Two important contributions to the literature on the effects of monetary policy on the stock market have been made. The first one emphasizes the roles of financial markets’ expectations about the future course of monetary policy. Bernanke and Kuttner (2003) extract unanticipated monetary policy from Federal funds futures and find that monetary policy surprises appear to have a significant effect on equity prices through changes in the equity premium. The second focus is on the prospect of endogeneity. Rigobon and Sack (2003) show that the causality between interest rates and stock prices may run in both directions. After accounting for this endogeneity, they find a significant monetary policy response to the stock market.

Furthermore, cyclical variations in stock returns are widely reported in the literature. (1) Particularly, bull and bear markets have been explicitly identified in Maheu and McCurdy (2000), Pagan and Sossounov (2003), Edwards, Gomez Biscarri, and Perez de Gracia (2003), and Lunde and Timmermann (2004). Therefore, two interesting questions emerge. First, can the debate over the (in)significance of the effects of monetary policy as measured by money aggregates be resolved under a non-linear framework? Second, are the effects of monetary policy on stock returns asymmetric? That is, does a monetary policy have different impacts on stock returns in bull and bear markets? (2) The class of models in which there exist agency costs of financial intermediation (finance constraint) asserts that when there is information asymmetry in the financial market, agents may behave as if they are constrained financially. Moreover, the financial constraint is more likely to bind in bear markets. Hence, a monetary policy may have greater effects in bear markets. See Bernanke and Gertler (1989) and Kiyotaki and Moore (1997).

This paper empirically examines the asymmetric effects of monetary policy using a modified version of the Markov-switching model developed by Hamilton (1989). The effects of monetary policy are investigated in two different perspectives. First, I assume that monetary policy may affect stock returns directly in a fixed-transition-probability (FTP) Markov-switching model where the transition probabilities are fixed over time. Second, I consider a time-varying-transition-probability (TVTP) Markov-switching model and allow the probability of switching between states (bull markets versus bear markets) to depend on monetary policy.

This paper investigates many different measures of the stance of monetary policy: money aggregates (M2), discount rates (DR), Federal funds rates (FF), and VAR-based measures of monetary policy. Moreover, an event-study approach is also employed. It is worth noting that this paper is not the first one to study the possible asymmetric effects of monetary policy under a Markov-switching framework. Garcia and Schaller (2002) use Markov-switching models to investigate how output growth (measured by industrial production growth) responds to monetary policy in expansion and recession periods. Perez-Quiros and Timmermann (2000) study the returns on size-sorted decile portfolios and consider a small set of alternative measures of monetary policy. Their focus, however, is on the presence of asymmetries in the variation of a small firm’s and large firm’s risk over the economic cycle. Furthermore, they did not investigate the possibility that the monetary policy may affect the probability of moving from one state to another.

The empirical results from monthly returns on the Standard & Poor’s 500 price index suggest that when monetary policy is measured by interest rate instruments (the discount rate, the Federal funds rate, and the innovations to the Fed funds rate from VAR models), a contractionary monetary shock strongly lowers stock returns in both bull and bear markets. Furthermore, monetary policy has larger effects on returns in the bear-market regime. This result may provide evidence supporting models which emphasize the important role of finance constraints. In order to check the robustness of the empirical results, full returns data containing dividends are used. An event study is also conducted in response to Bernanke and Kuttner (2003) accounting for market expectations, and Rigobon and Sack’s (2003) argument of endogeneity. Finally, it has been shown that contractionary monetary policy leads to a higher probability of switching to a bear-market regime. Thus, a tightening monetary policy may depress stock returns in two different ways: it lowers the returns directly and makes the returns more likely to shift to low-return regimes (bear markets).

The paper is structured as follows. Section 1 presents an FTP Markov-switching model of stock returns. Section 2 describes the data and different measures of the stance of monetary policy. Section 3 reports the empirical results regarding the potentially asymmetric effects of monetary policy on stock returns. Robustness checks are provided in Section 4. Section 5 examines whether monetary policy affects the transition probability of switching between bull and bear markets. Finally,

The second part of Tobin’s argument, namely the relationship between monetary policy and equity prices, is still not very well understood. On the one hand, it has proven difficult to properly identify monetary policy, since monetary policy may be endogenous in that central banks might react to developments in stock markets. Considerable progress has recently been made in this respect. Rigobon and Sack (2002, 2003) develop a methodology that exploits the heteroskedasticity present in financial markets to identify monetary policy shocks, while Kuttner (2001) and Bernanke and Kuttner (2003) derive monetary policy shocks through measures of market expectations obtained from federal funds futures contracts. In this paper, we will employ a methodology similar to Bernanke and Kuttner (2003), by identifying monetary policy shocks through market expectations obtained from surveys of market participants.

On the other hand, more research is needed to understand why individual stocks react so differently to monetary policy shocks and what the driving force is behind this reaction. The recent paper by Bernanke and Kuttner (2003) shows that very little of the market’s reaction can be attributed to the effect of monetary policy on the real rate of interest. Rather, the response of stock prices is driven by the impact on expected future excess returns and to some extent on expected future dividends. In this paper, we go a step further by analyzing which factors of these expectations are important for understanding the large heterogeneity in the reaction of individual stocks to monetary policy.

In the literature on the credit channel of monetary policy transmission, Bernanke and Blinder (1992) and Kashyap, Stein, and Wilcox (1993) show that a tightening of monetary policy has a particularly strong impact on firms that are highly bank-dependent borrowers as banks reduce their overall supply of credit. Bernanke and Gertler (1989) and Kiyotaki and Moore (1997) argue that worsening credit market conditions affect firms also by weakening their balance sheets as the present value of collateral falls with rising interest rates, and that this effect can be stronger for some firms than for others. Both arguments are based on information asymmetries: firms for which less information is publicly available may find it more difficult to access bank loans when credit conditions become tighter as banks tend to reduce credit lines first to those customers about whom they have the least information (Gertler and Hubbard, 1988, Gertler and Gilchrist, 1994). For instance, Thorbecke (1997) and Perez-Quiros and Timmermann (2000) show that the response of stock returns to monetary policy is larger for small firms.

If a credit channel is at work for firms that are quoted on stock markets, one would expect that their stock prices respond to monetary policy in a heterogeneous fashion, with the prices of firms that are subject to relatively larger informational asymmetries reacting more strongly. The reason is that their expected future earnings are affected more, since these firms will find it harder to access funds following a monetary tightening, which should lead to a constraint of the supply of their goods.

Another differentiation of the response of stock prices to monetary policy is likely to be related to the response of the demand for firms’ products. Firms that produce goods for which demand is highly cyclical or interest-sensitive should see their expected future earnings affected relatively more following a monetary policy move. These effects are not based on the credit channel; rather, they arise through the interest-rate channel. Therefore, one would expect that the differentiation of responses to monetary policy is not only dependent on the firm-specific characteristics, but also on those of the industry to which the firm is affiliated.

This paper analyses both effects, and aims to distinguish their respective contributions to the overall stock market response. In a first step, we present evidence that the individual firms included in the S&P500 index react in a highly heterogeneous fashion to U.S. monetary policy shocks. Second, we investigate whether we can identify industry-specific effects of monetary policy. It is found that cyclical sectors, such as technology, communications, and cyclical consumer goods, react two to three times stronger to monetary policy than less cyclical sectors