Does the Equity Term Structure Respond to Monetary Policy Shocks? 

Henry Dyer and Tomas Jankauskas

A long-standing body of research, inspired by Bernanke and Kuttner (2005), has documented the effects of Fed interest rate surprises on stock markets. While stock markets provide valuable information about the investor risk premium and dividend growth expectations, researchers have only recently developed more comprehensive tools to estimate the term structure of equity risk premia and dividend growth expectations across a broad range of maturities. In this post, we investigate the impact of monetary policy surprises (or shocks) on short- and long-term estimates of risk premia and growth expectations through the lens of the Giglio, Kelly, and Kozak (2024) model.

Pinning Down Monetary Policy Shocks

Measuring monetary policy shocks is challenging, but most current frameworks rely on the high-frequency identification approach of Kuttner (2003) and Bernanke and Kuttner (2005). At their core, monetary policy surprises (MPS) are constructed by examining price changes in interest rate-linked futures contracts within a narrow window around FOMC announcements. Positive (negative) MPS values correspond to hawkish (dovish) policy surprises. The Federal Reserve Bank of San Francisco’s Monetary Policy Surprise dataset extracts these shocks from different maturity Eurodollar futures and aggregates them into a monthly series. The chart below displays the dynamics of these shocks over the last three decades.

Since the series represents surprises relative to prevailing interest rate expectations it does not necessarily align with broader economic cycles, except at the onsets of economic business cycles. The average value of the surprises in the sample is close to zero, with a slight negative mean in NBER recessions and slight positive mean otherwise. For simplicity, we classify economic episodes into three subsamples: periods with positive MPS (hawkish surprises), negative MPS (dovish surprises), and no change (no FOMC meeting). This allows us to test whether the news per se or its directional change is associated with movements in risk premia.

Connection with Equity Term Structure

While the MPS mechanically move the term structure of government bond interest rates, that is not the only channel driving asset prices. Equity risk premia and dividend growth expectations are two fundamental inputs in present value calculations, yet they are difficult to disentangle using stock prices alone. This is particularly true when considering the entire term structure of risk premia and growth expectations, which summarize the expected path of these variables across maturities, analogous to the term structure of interest rates. To illustrate the relationship between these components, one can express the value of a stock or index as the discounted present value of future dividends:

$\displaystyle \sum\limits_{m=1}^{\infty} \frac{E_{t}[D_{t+m}]}{(1+r_{t,m})^m}=P_{t}$

where $E_{t}[D_{t+m}]$ denotes expected future dividends embedding growth rate expectations, $P_{t}$ is the market value of a stock or index, and $r_{t,m}$ is the $m$-maturity zero-coupon discount rate. While it is customary to assume that the discount rate is constant across maturities, economic models (such as habit formation and long-run risk) suggest that investors dislike long-duration cash flows more than short-duration cash flows because of their greater exposure to risk and uncertainty. More generally, the discount rate therefore can be decomposed into a risk-free rate ($rf_{t,m}$) component and a maturity-matched risk premium ($rp_{t,m}$):

$r_{t,m}=rf_{t,m}+rp_{t,m}$

The object of this post is to investigate how the entire term structure of risk premia and expected growth rates respond to different monetary policy shocks.

Measuring Risk Premia

We leverage the recent model of Giglio, Kelly, and Kozak (2024), which allows us to disentangle risk premia and dividend growth rates (in excess the of risk-free rate). The model estimates risk parameters by fitting the cross-sectional and time-series dynamics of stock market and fifty-one anomaly portfolio returns over the 1973-2020 period. The paper seeks to identify risk factors (principal components of anomaly returns and their valuation ratios) that drive investors’ expectations of the future evolution of stock prices. The estimation produces monthly series of dividend growth rates and risk premia for a wide range of maturities.

The full sample (1988-2020) estimates of risk premia and dividend growth rates are plotted in the chart below. As we can see, expected dividend growth rates are relatively stable at around three percent. This is intuitive since short-term dividend growth rates should, over time, converge toward the long-run growth rate if expectations are internally consistent and the sample is well-balanced. More interesting insights emerge from the term structure of risk premia. In line with classical asset pricing models, the term structure is upward sloping, starting slightly negative for the shortest maturities and converging towards 3.6 percent at the fifteen-year horizon. The term structure indicates that investors dislike long-term risk and hence apply substantially higher risk premia when discounting long-term equity cash flows.

Are Monetary Policy Shocks Good or Bad News?

The monetary policy information channel is one of the leading hypotheses used to explain stock market reactions to monetary policy surprises. All else equal, one might expect that sudden cuts in interest rates signal private information about a weakening economy, which should in turn affect both risk premia and expected dividend growth rates. To test this idea, we estimate the average term structure across different MPS subsamples (charts below).

Based on the estimates, there is some support for the information channel of MPS. Negative surprises are associated with, on average, a 25-basis-point increase in the average risk premium. This effect is uniform across different maturities and indicates a parallel upward shift in the level of the risk premium. On the other hand, we observe similar movements following positive monetary policy surprises, potentially suggesting that rapid rate hikes often signal similar bad news about the economy (for instance, supply side inflationary pressures). The effects of both negative and positive surprises are not very large in economic magnitude and are statistically insignificant, but this may be explained by the fact that, at most FOMC meetings, these surprises are very small.

Lastly, expected dividend growth rates appear to co-move only with dovish surprises. There is an over 50-basis-point drop for the shortest maturities and a 20-basis-point decrease for the longest maturities. This is an intuitive result, given that large rate cuts typically occur around the onset of economic distress and therefore signal deteriorating growth prospects. Interestingly, the same pattern is not observed for hawkish surprises. This may suggest that interest rate hikes often reflect strong demand conditions or inflationary pressures, which do not necessarily reduce nominal economic growth.

Conclusions

Estimation of the equity term structure and its interplay with monetary policy remains an active and important area of research. In this post, we extend a recent model of Giglio et al. (2024) and investigate the effects of FOMC monetary policy surprises on equity risk premia and dividend growth expectation across a wide range of maturities. Our findings suggest that large interest rate shocks induce a parallel increase in the level of equity risk premium. On the other hand, only negative monetary policy surprises lower dividend growth expectations.

Henry Dyer, a former research analyst in the Federal Reserve Bank of New York’s Research and Statistics Group, is pursuing a master’s in finance at the MIT Sloan School of Management.

Tomas Jankauskas is a financial research economist in the Federal Reserve Bank of New York’s Research and Statistics Group. 

 
@article{DyerJankauskas2026,
    author={Dyer, Henry and Jankauskas, Tomas},
    title={Does the Equity Term Structure Respond to Monetary Policy Shocks? },
    journal={Liberty Street Economics},
    note={Liberty Street Economics Blog},
    number={August 12},
    year={2026},
    url={https://libertystreeteconomics.newyorkfed.org/2026/08/does-the-equity-term-structure-respond-to-monetary-policy-shocks/}
}