The Effect of Federal Reserve Policy, Yield Curves, and Current Level of Interest Rates on Equity Returns

Abstract

Empirical research investigating the effect of Federal Reserve policy on equity markets has produced mixed results. Practitioners and some academics assert that an expansive policy by the Federal Reserve will positively affect expected market returns while restrictive action will adversely affect market return, while others assert that Federal Reserve action is ineffective in influencing equity returns. In addition, other researchers have attempted to identify a relation between yield spreads and equity risk premiums. While these researchers typically have found a positive relation between yield spread and equity risk premiums, they have not addressed the changing temporal influence of yield spreads on equity returns, nor have they incorporated Fed policy or varying interest rate or monetary environments in their analysis. Likewise, research focusing on Fed policy has not incorporated yield spreads or the concurrent interest rate environment. The primary purpose of this research is to examine the combined effects of Fed policy, yield spreads, and concurrent level of interest rates on future equity returns. The authors find that (1) Fed policy continues to be relevant, but only when considered in conjunction with the yield, (2) the explanatory power of the yield curve is enhanced by the identification of Fed policy, (3) the influence of Fed policy and the yield spread changes over time and over varying economic and monetary environments, and (4) incorporating the concurrent level of interest rates into a relative yield spread increases the robustness of the relationship between Fed policy, yield spread, and future equity returns.