Fearing the Fed : How Wall Street Reads Main Street

We provide strong evidence of persistent cyclical variation in the sensitivity of stock returns to macroeconomic news announcement (MNA) surprises. When the economy is significantly below trend (output gap is large and negative) and interest rates are not expected to go up, the stock return sensitivity to news is large. On the other hand, stock returns hardly react to news during periods when the economy is near trend (output gap is small) and interest rates are expected to rise. A monetary regime-switching model is shown to have implications consistent with this evidence. Taken together, the phase of the economy and interest rate expectations are key determinants of the cyclicality of the response of the stock market