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Capital Ideas: ''Timing'' the Fed

Researchers find an ''incredible consistency'' in the correlations of Fed monetary policy and stock-market fluctuations over a 38-year period, suggesting several practical applications for finance executives.
Marie Leone, CFO.com | US
December 2, 2004

Federal monetary policy should help guide corporate finance decisions, maintains a recent report by university researchers and the CFA Institute.

The guidance, according to the report, can be harnessed by keeping tabs on the Federal Reserve Board's discount rate — the interest rate at which member banks borrow short-term funds directly from one of the 12 federal reserve banks.

The discount rate acts like "a proxy for federal monetary policy," asserts Robert Johnson, executive vice president of the CFA Institute and one of the study's authors, because it represents a longer-term stance than either the federal funds rate (the interest rate at which banks borrow from each other overnight) or open-market operations (which concern the sale of Treasurys by federal reserve banks to member banks). A rise in the discount rate usually signals a restrictive monetary period; a dip in the rate portends an expansive monetary period.

What's important for senior finance executives, says Johnson, is that the expansive and restrictive periods have a direct relationship to stock performance and market capitalization.

The researchers — who include professors C. Mitchell Conover of the University of Virginia, Gerald Jensen of Northern Illinois University, and Jeffrey Mercer of Texas Tech University, in addition to Johnson — found an "incredible consistency" in the correlations of Fed monetary policy and stock-market fluctuations. They assert that over a 38-year timeframe, when monetary policy was in an expansive period, stock-market returns for an index of 19 industries were 3.35 times higher than during a restrictive period.

The researchers stress that they cannot establish a direct cause-and-effect relationship between stock performance and the discount rate; in fact, it's not clear to what extent the markets influence Federal Reserve policy, and to what extent the converse is true. Johnson notes, however, that while it's hardly an exact science, timing the board's policy changes is worthwhile because the markets have become "pretty good at anticipating the Fed's moves." That suggests several practical applications for finance executives.

Conditions are more favorable for issuing new stock, say the authors, when the Fed's policies are in an expansive mode. "The best time," advises Johnson, "is near the end of an expansive period, when stock prices are highly valued or overvalued." Conversely, he adds, the best time for stock buybacks is when Fed policy has been restrictive for a while, "when value dips and the stock price is cheaper."

On the debt side of the equation, the researchers advise companies to issue floating-rate debt at the end of a restrictive period or the beginning of an expansive period, in anticipation of falling interest rates. The best time to issue fixed-rate debt, by contrast, would be at the end of an expansive period or the beginning of a restrictive period, when rates are expected to rise. In addition, say the authors, companies should build liquidity into their balance sheets when a restrictive period approaches; generally, funds will be harder to raise when rates begin to climb.

Keeping an eye on monetary policy also helps when mergers and acquisitions are being considered. "The most opportune time for an acquisition," says Johnson, "is near the conclusion of a restrictive period," when stock prices drop and valuations are dampened. This advice runs counter to the typical "pro-cyclical M&A scene"; one reason acquirers overpay for target companies, he maintains, is because they buy at the height of an expansive market, when market capitalizations are high and companies are often overvalued. If dealmakers can wait to pull the trigger until the end of a restrictive period, Johnson believes, there's more value to be added.

The study also found that "there's a lot less benefit from geographical diversification than in the past," according to Johnson, and that cross-border corporate efforts do little to stave off the effects of shifts in monetary policy. Industries across the globe are highly correlated — "more interdependent than independent," says Johnson. Best practices are similar, and so are the pressures felt by central banks. The only significant differences that the researchers uncovered among national monetary policies were regulatory or legal diversity — but world trade pacts may be chipping away at those differences, too.

Marie Leone's "Capital Ideas" column appears every other Thursday. Contact her at MarieLeone@cfo.com.




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