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Fed funds rate surprises and financial markets.

This paper investigates the sensitivity of various financial markets to surprises in the federal funds rate. We employ the methodology outlined by Kuttner [2001] to reevaluate prior results and expand the analysis to include data up until the financial crisis, inclusive. Our data set includes additional events to previous studies, which led our results to differ than those earlier studies. For our sample excluding the financial crisis (1994-2007), we found that Fed funds surprises had a significant effect on the percent change in the S&P 500 index, but generally had little significant effect on Treasury yields and the trade-weighted dollar. We also studied a decomposition of the yield curve and found that the lack of significant effect on Treasury yields was a result of the offsetting effects of surprises on the term premium and risk-neutral yield. In addition, our analysis of the financial crisis revealed several shifts in the response of many asset classes, likely a result of the large signaling effects contained in monetary policy combined with the extraordinary events that were occurring.

Business Economics (2016) 51, 36-49 doi: 10.1057/be.2016.10

Keywords: Fed funds rate, surprises, equity markets, Treasury, foreign exchange


With the uncertainty surrounding rate hikes by the Federal Reserve, the timing and likely impact on financial markets is of the upmost importance to market participants and decision makers. In this study, we seek to quantify the expected reaction of a Fed funds rate surprise--a significant difference between anticipated and actual Fed funds rate changes --on several different markets, including Treasury securities, equities, and foreign exchange. Our data set includes additional events to previous studies, which led us to different results than those earlier studies. Our sample included the time period from 1994 to 2008. Here, our goal is to replicate the established methodology of prior research using additional data, which includes the financial crisis, although we make our own contributions to the literature as well.

How financial markets respond to surprises in the funds rate is relevant for participants in these markets, as well as firms, households, and policymakers. As demonstrated by the many financial crises of the past, changes in financial markets can have significant knock-on effects on the real economy. Standard economic theory suggests that changes in interest rates affect consumption and investment decisions. Moreover, exchange rates affect the relative competitiveness of domestically produced goods and drive cross-border investment, and changes in equity markets can also impact the real economy through wealth effects and altering the cost of capital for firms. Therefore, it is clear that understanding how markets respond to surprises in the federal funds rate does have implications for decisions that are currently being made by businesses, households, and policymakers.

The effect of unanticipated macroeconomic news on financial markets has been studied extensively in the academic literature [Barro 1981]. In addition, there is a rich literature studying the response of financial markets to surprises in monetary policy. Much of the work stems from Kuttner [2001], which studied the impact on interest rates of unanticipated Fed funds announcements. From this work, there were a number of similar studies that investigated the response of different asset classes to the same surprises [Bernanke and Kuttner 2005]. We expand upon this style of analysis to reevaluate these empirical relationships as a result of the financial crisis. In addition, we expand upon the previous literature by studying the sensitivity of components of Treasury yields to surprises in the Fed funds rate, using the methodology of Kuttner [2001]. We must emphasize that much of our study is replicating prior work, but we include additional data to reevaluate the relationships including data during the financial crisis. Our study is restricted to Fed funds rate surprises rather than extending to other macroeconomic news in this study because of the importance of the impending liftoff of the federal funds rate from the zero-lower bound.

We utilize data on Fed funds futures to calculate the surprises, and then our analysis is rather straightforward. We investigate the relationship between the change in the dependent variable (Treasury yields, equity index, and foreign exchange value of the dollar) and the Fed funds surprise via a linear regression. To anticipate our results, our investigation reveals that, generally, short-term Treasury yields rose, long-term rates were not significantly affected, equities fell (although the crisis complicated this relationship), and the dollar was not significantly affected, at least initially by surprises in the Fed funds rate.

Section 1 introduces the concept of a Fed funds surprise and develops the theory as to why we employ surprises instead of the actual release value. In Section 2, we briefly explain the theoretical underpinnings of our study and the intuition of how Fed funds surprises should affect financial markets. Sections 3 and 4 describe the methodology and data, respectively. We present the results of our analysis in Section 5, and Section 6 concludes.

1. How to Measure Fed Funds Rate Surprises

Why use the surprise component?

In an efficient financial market, all publicly available information is discounted into prices [Fama 1969]. This means that market expectations would already be incorporated into prices before any macroeconomic news announcement, and there is substantial literature confirming this claim [Kim, McKenzie, and Faff 2004], In theory, if macroeconomic news were released and perfectly matched market expectations, asset prices would not move because there is no new information. This may not be the case in practice, however, as uncertainty surrounding the event is now resolved and expectations regarding future news releases may be revised, but the literature does offer some support for this claim. Moreover, there still may be trading following a release that perfectly matches expectations, as individual market participants may have taken positions differing from consensus expectations. To control for expectations in our analysis, we use the surprise component of the macroeconomic news rather than the actual release value. The surprise component is simply the difference of the actual release from expectations.

Survey- or market-based expectations?

There are three main methods for determining the surprise component of a Fed funds rate announcement. The first is to determine market expectations and then calculate the surprise by comparing the actual release relative to expectations.

A second method is to look at the markets for certain financial assets themselves, which already incorporate expectations regarding the news, and see how their prices change following the announcement. Expectations regarding the Fed funds rate are influential in the prices of many financial market instruments, particularly in the money markets. Changes in the prices of these assets immediately following the macroeconomic news announcement reveal the extent to which the news was expected or a surprise, and the surprise component can be calculated from these movements. We believe that such market-based measures are the most appropriate for our purposes.

A third method is to develop a statistical proxy for Fed funds expectations. Model selection would be an issue if this method is employed, and we prefer to measure the surprise using actual data when possible.

Before proceeding to our development of market-based measures rather than survey-based measures, it is useful to discuss the rationale for doing so. There are numerous survey-based methods to gauge financial market participants' expectations for the Fed funds rate. Economists at the Federal Reserve Bank of New York outlined several of these, including the Survey of Primary Dealers and the Pilot Survey of Market Participants [Crump and others 2014]. In addition, economists' consensus estimates can easily be retrieved from various news outlets and data providers. Surveys are relatively infrequent compared with market-based measures, however, meaning that additional news between the survey date and the actual announcement date could add noise to the data. This is one drawback to the use of survey-based measures.

In addition, regardless of the survey, some market participants would be excluded; thus, the survey results may not accurately reflect expectations of the market as a whole. Finally, and most importantly, survey-based measures of expectations generally present the modal, or most likely, estimate of the funds rate. A major advantage of market-based measures is that they typically represent a probability-weighted average of the possible paths of the funds rate, which can differ from the modal estimate. It is this probability-weighted average that should be discounted into financial assets, since their prices should discount the entire distribution of possible outcomes, not just the most likely.

Moreover, the modal estimate does not allow for "partial" surprises, as evident when comparing Figure 1 to Figure 2. As is readily apparent, the survey-based surprises typically have a magnitude of 25 basis points (bps), although there are occasionally larger surprises. Market-based measures, however, can capture more uncertainty around a release and the average surprise has a magnitude of 6 bps. Even if consensus estimates are correct, markets may still react as they priced in a possibility for fed action, and market-based measures of surprises should better account for this reality. This limits the number of surprises and is not as indicative of reality. In addition, money market data are readily available from a number of sources and have a relatively long time horizon.

Fed funds futures and expectations

Now that we have decided on a market-based measure, we must decide what instrument is most appropriate for determining expectations regarding a Federal Open Market Committee (FOMC) policy announcement. Gurkaynak Sack, and Swanson [2007] studied several different money market instruments--including term Fed funds rates, Fed funds futures, Eurodollar rates, Eurodollar futures, Treasury Bills, and commercial paper--to determine which is best for measuring monetary policy expectations. The authors find that Fed funds futures contracts are superior at predicting the Fed funds rate for the short time horizons we are studying. Several other studies similar to ours also utilize Fed funds futures contracts and the methodology for extracting the surprise component is more or less standard in the literature. (1)

2. Theoretical Response to Fed Funds Surprises

Treasury securities

Kuttner [2001] found that Treasury yields increase in response to surprises in the Fed funds rate. We will reevaluate these results to include additional data. In addition, to understand the impact of changes in the federal funds rate on other interest rates, we find it helpful to decompose Treasury yields into two underlying components, the risk-neutral yield and the term premium. (2) Our intuition suggests that the risk-neutral rate would be positively affected by surprises in the Fed funds rate. This seems rather straightforward, as an unexpected increase in the Fed funds rate likely shifts expectations for future short-term rates higher.

The effect of a Fed funds rate surprise on the term premium, however, is more ambiguous. On one hand, a shock to the Fed funds rate may reduce uncertainty surrounding the path of future policy and thus interest rates, likely reducing the term premium. On the other hand, a shock could increase uncertainty about future policy, as investors discount further unanticipated moves by the Federal Reserve. In other words, a Fed funds surprise may increase the term premium as investors are less confident about their expectations for the evolution of the short-term rate. During the 1994 tightening cycle, there were several fairly large positive Fed funds surprises. Some of these were accompanied by increases in the term premium and others were accompanied by declines. Thus, we cannot predict simply from inspection how term premiums on Treasury securities behave following a Fed funds shock. Further analysis is required. (3)

Trade-weighted dollar

The interest rate differential between two countries is a large driver of the exchange rate. Thus, we suspect that unexpected moves in the federal funds rate would also drive moves in the dollar around these announcements. We hypothesize that an unexpected positive shock in the Fed funds rate would, on average, be associated with a strengthening of the dollar, as dollar-denominated assets are relatively more attractive to investors. Of course this works well in theory, but as we saw in the previous section, the effect of a Fed funds rate surprise on other market interest rates is not as direct as it may seem; therefore, further investigation is required to see if this is what happens to the dollar in response to Fed funds surprises.

This portion of our study is similar to the research conducted by Evans [1994] of the Chicago Fed. The Chicago Fed study found that the dollar/mark and dollar/yen exchange rates were affected by the unexpected component of a Fed funds rate announcement, although this effect was not evident until a large amount of time had passed. Our analysis would not capture this delayed effect, since we are looking at daily returns around the event.


The theoretical link between equities and the Fed funds rate is not as direct as that of Treasury securities or foreign exchange. An equity's fundamental value is the discounted value of expected future cash flows. Although there are numerous methods for estimating both future cash flows and the appropriate discount rate, here we will address qualitatively how each component would be affected by a surprise in the funds rate from a macroeconomic perspective.

Intuitively, there is a rather clear relationship between the discount rate and the Fed funds rate. (4) As mentioned earlier, however, the relationship between Fed funds surprises and other interest rates might be less clear than it seems. In addition, the expected cash flows from an equity investment are not discounted at a constant risk-free rate because the cash flows are uncertain, and the risk premium imbedded in the discount rate could plausibly be affected by Fed funds rate surprises. Therefore, the effect on the discount rate of a Fed funds rate surprise is ambiguous.

Shocks to the Fed funds rate also may impact expected cash flows. Corporate profits, a driver of equity earnings, are one of the more cyclical components to GDP [Silvia 2014], Because of their cyclical nature, expectations regarding corporate profits--and therefore cash flows from equities--may be altered by surprises in the Fed funds rate. A positive surprise in the Fed funds rate likely leads to decreased expectations of future cash flows in the aggregate. The positive surprise, ceteris paribus, indicates tighter-than-expected monetary policy, which would have a negative effect on economic growth and, therefore, corporate profits. In addition, changes in the foreign exchange value of the dollar could alter expected corporate profits following a Fed funds surprise. A positive surprise in the Fed funds rate may also lead to dollar appreciation, which would decrease the value of foreign earnings and make exports relatively less competitive and could therefore have a negative impact on equities.

In sum, while the sensitivity of the change in equity prices to Fed funds surprises is somewhat ambiguous, our hypothesis is that equities will be negatively impacted by a surprise in the Fed funds rate. This is because market interest rates (and therefore the discount rate) should increase, driven higher by the increased risk-neutral yields, and aggregate expected cash flows are likely to suffer following a Fed funds shock. In addition, prior empirical work by Bernanke and Kuttner [2005] found that broad equity indices fall in response to an unexpected rate hike.

3. Methodology

Calculating surprises in the Fed funds rate

Following the work of Kuttner [2001] and Bemanke and Kuttner [2005], we utilize the Fed funds futures market to calibrate the surprise component of changes in the Fed funds rate. (5) Because the contracts represent the expected Fed funds rate during the month, for a given event on day d of month m, the surprise component can be calculated as the change in the Fed funds futures. (6) Recall, however, that the contract represents the average Fed funds rate; thus, the change in the futures must be multiplied by a scaling factor, including the number of days left until settlement. To summarize, the unexpected change in the target rate, following Bernanke and Kuttner [2005] can be calculated as follows:

[DELTA][i.sup.u] = [D / D - d] ([f.sup.0.sub.m,d] - [f.sup.0.sub.m,d-1]), (1)

where [DELTA][i.sup.u] is the surprise component of the Fed funds target rate change, [f.sup.0.sub.m,d] is the current-month futures rate on day d, and D is the number of trading days in the month. An additional complication is that the Fed funds futures are based on the effective Fed funds rate while we study expectations regarding the target rate. Kuttner [2001] and Bernanke and Kuttner [2005] both point out this is generally not an issue except around the end of the month because of the increased scaling factor and the magnified effect that any noise may have. For this reason, the unsealed one-month-ahead futures rate is utilized to determine the surprise when the change is in the last three days of the month. In addition, if the announcement is on the first day of the month, we correct for the fact that the one-month ahead futures rate is now the current futures rate (substitute [f.sup.1.sub.m,d-1], the one-month ahead futures contract, for [f.sup.0.sub.m,d-1] in the above equation).

At the December 2008 meeting, the FOMC reduced the Fed funds rate 75 bps to the current 0-25 bps range. Since this meeting, the FOMC has undertaken numerous unconventional monetary policy measures to meet its objectives, and market participants have only recently experienced a modest liftoff. For this reason, we suspect that the small surprise readings seen following this meeting were mostly noise associated with the futures data and decided to truncate our data set at the end of 2008. Note that there were "shocks" to market expectations for the funds rate during this period, most notably the "Taper Tantrum" in 2013. The "Taper Tantrum," however, only caused agents to revise expectations for the funds rate further out into the future, and thus would not be captured in this study.

We partition our data set to study how Fed funds rate surprises affect different markets before and during the crisis. Our definition for the beginning of the crisis is the first time the FOMC reduced interest rates for the cycle, which was at the September 2007 meeting.

Empirical methodology

Our analysis was structured as an event study around unexpected changes in the Fed funds rate. Following the work of Kuttner [2001] and Bernanke and Kuttner [2005], we estimated an ordinary least squares regression of the following form:

[DELTA][y.sub.t] = [[beta].sub.0] + [[beta].sub.1][DELTA][i.sup.u.sub.t], (2)

where the dependent variable is the one-day change in the variable of interest ([DELTA][y.sub.t]) and the independent variable is the surprise in the Fed funds rate ([DELTA][i.sup.u.sub.t]). (7) We will also control for asymmetric responses by including an interaction term as an additional independent variable, to see if certain markets have an asymmetric response to surprises in the Fed funds rate.

4. Data

Treasury securities, dollar indices, equities, and Fed funds futures

To understand the impact of changes in the federal funds rate on other interest rates, we find it helpful to decompose Treasury yields into two underlying components, the risk-neutral yield and the term premium. These different components are unobservable and, therefore, must be estimated. There are a variety of methods for this, although a thorough treatment of the literature is beyond the purview of this study. We choose to use the estimates provided by the Federal Reserve Bank of New York based upon the work of Adrian, Crump, and Moench [2013], and we refer interested readers to their study for specifics of their methodology. Figures 3 and 4 plot the daily difference in yield components along with the Fed funds surprise in event time for the 10-year Treasury. Visually, it appears that the risk-neutral yield and surprise measure are correlated, but the term premium and the surprise are less so.

Trade-weighted dollar indices are obtained from the Federal Reserve Board and the S&P 500 index is obtained from Moody's Analytics. For all series, we measure the change in daily closing prices. The change in Treasury data is measured as the difference in yields (in basis points). The change in the remaining series is the percent change in the dollar indices (in basis points) and the percent change in the S&P 500 index (in percentage points) (Figures 5 and 6).

Summary statistics

Summary statistics are in Table 1. The surprise values are calculated from the Fed funds futures prices, as outlined in our introductory comments. Also note that we excluded instances where there was no Fed funds surprise. It is worth pointing out that the trade-weighted dollar has a slightly negative correlation coefficient, like we would expect, although the correlation coefficient with the major currencies is slightly positive. This may suggest that these are spurious correlations, and that there is no significant effect, we will investigate. Risk-neutral yields increase, on average, in response to a positive surprise in the Fed funds rate, while term premiums fall, on average. In addition, the S&P 500 falls, on average, in response to a positive Fed funds surprise. Although these correlations are interesting, we will continue to study the relationship utilizing linear regressions to try and quantify the sensitivity of each to surprises in the funds rate.

5. Results and Discussion

Treasury securities

Which part of yields are affected by Fed funds surprises?. Now we address whether surprises in the federal funds rate affect the different components of interest rates and, if so, we explore the sensitivities of these components and what implications that may have for the future. Recall we use the simple difference of the yield, the term premium and the risk-neutral yield from the day prior to the surprise to employ as the dependent variables in our analysis.

Sensitivity varies by maturity. As outlined in the methodology section, we estimate several simple regressions, where the Fed funds surprise was the independent variable and the dependent variable was the change in the interest rate, the term premium and the risk-neutral rate. (8) The results of these regressions are presented in Table Al. We find that Treasury yields are significantly affected for maturities up to five years, with sensitivities to Fed funds surprises declining as the maturity gets longer. For short-term rates, the coefficient is of meaningful magnitude and the surprises in Fed funds rates explain a reasonable amount of the changes in yields around these dates. For a Treasury security with a maturity of one year, a 100 bps surprise in the Fed funds target rate corresponds, on average, with a 35 bps increase in the yield. This sensitivity decreases as the maturity increases, but remains statistically significant out to five years. If we control for asymmetric responses, a 100 bps positive Fed funds surprise corresponds with a roughly 70 bps increase in one-year Treasury yields, while a 100 bps negative Fed funds surprise corresponds with a roughly 28 bps decrease in yields. This asymmetric response suggests Treasury securities are more sensitive to increases in the Fed funds rate than decreases.

Delving into the components of yields and what explains the relationship between Fed funds and Treasury yields, we find that the risk-neutral yields are the most sensitive to changes in the Fed funds rate. The sensitivity of the risk-neutral rate is significant across all of the maturities studied, although the magnitude of the coefficient decreases as maturities increase. For a one-year Treasury note, a 100 bps surprise in the Fed funds rate corresponds, on average, with a 43 bps increase in the risk-neutral rate. This sensitivity is only 23 bps for a 10-year Treasury security, which is still meaningful. In addition, Fed funds surprises explain more of the variation in the risk-neutral rate than the term premium or yields. This makes sense intuitively, as a rather direct link can be seen between a shock to the Fed funds rate and the expected future path of short-term interest rates, which is the determinant of the risk-neutral rate.

The results for the term premium are a bit more difficult to interpret. The coefficient on the Fed funds surprise is negative across all maturities and statistically significant. The term premium seems to serve as a buffer, muting (or sometimes completely counteracting) the effect a change in the risk-neutral rate has on the overall yield. One possible explanation for this could be that as investors' expectations regarding the Fed funds rate are revised following a Fed funds surprise, there is more or less perceived risk to fixed income investors. For example, when the FOMC cut rates beginning in 2007, the term premium rose as the funds rate approached the zero lower bound. The further rates fell, the more the distribution of possible Fed funds rate paths was skewed upward. This represented additional risk to fixed income investors and may have resulted in an increase in the term premium.

We are careful, however, not to draw too many conclusions from this data regarding the term premium, as the results are by no means conclusive. First, the term premium is a tricky concept; and even estimating the different yield components is debated, and there are many methods of doing so. Second, we have a limited amount of data, and the surprise data we have are skewed to the downside, leading us to be cautious about our results. Finally, the fixed income market has changed over time. Changes in demographics, the regulatory environment, unconventional monetary policies, and the economy all can influence the term premium and affect the relationship it has with the Fed funds rate.

Differences before and during the crisis. We partitioned our data set into two periods: the period before the financial crisis and the period containing the crisis. Results for the precrisis and crisis periods are presented in Tables A2 and A3. The results between the two periods are similar, although the magnitudes of the coefficients for the sample including the crisis are generally larger and more significant than the precrisis sample. This may suggest that the relationship between yields, and yield components, and surprises in the Fed funds rate was more pronounced during the crisis relative to the precrisis period.

It is worth noting, however, that the crisis sample only included an easing cycle and the abrupt rate cuts made by the FOMC likely had stronger signaling effects regarding the economy and future policy. It is unclear whether trends experienced before the crisis will be resumed or if the increased sensitivity to Fed funds surprises experienced during the crisis will be the new norm. Nonetheless, the results are qualitatively similar.

Surprises and the maturity spectrum. We now discuss the results as we move across the maturity spectrum and try to understand why yields are more affected at shorter maturities. As illustrated in Figure 7, this impact clearly deteriorates as the maturity is extended. To first discuss the risk-neutral yield, the decreasing sensitivity is consistent with our intuition. The risk-neutral rate of a longer maturity bond is constructed from expected short-term interest rates reaching out far into the future. Expectations further out into the future of the short-term rate likely display more persistence than shorter-term expectations. There are more important drivers of future short-term rates when we look out years into the future than the current Fed funds rate, such as expected growth and inflation. Admittedly, these may be affected by the current Fed funds rate, although expectations regarding growth and inflation years into the future are likely to be very weakly affected by a small change to the Fed funds target rate today. Thus, because longer-term expectations regarding the short-term rate are not as strongly affected, the impact of a shock to the current Fed funds rate on the risk-neutral rate would be diluted as the maturity is extended.

Looking now at the term premium, we can see why the sensitivities of yields fall and are not statistically significant in longer-maturity Treasury securities. A positive shock to the Fed funds rate is associated with a fall in the term premium, on average, and the magnitude of the shock increases with maturity. Thus, because risk-neutral yields are less sensitive and term premiums are more sensitive at longer maturities, the offsetting effects lead to a small and insignificant sensitivity of yields to surprises in the Fed funds rate at maturities longer than five years.

Dollar shows no significant response, at least initially

Our findings, shown in the Appendix, support the results of Evans [1994] immediately following the event, which was that Fed funds surprises have a statistically insignificant effect on the dollar initially. This was at odds with our initial hypothesis, which suggested that the dollar would strengthen immediately following a positive Fed funds surprise. An alternative explanation could be the signaling effect that is contained if the unexpected component of a Fed funds rate announcement cancels out, on average, the effect caused by interest rate differentials. It is plausible that news contained in a federal funds surprise could cause investors to revise their expectations regarding the domestic economy. Because of the size of the U.S. economy, this may have large implications on the global economy, which could change investors' risk preferences. For example, an unexpected rate cut could signal that the economy is weaker than many thought, which could ignite fears regarding the global economy and cause a flight to safety to the dollar. Clearly the relationship is more complicated than we initially thought, and the insignificant sensitivity of the dollar to Fed funds surprises confirms this. Investigating the subsamples before and during the crisis also yielded similar insignificant results. In addition, we checked for asymmetric responses to see if the dollar responded differently to positive vs. negative surprises. We found that the sensitivity of the dollar was still insignificant.

Relationship between equities and surprises has broken down

For the entire sample, we found that, similar to Bernanke and Kuttner [2005], a positive surprise in the Fed funds target rate was associated with a decline in the S&P 500 immediately following the event. For the full sample, we found that, on average, a positive surprise of 1 percent is associated with a 1.23 percent decline in the S&P 500, although this result was not statistically significant (Table Al). The precrisis relationship was stronger and statistically significant, with a 1 percent positive surprise in the Fed funds rate associated with a decline of 4.83 percent in the S&P 500.

During the crisis, the sensitivity of equities to surprises in the Fed funds rate was positive, although statistically insignificant. The rapid rate cuts during the crisis likely were a major reason for the differing results. As we have discussed, the rate cuts also contained large signals to financial markets regarding the health of the U.S. economy and the severity of the crisis. In other words, the unexpected negative surprises by the Federal Reserve may have signaled even more weakness in the economy than was thought by financial markets. In addition, issues with liquidity and credit constraints may have contributed to the relationship's breakdown during the crisis. It is unclear whether the relationship will revert back to historical norms, as many things have changed in the financial markets. That said, we believe that the extraordinary events during the crisis did play a large role in the breakdown of the relationship between Fed funds surprises and changes in equity prices. We believe the relationship should at least partially revert back to the historical norm now that the large signaling effects that monetary policy contains regarding the economy have subsided to some extent.

In addition, to see if there was an asymmetric response to Fed funds surprises, we created an interaction term and ran another regression including this interaction term as a dependent variable. We found that equity markets are slightly less sensitive to positive Fed funds surprises, although the difference was not statistically significant.

6. Conclusion

In this study, we have investigated the sensitivity of Treasury securities, the dollar and equity indices to surprises in the Fed funds target rate. Generally speaking, we found that Treasury and foreign exchange markets are not as sensitive as we would have expected to surprises in the funds rate, but equities did appear to react significantly to the surprises. While this is somewhat surprising, it does have some implications for decision makers.

Our analysis suggests that yields on longer-term Treasury securities may be less sensitive to shocks in the Fed funds rate than many analysts have come to expect. This should comfort policymakers to some extent, but also be a cause for concern. Although it suggests we should not see a repeat of the taper tantrum scenario when the Federal Reserve begins to raise rates (assuming no unusual adjustment to the expected Fed funds rate out into the future), it also means that the Federal Reserve may be less able to increase long-term yields with its traditional policy tool. That said, the Federal Reserve could always sell assets from its balance sheet if it needed to rapidly tighten policy as another channel for policy implementation.

With respect to equities, we suspect that the more traditional historical relationship between equities and Fed funds surprises will prevail, although there is uncertainty as to the validity of this expectation. The extraordinary factors surrounding the rapid Fed funds rate cuts during the crisis likely contained more signaling regarding the health of the overall economy than was the case for traditional changes to the funds rate. We suspect that these signals will not be as strong when the Federal Reserve begins raising rates. This would suggest that positive Fed funds surprises may have a negative effect on the equity market due to lower expected cash flows and a modestly higher discount rate. Wealth effects were one mechanism through which monetary stimulus has affected the real economy, and positive surprises in the funds rate may have negative wealth effects. That said, we suspect that other determinants of consumer spending will dominate and lead to continued improvement in consumer spending. In addition, it appears as if the Federal Reserve is trying to mitigate surprises when it moves by emphasizing its intent on a measured pace of rate increases and reinforcing its emphasis on a data-dependent approach to policy.

Recall that this study only investigated surprises in the Fed funds target rate and the immediate financial market response. Therefore, the conclusions we drew from the study do not include the many other factors affecting financial markets. That said, our analysis still helps fill in part of the picture for decision makers around the coming rate hikes.


Adrian, Tobias, Richard K. Crump and Emanuel Moench. 2013. "Pricing the Term Structure with Linear Regressions." Journal of Financial Economics, 110(1): 110-138.

Barro, Robert. 1981. Money, Expectations and Business Cycles. Academic Press.

Bernanke, Ben S. and Kenneth N. Kuttner. 2005. "What Explains the Stock Market's Reaction to Federal Reserve Policy?" Journal of Finance, 60(3): 1221-1257.

Crump, Richard, Emanuel Moench, William O'Boyle, Matthew Raskin, Carlo Rosa and Lisa Stowe. 2014. Survey Measures of Expectations for the Policy Rate. Liberty Street Economics, Federal Reserve Bank of New York.

Evans, Charles L. 1994. The Dollar and the Federal Funds Rate. Chicago Fed Letter.

Fama, Eugene F. 1969. "Efficient Capital Markets: A Review of Theory and Empirical Work." The Journal of Finance, 25(2): 383-417.

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Gurkaynak, Refet S., Brian P. Sack and Eric T. Swanson. 2007. "Market-Based Measures of Monetary Policy Expectations." Journal of Business and Economic Statistics, 25(2): 201-212.

Kim, Suk-Joong, Michael D. McKenzie and Robert W. Faff. 2004. "Macroeconomic News Announcements and the Role of Expectations: Evidence for US Bond, Stock and Foreign Exchange Markets." Journal of Multinational Financial Management, 14(4): 217-232.

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Table A1. Full-Sample Results

                             Constant    Surprise

Trade-Weighted Dollar        -4.50       14.96
Major Currencies Index       -5.20       52.56
1-Year Yield                  0.21       34.65 ***
2-Year Yield                  0.53       25.98 ***
3-Year Yield                  0.54       20.32 ***
4-Year Yield                  0.47       16.00 **
5-Year Yield                  0.39       12.45 *
6-Year Yield                  0.32        9.43
7-Year Yield                  0.26        6.81
8-Year Yield                  0.21        4.55
9-Year Yield                  0.17        2.57
10-Year Yield                 0.14        0.84
1-Year Term Premium           0.28       -8.13 ***
2-Year Term Premium           0.35      -12.63 ***
3-Year Term Premium           0.27      -15.07 ***
4-Year Term Premium           0.16      -16.74 ***
5-Year Term Premium           0.07      -18.06 ***
6-Year Term Premium           0.01      -19.18 ***
7-Year Term Premium          -0.05      -20.13 ***
8-Year Term Premium          -0.09      -20 92 ***
9-Year Term Premium          -0.12      -21.58 ***
10-Year Term Premium         -0.14      -22.11 ***
1-Year Risk-Neutral Yield    -0.07       42.77 ***
2-Year Risk-Neutral Yield     0.18       38.61 ***
3-Year Risk-Neutral Yield     0.28       35.39 ***
4-Year Risk-Neutral Yield     0.31       32 74 ***
5-Year Risk-Neutral Yield     0.32       30.52 ***
6-Year Risk-Neutral Yield     0.32       28.61 ***
7-Year Risk-Neutral Yield     0.31       26.94 ***
8-Year Risk-Neutral Yield     0.30       25.47 ***
9-Year Risk-Neutral Yield     0.29       24.15 ***
10-Year Risk-Neutral Yield    0.28       22.96 ***
S&P 500                       0.39 **    -1.23

                             F-Statistic   R-Squared

Trade-Weighted Dollar          0.22          0.00
Major Currencies Index         1.81          0.02
1-Year Yield                  32.11 ***      0.28
2-Year Yield                  13.34 ***      0.14
3-Year Yield                   7.34 ***      0.08
4-Year Yield                   4.47 **       0.05
5-Year Yield                   2.79 *        0.03
6-Year Yield                   1.68          0.02
7-Year Yield                   0.93          0.01
8-Year Yield                   0.44          0.01
9-Year Yield                   0.15          0.00
10-Year Yield                  0.02          0.00
1-Year Term Premium           15.44 ***      0.16
2-Year Term Premium           24.87 ***      0.23
3-Year Term Premium           28.82 ***      0.26
4-Year Term Premium           27.82 ***      0.25
5-Year Term Premium           26.39 ***      0.24
6-Year Term Premium           25.45 ***      0.24
7-Year Term Premium           24.78 ***      0.23
8-Year Term Premium           24.20 ***      0.23
9-Year Term Premium           23.61 ***      0.22
10-Year Term Premium          23.00 ***      0.22
1-Year Risk-Neutral Yield     52.76 ***      0.39
2-Year Risk-Neutral Yield     36.66 ***      0.31
3-Year Risk-Neutral Yield     30.16 ***      0.27

4-Year Risk-Neutral Yield     26.88 ***      0.25
5-Year Risk-Neutral Yield     24 95 ***      0.23
6-Year Risk-Neutral Yield     23.69 ***      0.22
7-Year Risk-Neutral Yield     22.80 ***      0.22
8-Year Risk-Neutral Yield     22.15 ***      0.21
9-Year Risk-Neutral Yield     21.65 ***      0.21
10-Year Risk-Neutral Yield    21.26 ***      0.21
S&P 500                        0.74          0.01

Table A2. Precrisis Results

                             Constant   Surprise

Trade-Weighted Dollar        -4.95 *    -16.34
Major Currencies Index       -4.07       -4.01
1-Year Yield                 -0.14       23.91 ***
2-Year Yield                  0.02       13.72
3-Year Yield                 -0.04        6.93
4-Year Yield                 -0.12        2.56
5-Year Yield                 -0.18       -0.30
6-Year Yield                 -0.22       -2.24
7-Year Yield                 -0.23       -3.61
8-Year Yield                 -0.24       -4.60
9-Year Yield                 -0.25       -5.36
10-Year Yield                -0.24       -5.95
1-Year Term Premium           0.27       -4.06
2-Year Term Premium           0.28       -9.25 ***
3-Year Term Premium           0.16      -12.76 ***
4-Year Term Premium           0.05      -14.85 ***
5-Year Term Premium          -0.02      -16.02 ***
6-Year Term Premium          -0.07      -16.64 ***
7-Year Term Premium          -0.10      -16.93 ***
8-Year Term Premium          -0.12      -17.02 ***
9-Year Term Premium          -0.13      -17.01 ***
10-Year Term Premium         -0.13      -16.92 ***
1-Year Risk-Neutral Yield    -0.41       27.97 ***
2-Year Risk-Neutral Yield    -0.26       22.97 ***
3-Year Risk-Neutral Yield    -0.20       19.69 **
4-Year Risk-Neutral Yield    -0.17       17.41 **
5-Year Risk-Neutral Yield    -0.16       15.72 **
6-Year Risk-Neutral Yield    -0.14       14.40 **
7-Year Risk-Neutral Yield    -0.13       13.32 *
8-Year Risk-Neutral Yield    -0.13       12.42 *
9-Year Risk-Neutral Yield    -0.12       11.65 *
10-Year Risk-Neutral Yield   -0.11       10.97 *
S&P 500                       0.24       -4.83 ***

                             F-Statistic   R-Squared

Trade-Weighted Dollar          0.35          0.01
Major Currencies Index         0.01          0.00
1-Year Yield                  10.08 ***      0.13
2-Year Yield                   2.46          0.03
3-Year Yield                   0.58          0.01
4-Year Yield                   0.08          0.00
5-Year Yield                   0.00          0.00
6-Year Yield                   0.07          0.00
7-Year Yield                   0.18          0.00
8-Year Yield                   0.32          0.00
9-Year Yield                   0.45          0.01
10-Year Yield                  0.58          0.01
1-Year Term Premium            1.91          0.03
2-Year Term Premium            7.06 ***      0.09
3-Year Term Premium           12.35 ***      0.15
4-Year Term Premium           14.18 ***      0.17
5-Year Term Premium           13.87 ***      0.17
6-Year Term Premium           12.89 ***      0.16
7-Year Term Premium           11.79 ***      0.15
8-Year Term Premium           10.71 ***      0.13
9-Year Term Premium            9.73 ***      0.12
10-Year Term Premium           8.86 ***      0.11
1-Year Risk-Neutral Yield     16.48 ***      0.19
2-Year Risk-Neutral Yield      9.31 ***      0.12
3-Year Risk-Neutral Yield      6.65 **       0.09
4-Year Risk-Neutral Yield      5.39 **       0.07
5-Year Risk-Neutral Yield      4.69 **       0.06
6-Year Risk-Neutral Yield      4.24 **       0.06
7-Year Risk-Neutral Yield      3.94 *        0.05
8-Year Risk-Neutral Yield      3.72 *        0.05
9-Year Risk-Neutral Yield      3.56 *        0.05
10-Year Risk-Neutral Yield     3.43 *        0.05
S&P 500                        8.18 ***      0.11

Table A3. Crisis Results

                             Constant   Surprise

Trade-Weighted Dollar         -3.50      44.14
Major Currencies Index       -13.17      97.31
1-Year Yield                   2.39      49.11 ***
2-Year Yield                   3.75      43.68 **
3-Year Yield                   4.20      39.87 **
4-Year Yield                   4.20      35.73 *
5-Year Yield                   4.01      31.28
6-Year Yield                   3.73      26.81
7-Year Yield                   3.42      22.53
8-Year Yield                   3.13      18.57
9-Year Yield                   2.85      14.97
10-Year Yield                  2.59      11.72
1 -Year Term Premium           0.41     -12.07 ***
2-Year Term Premium            0.82     -15.30 ***
3-Year Term Premium            0.95     -16.31 **
4-Year Term Premium            0.89     -17.48 **
5-Year Term Premium            0.73     -19.08 **
6-Year Term Premium            0.54     -20.91 **
7-Year Term Premium            0.34     -22.77 **
8-Year Term Premium            0.15     -24.52 **
9-Year Term Premium           -0.02     -26.08 **
10-Year Term Premium          -0.17     -27.45 **
1-Year Risk-Neutral Yield      1.98      61.18 ***
2-Year Risk-Neutral Yield      2.93      58.98 ***
3-Year Risk-Neutral Yield      3.25      56.18 ***
4-Year Risk-Neutral Yield      3.31      53.21 ***
5-Year Risk-Neutral Yield      3.27      50.36 ***
6-Year Risk-Neutral Yield      3.19      47.72 ***
7-Year Risk-Neutral Yield      3.09      45.30 ***
8-Year Risk-Neutral Yield      2.98      43.09 ***
9-Year Risk-Neutral Yield      2.87      41.05 ***
10-Year Risk-Neutral Yield     2.76      39.17 ***
S&P 500                        1.33 *     3.98

                             F-Statistic   R-Squared

Trade-Weighted Dollar          0.19          0.02
Major Currencies Index         0.65          0.06
1-Year Yield                  12.74 ***      0.54
2-Year Yield                   7.56 **       0.41
3-Year Yield                   5.42 **       0.33
4-Year Yield                   4.11 *        0.27
5-Year Yield                   3.13          0.22
6-Year Yield                   2.35          0.18
7-Year Yield                   1.72          0.14
8-Year Yield                   1.22          0.10
9-Year Yield                   0.83          0.07
10-Year Yield                  0.53          0.05
1 -Year Term Premium          27.25 ***      0.71
2-Year Term Premium           14.24 ***      0.56
3-Year Term Premium            7.58 **       0.41
4-Year Term Premium            5.49 **       0.33
5-Year Term Premium            4.97 **       0.31
6-Year Term Premium            5.01 **       0.31
7-Year Term Premium            5.29 **       0.32
8-Year Term Premium            5.63 **       0.34
9-Year Term Premium            5.98 **       0.35
10-Year Term Premium           6.30 **       0.36
1-Year Risk-Neutral Yield     19.66 ***      0.64
2-Year Risk-Neutral Yield     16.24 ***      0.60
3-Year Risk-Neutral Yield     14.73 ***      0.57
4-Year Risk-Neutral Yield     13.90 ***      0.56
5-Year Risk-Neutral Yield     13.37 ***      0.55
6-Year Risk-Neutral Yield     13.01 ***      0.54
7-Year Risk-Neutral Yield     12.74 ***      0.54
8-Year Risk-Neutral Yield     12.54 ***      0.53
9-Year Risk-Neutral Yield     12.38 ***      0.53
10-Year Risk-Neutral Yield    12.26 ***      0.53
S&P 500                        1.70          0.13

Table A4. Asymmetric Information Results

                             Constant    Surprise   Interaction

Trade-Weighted Dollar         0.65 ***    43.73     -244.83
Major Currencies Index       -1.53 ***    74.98     -140.31
1-Year Yield                 -0.86        28.09       41.02 ***
2-Year Yield                 -0.88        17.35       54.04 **
3-Year Yield                 -0.81        12.07       51.64
4-Year Yield                 -0.71         8.77       45.27
5-Year Yield                 -0.61         6.29       38.53
6-Year Yield                 -0.52         4.24       32.42
7-Year Yield                 -0.44         2.48       27.11
8-Year Yield                 -0.37         0.95       22.53
9-Year Yield                 -0.31        -0.40       18.59
10-Year Yield                -0.26        -1.58       15.17
1 -Year Term Premium         -0.04       -10.10       12.38 ***
2-Year Term Premium           0.02       -14.60       12.34 ***
3-Year Term Premium           0.09       -16.13        6.65 ***
4-Year Term Premium           0.16       -16.77        0.23 ***
5-Year Term Premium           0.22 ***   -17.20       -5.39 ***
6-Year Term Premium           0.27 ***   -17.59       -9.95 ***
7-Year Term Premium           0.31 ***   -17.96      -13.59 ***
8-Year Term Premium           0.34 ***   -18.29      -16.50 ***
9-Year Term Premium           0.37 ***   -18.57      -18.84 ***
10-Year Term Premium          0.40 ***   -18.80      -20.71 ***
1-Year Risk-Neutral Yield    -0.82        38.20       28.64 ***
2-Year Risk-Neutral Yield    -0.91        31.95       41.70 ***
3-Year Risk-Neutral Yield    -0.90        28.20       44 99
4-Year Risk-Neutral Yield    -0.87        25.54       45.04 ***
5-Year Risk-Neutral Yield    -0.83        23.50     4392 ***
6-Year Risk-Neutral Yield    -0.79        21.84       42.37 ***
7-Year Risk-Neutral Yield    -0.75        20.44       40.70 ***
8-Year Risk-Neutral Yield    -0.72        19.23       39.04 ***
9-Year Risk-Neutral Yield    -0.68        18.17       37.42 ***
10-Year Risk-Neutral Yield   -0.65        17.22       35.88 ***
S&P 500                       0.34        -1.49        1.67

                             F-Statistic   R-Squared

Trade-Weighted Dollar          1.45          0.04
Major Currencies Index         1.30          0.03
1-Year Yield                  17.84 ***      0.31
2-Year Yield                   8.73 ***      0.18
3-Year Yield                   5.26 ***      0.11
4-Year Yield                   3.39 **       0.08
5-Year Yield                   2.24          0.05
6-Year Yield                   1.46          0.03
7-Year Yield                   0.92          0.02
8-Year Yield                   0.55          0.01
9-Year Yield                   0.31          0.01
10-Year Yield                  0.17          0.00
1 -Year Term Premium           8.96 ***      0.18
2-Year Term Premium           13.25 ***      0.25
3-Year Term Premium           14.47 ***      0.26
4-Year Term Premium           13.74 ***      0.25
5-Year Term Premium           13.13 ***      0.24
6-Year Term Premium           12.84 ***      0.24
7-Year Term Premium           12.69 ***      0.24
8-Year Term Premium           12.55 ***      0.24
9-Year Term Premium           12.38 ***      0.23
10-Year Term Premium          12.16 ***      0.23
1-Year Risk-Neutral Yield     27.27 ***      0.40
2-Year Risk-Neutral Yield     20.06 ***      0.33
3-Year Risk-Neutral Yield     17.01 ***      0.30
4-Year Risk-Neutral Yield     15.42 ***      0.28
5-Year Risk-Neutral Yield     14.46 ***      0.26
6-Year Risk-Neutral Yield     13.83 ***      0.25
7-Year Risk-Neutral Yield     13.38 ***      0.25
8-Year Risk-Neutral Yield     13.04 ***      0.24
9-Year Risk-Neutral Yield     12.78 ***      0.24
10-Year Risk-Neutral Yield    12.58 ***      0.24
S&P 500                        0.41          0.01

(1) We used announcement dates provided in Fleming and Piazzesi [2005] from 1994 to 2004. From 2004 onward, the meeting dates were obtained from Bloomberg, LP.

(2) The risk-neutral rate is the interest rate equal to the expected return from continuously rolling over short-maturity Treasury Bills. Hence, the risk-neutral rate is the expected average short-term interest rate over the life of a longer-term bond. The term premium, on the other hand, is the residual. We assume that Treasuries carry no default risk, as is common in both theory and practice. This residual is, therefore, the compensation investors receive for the risk associated with short-term rates behaving differently in the future than expected [Kim and Wright 2005].

(3) We also repeated our analysis of the sensitivity of the term premium to the absolute value of the surprise to see if the magnitude of the surprise was the driver of changes in the term premium, rather than the actual surprise. The model fit was better when using the actual surprise, however.

(4) There are many different ways of discounting expected future cash flows from an equity security and a detailed explanation is beyond the purview of this study. That said, the discount rate can be thought of as the risk-free rate plus a risk premium, to account for the fact that cash flow from equities are uncertain.

(5) Kuttner [2001] restricts the analysis to days when the target funds rate was changed. We, however, include all FOMC meetings with a nonzero surprise. This is because no action by the Federal Reserve when the market is expecting action is also a surprise, in our opinion, and markets should react. That said, this may come at the cost of adding noise to our analysis.

(6) We use the 30-day Fed funds futures offered by the CME Group. Our analysis is restricted to the time period 1994-2014. The futures are quoted as 100 minus the average daily effective Fed funds rate. The last trading day for the active contract is the last business day of the month. Contracts are cash settled on the first business day following the last trading day. We used the generic first future data series from Bloomberg.

(7) We used the daily difference in yields for the Treasury market, the daily percent change in the S&P 500 index for equities and the daily percent change in dollar indices for foreign exchange.

(8) We also ran analysis including an interaction term for positive surprises to test for asymmetric responses to Fed funds surprises. In general, short-term Treasury yields and risk-neutral yields are more sensitive to positive surprises, while the term premium is more sensitive to negative surprises. In addition, only nonzero surprises were included.


* John Silvia is a managing director and the chief economist for Wells Fargo. He has held this position since he joined Wachovia, a Wells Fargo predecessor, in 2002 as the company's chief economist. Prior to his current position, he worked in Capitol Hill as senior economist for the U.S. Senate Joint Economic Committee and chief economist for the U.S. Senate Banking, Housing and Urban Affairs Committee. Before that, he was chief economist of Kemper Funds and managing director of Scudder Kemper Investments, Inc. Silvia served as the president of NABE in 2015 and was awarded a NABE Fellow Certificate of Recognition in 2011 for Outstanding Contributions to the Business Economics Profession and Leadership among Business Economists to the Nation. He holds B.A. and Ph.D. degrees in economics from Northeastern University in Boston and has a master's degree in economics from Brown University. John is a Certified Business Economist (CBE). Azhar Iqbal is a director and econometrician at Wells Fargo, responsible for providing quantitative analysis to the Economics group and modeling and forecasting of macro and financial variables. Before joining Wells Fargo in 2007, he was an economist and course instructor at the Applied Economics Research Center at the University of Karachi in Pakistan. He has also worked as an economist at the United Nations, Arif-Habib Investment Bank, and for Government of Pakistan-funded projects. He received his bachelor's degree in economics from the University of Punjab and has a master's degree in economic forecasting from the University at Albany, State University of New York, where he also earned a Certificate of Graduate Study in economic forecasting. He also has master's degrees in applied science and applied economics from University of Karachi, and a master's degree in econometrics and mathematics from the University of the Punjab in Lahore, Pakistan. Alex Moehring is an economic analyst with Wells Fargo Securities. He is responsible for covering U.S. macro and regional economic trends. He joined the economics group in 2014. He contributes to the group's Weekly Economic & Financial Commentary and regional reports. Moehring graduated from the University of North Carolina at Chapel Hill, earning a B.S. in business administration with an investments concentration, a B.A. in economics and a minor in mathematics.

Caption: Figure 1. Fed Funds Surprise Component

Caption: Figure 2. Fed Funds Surprise Component

Caption: Figure 3. Fed Funds Surprises vs. Risk-Neutral Yield

Caption: Figure 4. Fed Funds Surprises vs. Term Premium

Caption: Figure 5. Fed Funds Surprises vs. Trade-Weighted Dollar

Caption: Figure 6. Fed Funds Surprises vs. S&P 500

Caption: Figure 7. Coefficients by Maturity

Table 1. Summary Statistics

                  Surprise (1)   TWD (2)   Major (3)   10Y (4)

Count                  84          77         84         84
Mean                 (0.02)      (3.39)     (4.01)     (0.08)
Std. Dev.             0.10       30.16      41.15       6.60
Correlation (8)       1.00        0.06       0.14       0.01

                      10Y          10Y        S&P
                     TP (5)      RN (6)     500 (7)

Count                  84          84          84
Mean                  0.27       (0.35)       0.33
Std. Dev.             5.21        5.58        1.39
Correlation (8)      (0.44)       0.42       (0.10

(1) Surprise is the unexpected component of Fed funds target
rate announcement

(2) TWD is percent change in trade-weighted dollar

(3) Major is percent change in trade-weighted major currencies

(4) 10Y is change in 10-year yield

(5) 10Y TP is 10-year term premium

(6) 10Y RN is 10-year risk-neutral yield

(7) S&P 500 is percent change in S&P 500 index

(8) Correlation is the correlation with surprise series


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Comment:Fed funds rate surprises and financial markets.
Author:Silvia, John; Iqbal, Azhar; Moehring, Alex
Publication:Business Economics
Date:Jan 1, 2016
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