the storm effect. ISEQ volatility is lower (calm) on the day prior to an FOMC announcement and higher (storm) on the day of the announcement6.
The main focus of attention has been solely on US monetary policy decisions based on the increasingly strong links between the two economies and on results from previous research. The findings reported here represent further evidence of the sensitivity of the Irish economy in general and the Irish stock market in particular to events in the US. This is the case in relation to new information regarding the US economy and behavioural changes around the time that the US Fed makes it interest rate decisions.
Dr. Don Bredin is a lecturer in U.C.D., and Dr. Gerard O’Reilly works in the Central Bank of Ireland. |
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| Article appeared in the October 2006 issue.
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