Are there reliable lead-lag relationships among stock market returns, changes in the Federal Funds Rate (FFR) and changes in Treasury bond yields? In their February 2011 paper entitled “The US Stock Market Leads the Federal Funds Rate and Treasury Bond Yields”, Kun Guo, Wei-Xing Zhou, Si-Wei Cheng and Didier Sornette apply a new “thermal optimal path” method to test whether: (1) U.S. stock market returns and changes in U.S. Treasury instrument yields have negative correlation; and, (2) FFR as a proxy for U.S. monetary policy predicts U.S. stock market returns. The thermal optimal path method applies statistical methods of thermodynamics to determine the most likely relationship between stock market returns and FFR/yields. Using both monthly and weekly time series for the S&P 500 Index, FFR and U.S. Treasury instrument yields grouped by short-term (three months to three years) and long-term (five years to 20 years) maturities over the period August 2000 through February 2010 (115 months), they find that:
- The S&P 500 Index, FFR and Treasury yields tend to move in the same direction, with stocks in the lead. FFR and short-term yields lead long-term yields until mid-2007, but precedence reverses thereafter. More succinctly, causal flows are:
- Before April 2007: Stocks → FFR → Short-term Yields → Long-term Yields
- After April 2007: Stocks → Long-term Yields → Short-term Yields → FFR
- Separate correlation analysis over the entire sample period confirms that stocks lead FFR/yields for all maturities, with a 3-month lead most likely.
- Results suggest that:
- The Federal Reserve focuses on U.S. stock market behavior, arguably attempting to limit losses, suppress bubbles and revive bear markets.
- Long-term investors are more sensitive to stock market signals than the Federal Reserve since the financial crisis.
In summary, evidence from two types of lead-lag analyses indicates that U.S. stock market behavior leads both the Federal Funds Rate and Treasury instrument yields during the 2000s.
Note that:
- Over the sample period used in the study, there are 17 (23) increases (decreases) in FFR, comprising two loosening trends (2001 through mid-2003 and late 2007 through 2008) and one tightening trend (mid-2004 through mid-2006) in monetary policy.
- Putting stock market performance during the 2000s in historical context suggests that, if the Federal Reserve is attempting to limit stock market volatility, they are unsuccessful.
See “Federal Funds Rate and the Stock Market” for a more investor-oriented analysis of the relationship between FFR changes and U.S. stock market returns based on simple tests. This alternative analysis uses a sample period about twice as long as that above and considers quarterly and semiannual lead-lag scenarios, as well as weekly and monthly.
