A new paper by two economists affiliated with the Federal Reserve System presents a new measure of the monetary policy exposure of individual stocks.
The simplest approach to this task would be to regress individual stock returns around major central bank moves (“shocks”). But that turns out not to be feasible, both because so many stocks have very high volatility and because they lack a sufficiently long history.
The authors, Ali K. Ozdagli and Mihail Velikov, of the FRB of Boston and Richmond, respectively, generated an MPE index. It is as they put it “based on observable firm characteristics” that drive this exposure, given parsimonious assumptions. Relevant firm characteristics include the cash at hand and the quantity of short-term investments. Interest rates, after all, are the opportunity cost of keeping one’s cash in a nearby drawer or the equivalent.
Cash flow volatility is another key firm feature for this model, as is operating profitability.
Ozdagli and Velikov created an index, crunched the resulting numbers and found that stocks that react positively to expansionary monetary policy generally earn lower average returns than stocks that don’t.
Leaving aside alpha-seeking plays for a moment, the theoretical reason that this is important is that (should the findings hold up to peer review) they could reframe a long running debate among macroeconomists as to how expansionary monetary policy works.
The Macroeconomic Line-Up
The different macroeconomic schools involved in the dispute agree on this much: monetary policy is an important source of risk in the stock market. The debate concerns the aggregate risk premia. According to the cash-in-advance model of, for example, Pierluigi Balduzzi (author of a 2007 article in the Journal of Economic Dynamics and Control the authors cite) whether the risk premium that follows from a monetary shock will be positive or negative depends on the elasticity of substitution between cash and credit goods.
An important consequence of Balduzzi’s view is that monetary policy commands a risk premium even if it has no real effect on output.
On the other hand, the New Keynesian model looks to the consequences of a monetary shock from the marginal utility of consumption. An expansionary monetary shock (an undiscounted cut in interest rates let us say) should increase consumption, decreasing its marginal utility, thus introducing a positive risk premium. A contractionary shock (an undiscounted increase in interest rates) should work the other way, decreasing consumption, increasing its marginal utility, thus introducing a negative risk premium.
A Funding Liquidity Model
On the third hand, there is a funding liquidity model expressed for example in a 2005 work by then-newly-appointed Fed chair Ben Bernanke and Kenneth Kuttner of the National Bureau of Economic Research. According to this view, monetary policy is not the driver of the business cycle but a mitigator, and (in the words of the abstract of the Bernanke-Kuttner paper) “the effects of unanticipated monetary policy actions on expected excess returns account for the largest part of the response of stock prices” to those moves.
In this funding-liquidity view, an expansionary shock should increase risk taking, and decrease risk premia. A contractionary shock should have the opposite effect. This is precisely the opposite of what the New Keynesian theories would lead on to predict.
Note that each of those three views makes a prediction about the aggregate risk premium, whereas the index that Ozdagli and Velikov have created allows them to take a more granular look, to see the “cross-section of risk premia” that result from the idiosyncrasies of firms’ exposure to monetary policy. They don’t propose so much to settle the debate among the views above as to reframe it.
To that end: Ozdagli and Velikov find that their MPE index does a good job of predicting returns on equity after monetary shocks. Specifically, the stocks that tend to perform poorly when there is an expansionary shock have significantly higher average returns than do stocks that perform well under those circumstances. The effect is sufficiently marked that a long/short trading strategy designed to exploit this effect (when back tested from data for 1975 – 2014) yields an annualized return of 10.56%, and Fama-French-Carhart alpha of 7.56%.
Their conclusion defers the question of which macro theory is right, saying that they index will be useful for “future research” on the subject. On the whole, though, the authors seem of the opinion that their work favors the funding liquidity model.