In the financial markets there are tools that allow extracting information about the expectations that investors have regarding the future behavior of certain economic and financial variables.
Within this category, Volatility indicators. The volatility index measures market uncertainty regarding the short-term (after 30 days) development of various variables. This could be a stock index, government bond yield or the price of crude oil, among others. Therefore, an increase in these volatility indicators means an increase in uncertainty in the stock market, in the fixed income market or in the commodity market.
The standard volatility index in international financial markets is VIX, which measures the uncertainty associated with the Standard & Poor’s 500 (S&P 500) and serves as a benchmark glass To measure investor fear.
Historically, VIX reached peak values in response to major events of a different nature, such as the terrorist attack on the Twin Towers in New York in September 2001, the fall of the Lehman Brothers in September 2008 or the coronavirus outbreak. COVID-19 epidemic in March 2020.
After years in which the traditional monetary policy of the European Central Bank and the Federal Reserve has been characterized by interest rates fixed at 0%, there is successive news about the reaction of financial markets (stock markets, debt market, risk premium…) in the face of interest rate hike decisions on both sides of the Atlantic .
The expected impact of monetary policy announcements on investor uncertainty
Unlike large and unexpected events associated with increased market uncertainty, monetary policy announcements are scheduled. In other words, the date on which the relevant authorities meet to take monetary policy decisions is known in advance.
This aspect is important for understanding the impact of monetary policy announcements on investor uncertainty. Edrington and me in their article Creating and resolving market uncertainty: the effect of information releases on implied volatility (Journal of Quantitative and Financial Analysis, 1996) presents a hypothesis about the expected effect of scheduled advertisements on market uncertainty.
Specifically, the authors expect a decrease in the level of uncertainty associated with a particular variable immediately after scheduled announcements which has a strong impact on the price of the said variable.
The logic is as follows:
Measuring volatility indicators every day The expected average price volatility of a variable over the next 30 days. If, after some scheduled major announcement, investors notice that the prices of a particular variable are moving violently (i.e. experience large fluctuations), such expected behavior will cause the 30-day average volatility before the announcement to be greater than after it.
This is because after the announcement, the estimate of expected volatility no longer includes the day of the announcement associated with particularly high volatility. Ultimately, the authors expected the uncertainty to resolve after relevant scheduled announcements.
Respond to market uncertainties by ad content
If we analyze the reaction of the VIX after the Fed’s monetary policy announcements from the first rate hike, in March 2022, to the last one, at the end of July, the average variance rate between the day before and the day of the announcement was -0.10%. This data indicates that the Federal Reserve’s recent announcements have contributed to resolving the uncertainty or fear of investors.
One might now ask, what is the meaning of the market response between March 2020 and March 2022, when there were no changes in interest rates?
In this case, VIX also saw, on average, a decline after announcements (-0.04%), although these are unchanged under current conditions. Therefore, the hypothesis of resolving uncertainty in the markets appears to have been fulfilled in both phases, regardless of the announced decision.
Communication strategy for monetary policy decisions
Now, why has investor uncertainty declined more, on average, in the phase of an interest rate hike announcement than in the earlier phase of no interest rate changes?
The uncertainty resolution hypothesis in this regard predicts that the magnitude of the decrease in uncertainty in a particular market will be greater the greater the impact of the announcement on the said market. That is, more fluctuations are observed after the announcement.
In the fluctuations reflected in stocks (in this case the S&P 500) after monetary policy announcements, the information announced by monetary authorities about the expected course of monetary policy in the near future plays a very important role. I mean that forward steering.
In order to be as transparent as possible about the future direction of monetary policy decisions, the Federal Reserve communicates the expected course of interest rates both in statements it issues immediately after meetings, and in subsequent press conferences.
In this sense, in the stage of fixed interest rates at 0%, the information repeatedly given by the monetary authority predicted no changes in the near future.
Instead, at the meeting of the Federal Reserve on January 26, 2022, the change of direction in its monetary policy was announced:
“With inflation above 2 percent and labor market strength, the Committee expects that it will soon be appropriate to raise the target range for the federal funds rate.”
In successive meetings throughout 2022, the US Monetary Authority announced future interest rate increases and, in some cases, provided information on the size of the increase.
An example is the June 15, 2022 meeting, where an interest rate hike of 0.75% was announced, something we haven’t seen since 1994. At the press conference after the statement from the Federal Reserve, its Chairman Jerome Powell announced that in the next meeting the hike could be 50 or 75 basis points.
This announcement greatly increased volatility in the stock markets.
Investors are now anticipating more volatility in stocks as a result of an unexpected or surprising element of announcements about the current and future course of monetary policy. This would explain why, following the Fed’s announcements, uncertainty has decreased in this new phase of restrictive monetary policy.
Can we expect the Fed to continue to announce new rate hikes? Will you do as much as economic agents expect? What will be the surprising component of the information that will be revealed about the future course of monetary policy? The answer to these questions will largely determine the level of resolution of uncertainty in the markets.
Raquel Lopez Garcia, Contracting Professor Interim Physician, Department of Economic Analysis and Finance, University of Castilla-La Mancha and Francisco Garino Cibrian, University Professor, Department of Financial Economics, Department of Economic Analysis and Finance, University of Castilla-La Mancha
This article was originally published in The Conversation. Read the original text.