HOW THE

FED MOVES
MARKETS
Central Bank Analysis for the Modern Era

EVAN A. SCHNIDMAN &

WILLIAM D. MACMILLAN
How the Fed Moves Markets
How the Fed Moves Markets
Central Bank Analysis for the Modern Era

Evan A. Schnidman and William D. MacMillan

HOW THE FED MOVES MARKETS
Copyright © Evan A. Schnidman and William D. MacMillan 2016
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 Contents

List of Figures and Tables vii

Foreword ix

Introduction 1

PART I Emergence and Evolution:

The Story of the Fed
1 Origins: From Chaos to Structure 9
2 Independence: Wars, Depression, and Politics 17
3 Centralization: The Rise of Technocracy 31
4 Transparency: Data Meets Democracy 39

PART II Fed Watching: Sentiment Analysis and

Data-Driven Investing
5 The Briefcase Watch: Fed Watching at Its Finest? 51
6 Data-Driven Fed Watching: Comprehensive,
Unbiased, and Quantitative 59
7 Fixed-Income Investing: Fed Sentiment Drives Bonds 69
8 Equity Market Investing: Macro Matters 79
9 Forecasting Policy: Market Response to Fed
Communication Trends 89
10 FOREX Investing: Central Bank Sentiment Data
across the Globe 99

PART III Global Monetary Policy: Analyzing

Central Banks around the World
11 ECB Sentiment: Decoding a Complex Monetary Union 115
vi CONTENTS

12 BOE Sentiment: The Origin of Modern Central

Bank Communications 127
13 BOJ Sentiment: Monetary Clues in Lost Decades 137
14 RBA Sentiment: Australia as a Proxy for China 147
15 Global Sentiment: International Central
Bank Transparency 159
Conclusion 183

Bibliography 189
Index 197
 Figures and Tables

Figures

1.1 Twelve Federal Reserve district boundaries

as they were drawn by the RBOC 12
7.1 Performance of a Fed Index-driven
simulated portfolio 75
7.2 Fed Index, FFR, and a ten-year bond yield 76
8.1 Fed Index, Russell 2K, S&P 500, and NASDAQ
from 1997 to 2014 85
8.2 Correlation of Fed Index with standard
market indexes 86
8.3 Correlation of Fed Index with industrial
sector indexes 86
8.4 Fed Index-driven simulated stock portfolio value,
compared to major indexes 87
9.1 FOMC meetings forecast, one-week lag 93
9.2 Fed Index six-month moving average,
April–September 2013 94
9.3 Fed Index projection as of December 14, 2013,
and actual FOMC sentiment 95
9.4 Fed Index-led portfolio, the S&P 500,
and the Dow Jones 97
10.1 USD-basket of currencies with Fed Index 103
10.2 ECB-USD with bank trends 104
10.3 GBP-USD with bank trends 105
10.4 JPY-USD with bank trends 106
10.5 CAD-USD with bank trends 107
10.6 AUD-CNY with bank trends 108
10.7 AUD-USD with bank trends 108
11.1 ECB Index and the ECB ten-year bond yield 123
viii FIGURES AND TABLES

11.2 ECB Index and European equities indexes 124

12.1 BOE Index, FTSE 100, and NASDAQ 133
12.2 BOE Index portfolio against buy-and-hold 135
13.1 BOJ Index and the Nikkei 225 142
13.2 BOJ Index and Japanese government
ten-year bond yield 143
13.3 BOJ Index, yen-USD, and yen-euro 145
14.1 RBA Index, the ASX 500, and SSE Composite Index 151
14.2 RBA Index and Australian government
ten-year bond yield 153
14.3 RBA Index and Chinese benchmarks 153
14.4 AUD-CNY and RBA Index 155
14.5 AUD-CNY and RBA Index (less smoothed) 156
15.1 BOC Index and TSX 60 161
15.2 SWE Index and OMX 30 163
15.3 SWE Index and Swedish government
ten-year bond yield 163
15.4 RNZ Index and exchange rates 165
15.5 SNB Index and Swiss Market Index (SMI) 167
15.6 BOK Index and KRX 100 169
15.7 BOI Index and Israeli government
ten-year bond yield 171
15.8 BOM Index and Mexican IPC 173
15.9 BCB Index and the BM&F BOVESPA Index 175
15.10 CBR Index and the MICEX Index 177
15.11 RBI Index and exchange rates 178
15.12 SARB Index and FTSE/JSE 40 180

Tables

1.1 Federal Reserve district populations in 1913 and 2000 13

3.1 Regional Bank president backgrounds 36
 Foreword

T his book was first conceived while reading a newspaper in

early 2008 before the financial crisis, before the world knew
terms like “quantitative easing,” “tapering,” and “considerable
time.” In fact, the spark for this book occurred before the Fed chair
began holding regularly scheduled press conferences or the Fed
even adopted an explicit inflation target. When I first conceived
of this subject, all I knew was that Fed policy was confusing and
the focus on few singular words seemed to be causing market tur-
moil as the housing crisis became a financial crisis—and nearly a
financial panic.
After that fateful day reading a newspaper as a college student
in early 2008, I set out to organize my graduate school curriculum
around researching central banks. I studied their origins, politics,
policy, evolution, and most importantly, their communications.
What I found was astounding: over the last two decades central
banks have become more transparent than at any point in their his-
tory, but the modern methods of “Fed watching” have not kept pace
with this change in central bank communication. In fact, modern
Fed watching often looks like a glorified version of the “Briefcase
Watch” from the early 1990s. The big difference is that today Fed
watchers are not cuing in on the thickness of Alan Greenspan’s
briefcase; rather they are hanging on singular words from Janet
Yellen. This focus on single words or phrases lends itself to group-
think and negates the careful construction of whole central bank
communications, thus leaving vital information about policy
unanalyzed. This book, and the methodology presented here, is the
first attempt to solve that problem with comprehensive, unbiased,
quantitative central bank sentiment data.
Our data has been jointly developed by myself and my coauthor
William MacMillan, but we would be remiss if we did not extend
x FOREWORD

our deepest gratitude to several others who have made our data
development, business development, and the writing of this book
possible. First and foremost are our families: both Bill and I walked
away from the calmer academic lifestyle in favor of the constant
pressure of entrepreneurship; the people bearing the brunt of that
pressure are our respective families, particularly our wives, Jacque
MacMillan and Whitney Phipps. Thank you for putting up with
the long hours, incessant travel, constant aggravation, and general
stress. We truly appreciate it.
Along with the strain on our family and friends, this book would
never have been possible if it was not for our incredible staff. Natty
Hoffman has done a masterful job picking up operational slack while
I have been busy with this book project. Similarly, Jermell Beane
has been invaluable in his work building and maintaining our data
management systems. In this process, our data development team
has been transformed to an army of researchers and we are deeply
grateful to Alister Bent, William Stein, Halle Orr, and Michelle
Tuma. Worthy of particular mention is our senior researcher, Joe
Sutherland, who has demonstrated himself to not only be an extraor-
dinarily hard worker, but a brilliant researcher as well.
Finally, this book would never have been possible without Alex
Detmering. Alex is not only our director of content at Prattle, he is
also our technical writer, editor, researcher, thought-organizer, and
the manager who pulled this all together. Like Bill and I, Alex has
subjected his family and friends to the strains of this process, so we
would like to extend a particular thanks to Stephen Fairbanks who
provided editorial support to Alex and therefore to us. We would
also like to thank Sarah Detmering, Alex’s wife, for tolerating the
long hours of work Alex has put into this project.
As I am sure any reader has by now surmised, this book has truly
been a collaborative effort to share Bill’s and my research with the
world. We hope that this work not only clearly explains our new
method of analyzing central banks, but it also gets you thinking
about how to use fundamental economic data (like central bank
policy) to make sound investment decisions. We believe under-
standing central bank communications (and therefore policy) is
crucial to any investment strategy; it is our sincere hope that the
methodology and data presented in the book help others to under-
stand central banks better than they ever have before.
 Introduction

L ike many Federal buildings, it’s very square. Very flat. Very
square. Four flat, square pillars frame the entrance to the build-
ing, which is almost entirely white. The entrance is embedded in a
massive, alabaster cube—the head of the imposing structure—and,
extending out from its level left and right cheeks, are two long,
identical, rectangular buildings. These too would be completely
white if it weren’t for the tall, black strips dedicated to office win-
dows that run the length of each with perfect symmetry. Flanked
by two square, carefully curated lawns, a narrow path, deep gray
and direct, runs from the small steps at the edge of the property to
the entrance. Bare of almost any ornament, the architecture’s lone
flourish is the bone-white statue of an eagle that sits directly above
its front door, overseeing the strict geometry and bleached colors
of the Eccles Building, headquarters of the Federal Reserve.
Banks look like temples. Not every bank, obviously, but many
do. The Eccles Building certainly does, and it doesn’t require too
much to understand why. The stone pillars, the clean architecture,
and the symmetry, all the features of the bank’s striking exterior
impart the highest degree of sobriety and seriousness—of trust.
Above all, trust is essential for the financial system, and nowhere is
this necessity more evident than it is with money.
In a very real sense, money is a measure of trust. For instance,
the faith American citizens have in their federal government sus-
tains the value of their currency. And what is true of currency is
also very true of the institutions that process it—banks. Like cur-
rency, banks succeed or fail based on the trust that they can inspire.
For instance, it is a well-known fact that banks continually operate
with reserves that do not match the total amount their customers
could withdraw. This practice, known as fractional reserve bank-
ing, is fundamental to banking operations and is also demonstrative
2 HOW THE FED MOVES MARKETS

of the integral part trust plays in the financial system. While any
given bank could not possibly withstand the simultaneous full
withdrawal of all its demand deposit accounts, we trust that when
we need it, the money will be available.
But, with the Eccles Building, with the Federal Reserve, the tem-
ple comparison runs deeper. The design invokes more than trust.
With exquisite precision, emerald lawns and ivory masonry grant
an aura of sacred—almost divine—authority, and, given its charge,
the appearance is fitting. With over a thousand economists at hand
and the printing press of the Treasury on tap, the Federal Reserve
is the financial vatican—an institution whose powers and prestige
have only grown over the hundred-plus years since its founding.
This ascendancy has been particularly evident since the financial
crisis, where unprecedented Fed policies, like quantitative easing,
have grabbed center stage in an economy reeling from the fallout of
the housing market’s collapse. During this period of global insta-
bility, the Fed has emerged as the undisputed leader—a command-
ing position the central bank seems well suited for.
The power that the Fed wields extends to its words, which have,
just like the rest of the central bank’s tools, multiplied in recent
years. In the entire history of the Federal Reserve, the institu-
tion has never been more verbose, never been more transparent.
Communication has become an integral tool of monetary policy,
used not only to explain policy—but actually as policy. Put plainly,
the Fed’s words move markets and have, therefore, become a vital
source of economic influence for the institution. It is this develop-
ment and the market practices that have developed in response that
are the central narrative of this book.

* * *

It wasn’t too long ago that the Fed’s version of transparency was
briefcase. In the early 1990s, the width of Alan Greenspan’s briefcase
was one of the sparse bits of evidence that financial analysts—now
known as Fed watchers—had to go on to project the central bank’s
ensuing monetary policy actions. The theory was as follows: a thick
briefcase meant that Greenspan has been reviewing numbers and
was likely to make change in monetary policy; a thin briefcase car-
ried the opposite implication. Interestingly, although the Federal
 INTRODUCTION 3

Reserve’s communicative practices have certainly changed, the

interpretive methods fundamental to the “briefcase watch” haven’t
quite as much.
Despite the fact that the Fed, among other things, now releases
meeting minutes and holds press conferences, Fed watchers often
give an inordinate amount of attention to the granular details of
the central bank’s communications to make their projections. This
approach does seem appropriate for the interpretation of press
releases that the Fed updates through track changes, but its applica-
tion has extended to the full breadth of the text now available over
the multiple channels the central bank utilizes to communicate
their message. By focusing on individual words and phrases instead
of attending to the entire text—let alone the broad trends that arise
when taking into account all the central bank’s channels—modern
Fed watchers are functionally performing an interpretive method
comparable to those that powered the “briefcase watch”: using min-
ute details to back bold forecasts. This myopic approach is clearly
vulnerable to miscalculation—section bias being but one of the
myriad of potential errors that could contaminate analysis.
In the modern market, the evaluation of Federal Reserve’s com-
munications is simply too important to be functionally monopo-
lized by such methods. Realizing this, we have developed a system
of textual interpretation specifically calibrated to tackle central
bank texts. Current methods rely on individual interpretation of
particular details to produce qualitative interpretations of the Fed’s
current economic position and projections of the central bank’s
future policy moves. Built on the breadth of historical connections
between the Fed’s words and the market’s reactions, our methodol-
ogy generates a quantitative analysis of the entire bandwidth of Fed
communications released within a given time period. This data,
known as the Prattle Sentiment Index, represents the first compre-
hensive, real-time, unbiased, and quantitative interpretations of
Federal Reserve communications in existence.

* * *

This book is divided into three parts. The first part is dedicated
to the birth and evolution of the modern Fed—tracing the grad-
ual development of the institution’s utilization of transparency.
4 HOW THE FED MOVES MARKETS

Growing out of a troubled banking system and chronic economic

collapses, the Federal Reserve was created to serve as the finan-
cial backbone of the nation. Under this charge, the Fed and its
specific powers and privileges would continuously evolve over a
series of monumental challenges—trials that began with the Great
Depression. Not even 20 years after its inception, the young central
bank was first confronted with an economy in ashes—then a world
at war. This global conflict was quickly followed by the Korean
War and the stagflation crisis. As the Fed reacted to each wave of
chaos, changes began to brew. The institution began to grow more
academic to deal with the tremendous complexity of the problems
it faced; it grew more centralized to create the stability and power
needed to act; it grew more independent to give itself the freedom
to act according to the data-driven recommendations of its expert
personnel. As the Fed became more centralized, autonomous,
and technocratic, those outside the institution looked on—with
anxiety—at a financial fortress. It became apparent the Fed’s
power needed to be balanced with openness—with transparency.
The culmination of that development is the purview of the book’s
second part.
Focusing on the era of the transparent Federal Reserve, Part II
chronicles how “Fedspeak” changed from a tool of obfuscation to
means of open communication—and what that evolution meant
(and means) for the market. Fed Chairmen Paul Volcker and Alan
Greenspan were famous for using obscure and opaque verbiage to
comment on Fed’s position. This rhetorical technique, known as
Fedspeak, was meant to maintain a veil of mystery around the cen-
tral bank, keeping its intentions unknown and unknowable. By the
close of Greenspan’s tenure, Fedspeak began to take on an entirely
different role: clarification. Bernanke and Yellen have continued
this trend, harnessing communication to calm markets and explain
policy. As the Fed embraced transparency, an analytic tradition
grew, and our methodology was born of frustration with these
orthodox methods. Exploring the mechanics of our process, this
part looks at how our data performs in the equity, fixed-income,
and FOREX markets and puts both our methodology and the thesis
that the Fed’s words move markets to the test.
The third part looks at transparency as a global phenomenon.
While the Fed and its practices may be the focus of this book, open
 INTRODUCTION 5

communication is far from a local development. The European

Central Bank, the Bank of England, the Bank of Japan and many
other central banks around the world have also integrated trans-
parency as a vital tool of monetary policy, and our methodology
also applies to those banks. As the previous part did with the Fed,
Part III investigates how our data on these central banks bears out
against market oscillations.

* * *

Over the past decade, the economic landscape has changed dra-
matically. The titanic sums that flow through the financial markets
have increasingly been shepherded by the hand of central bankers.
For financial professionals, these developments make grappling
with the impact central banks have on the economy more vital than
ever before—and integral to that effort is the study of the effects
of central banking communications. These texts stand as perhaps
the most unwieldy aspect of central banking policy, and, in both
academia and the private sector, the impact they have on the mar-
ket is only beginning to be examined. Our work in this space has
afforded us the ability to take a unique look at the authority and
power central banks command and, through our novel approach,
better understand the institutions that govern the financial world.
 PART I

Emergence and Evolution:

The Story of the Fed
 1

Origins: From Chaos to

Structure

E ven a century after its founding, the US Federal Reserve

remains an enigma in the minds of many Americans. Scholars
have spent decades examining the inner workings and evolution
of powers exercised by Congress, the presidency, the bureaucracy,
and the courts, but, despite the tremendous power the Fed wields,
its history and mechanics are seldom researched, let alone under-
stood. The next few chapters will explore the history of banking’s
ultimate black box, a history inundated with not only, of course,
board meetings and bureaucracy, but also political intrigue, power
plays, pioneers, and traitors. Amid warring factions and economic
disasters, the last century has seen the Fed evolve dramatically.
Originally designed as a regional organism, the Fed in the twenty-
first century is a centralized machine of information aggregation.
At its inception, its policy emerged from a plurality of voices; now
that policy is the product of complex data analyses and processes.
The Fed has transformed, in other words, from democracy to
data.
The Fed has also, and perhaps most importantly, become increas-
ingly independent—an independence it secures through an open
communications policy. This transparency, now known as forward
guidance, has not only become a vital aspect of policy—it is policy
(Yellen 2012). Fundamental to an adequate understanding of the
Fed, transparency is central to this book, and its development is an
essential theme in the Fed’s history.
Centralized, technocratic, independent, and transparent—
although technically the same institution, the modern central
10 HOW THE FED MOVES MARKETS

bank is very different from the institution as it was first designed in

1913. The modern institution, however, cannot be properly under-
stood without first looking at its origins.

* * *

The late nineteenth century was a most volatile time in America’s

financial history. Riddled with financial panics and crises that
struck almost every decade between the American Civil War and
World War I, the US economy reeled under a nationally chartered
private banking system that followed the “Free Bank Era” (1837–
1862). In Yankee Leviathan, Cornell scholar Richard Bensel identi-
fies a dysfunctional US Treasury as the source of the turmoil. The
rise of finance and capitalists in a single-party system in the North
bred clientelism and corruption sustained by finance-obsessed
political appointees dogmatically opposed to state intervention in
the economy. These Treasury positions limited “radical reconstruc-
tion” efforts—such as wealth redistribution—and placed the US
economy back on the gold standard in an effort to resume inter-
national trade. Treasury actions, according to Bensel, not only lim-
ited reconstruction efforts, but also fueled the banking panics that
culminated in the panic of 1907 and the ensuing financial crisis
(Bensel 1991).
As banks collapsed and businesses failed, J. P. Morgan and his
fellow wealthy investors poured millions into the banking system
to provide the necessary liquidity to keep the crisis from destroying
the economy. This bold move, coupled with the severity of the cri-
sis, prompted Congress to take action (Bruner and Carr 2009). The
1907 national meltdown demonstrated the need for a new system,
and Senate Majority Leader Nelson Aldrich realized it. With plans
in mind for a system based in government-issued bonds, Aldrich
formed and led a bipartisan commission to study the American
monetary system and European central banking.
Aldrich’s research would transform him. What he learned about
the Bank of England, the German Bundesbank, and other European
central banks helped him form a compelling vision. Abandoning
his original schemes, Aldrich began sketching the beginnings of
an American central bank (Law Librarians Society of Washington,
DC 2014).
 ORIGINS 11

His blueprint was ambitious. With 15 branches strategically

distributed throughout the United States, and united by a central
bank headquartered in the District of Columbia, the new system
would help manage a uniform elastic currency based on a com-
bination of gold and commercial paper. Ideally, Aldrich wanted
a central banking system independent of the government. But,
understanding the political impracticality of a central bank unre-
strained by public input, he incorporated a modicum of govern-
ment oversight into his design and sought to convince others that
decentralization would prevent corruption or undue political or
banker influence.
While admirably constructed, Aldrich’s design did not sat-
isfy his critics. His detractors, chiefly Southern Democrats and
Populist factions, feared Aldrich was swayed by his close ties to the
banking industry. In stark contrast to Aldrich’s plans, progressive
Democrats favored a system owned and operated by the govern-
ment. If the central bank was public property, Progressives envi-
sioned it could be used to loosen Wall Street’s current stranglehold
on the American currency supply.
As Democrats grabbed control of Washington after the 1912
election, hope for passage of Aldrich’s plan evaporated—but its
influence had taken root. In a Democrat-backed bill proposed by
Oklahoma’s Robert Owen, a new system was proposed that would
diverge from Aldrich’s vision in only one significant way: it placed
control over selecting its powerful board of directors with the gov-
ernment. Riding a wave of partisan support through Congress,
Owen’s bill passed in late 1913 to become the Federal Reserve Act,
and the Fed was born.

* * *

To begin building this new system, the Reserve Bank Operating

Committee (RBOC) was commissioned by Congress to select
the locations for the regional banks. The committee members—
Treasury Secretary William McAdoo, Agriculture Secretary David
Houston, and the incoming Comptroller of the Currency John
Williams—were quick to tackle the monumental task. Surveying
armies of bankers from thousands of banks and launching a “listen-
ing tour” of almost 20 cities linked by 10,000 miles, the committee
12 HOW THE FED MOVES MARKETS

eventually chose 12 locations from a list of 37 potential sites (Binder

and Spindel 2013).
In examining RBOC archives, scholars Sarah Binder and Mark
Spindel have identified the embedded political and financial strat-
egies that might have guided the committee’s choices. Their “polit-
ical model” assumes that the committee’s close ties to Democratic
president Wilson influenced the committee’s hand; their “financial
model,” as might be expected, assumes the committee’s decisions
were made for economic reasons (Binder and Spindel 2013). The
evidence, however, immediately casts doubt on the latter model.
Records of the committee’s banker survey reveal that the financial
community believed fewer locations would centralize finance and
minimize coordination problems and many bankers consequently
wanted only the minimum of eight regional banks required by
the Federal Reserve Act. Equally trying for the financial model
is the fact that, at the time, 5 of the 12 regional bank locations
were outside the country’s 12 largest financial hubs (see Figure 1.1
for details). Finance, it seems, took a backseat in the committee’s
choices.

Figure 1.1 Twelve Federal Reserve district boundaries as they were drawn by
the RBOC.
 ORIGINS 13

In contrast, the conspicuous clustering of the bank locations

around Democratic and Progressive strongholds presented an
obvious political advantage:

The RBOC sought to make up for the deficit of credit in the South, and
thus sought out southern locations when looking to extend the reserve
system beyond the nation’s financial centers in the East. In doing so, of
course, the RBOC also placed a coveted financial resource in the heart of
the Democratic South. (Binder and Spindel 2013, 10)

While the locations and the number of the regional banks ran
counter to financial strategy, regional boundaries were equally sus-
pect. As column two of Table 1.1 demonstrates, the population of
each of the districts seems as irrelevant to the boundaries as finance
was to the bank locations.
This is epitomized by the placement of a reserve bank in Kansas
City. Despite being the country’s 20th largest city and 18th larg-
est banking center, Kansas City was selected as one of the final 12
over bigger financial hubs in more centralized locations (relative
to other regional banks) like Denver, Omaha, and Lincoln. Why
choose Kansas City? Here again, politics is the prime suspect.
Unlike those other locations, Kansas City was home to a powerful
Democratic political machine. The apparent motivations behind

Table 1.1 Federal Reserve district populations in 1913 and 2000

District 1913 Population (%) 2000 Population (%)

San Francisco 6 19
Atlanta 12 15
Chicago 17 13
Richmond 9 10
Dallas 5 8
Philadelphia 11 8
New York 10 7
Boston 7 5
Kansas City 6 4
St. Louis 8 4
Cleveland 5 4
Minnesota 4 3

Note: Estimates calculated by the Federal Reserve Bank of San Francisco. Data originally
from the US Census Bureau (Federal Reserve Bank of San Francisco 2015).
14 HOW THE FED MOVES MARKETS

the committee’s decisions highlight an important theme in the his-

tory of the Fed: at/during nearly every step of the system’s creation,
politics was a driving force.
Those politics are still on display today—in the form of system-
atic over-representation. Using the 2000 census data, column three
of Table 1.1 clearly exhibits the significant over-representation and
influence that Minnesota, Cleveland, Kansas City, St. Louis, and
Boston have in the modern Fed. Residents in the Minnesota Fed
district are, for example, more than six times as represented as
those in the San Francisco district. This issue is exacerbated by Fed
voting policies: the president of the New York Fed has a permanent
vote on the Federal Open Market Committee, whereas the other
regional bank presidents rotate roughly every three years. In other
words, residents of the NY Fed district are nearly 7.5 times more
represented than those residing in the San Francisco district. In the
early years of the Fed, when the Board also included the Treasury
secretary and the Comptroller of Currency, this representation
dynamic was even more complex (Flaherty 2010).

* * *

The passage of the Federal Reserve Act and the January 1914
creation of the branch banks led to massive changes in the banking
system. The Act compelled all nationally chartered private banks
to join the Federal Reserve System and accept the newly estab-
lished national currency. These private banks were now required to
purchase specified nontransferable stock in their regional Federal
Reserve bank and to set aside a stipulated amount of non-interest-
bearing reserves within their respective reserve bank. Instead of
being forced, state chartered banks were invited to become mem-
bers of the system, and many did because of its numerous benefits;
in addition to borrowing privileges, members became a key con-
stituency for American banking’s new establishment.
Members of Congress might have been this establishment’s for-
mal principals, but, until Depression-era reforms were instituted,
regional interests drove Fed policy. Regional directors and staff
were selected by the local business community to represent local
business interests. An impotent board of directors combined with
 ORIGINS 15

economic diversity of the regions left the regional banks free to set
their own rates.
Within this independence, however, was the seed of centraliza-
tion. It didn’t take long for investors to notice, and take advantage
of, the arbitrage opportunities created by the disparity between
reserve bank rates. Regional banks were forced to act and decided
to unite behind a singular policy. Instead of setting their own rates,
the regional banks began to follow the lead of the Federal Reserve
Bank of New York—the highest volume exchange bank. Without
government interference, the Federal Reserve was slowly silencing
dissent and quietly beginning its march toward centralization.
By the time the roaring twenties slowed in 1927, the New York
Fed was the de facto capital of the entire system, and its governor,
Benjamin Strong, sat on the throne. No central bank in American
history had survived more than 20 years, and Strong was undoubt-
edly concerned with upholding the legitimacy of the young sys-
tem. Unfortunately, Strong’s reaction to the 1927 recession would
become a lightning rod for criticism of the Fed and helped lead the
United States into disaster. Perhaps failing to see the recession as
a natural market correction or perhaps pandering to Wall Street
banking interests, Strong decided to lower interest rates to sustain
rapid growth, and the entire system followed suit (Moss and Bolton
2009). The economy overheated, finally collapsing in the stock mar-
ket crash of 1929. Strong would never live to see it. Dying shortly
after the 1927 slowdown, Strong became an easy, defenseless scape-
goat for Fed officials looking to point fingers.
Regardless of where the blame lay, the Fed still had chaos on
its plate—and the turmoil only escalated. In 1930, with the stock
market still reeling, the enormous, privately owned, but authori-
tatively titled Bank of United States failed, and the Fed, still under
fire for 1927, had to decide whether or not to step in (Moss and
Bolton 2009). It was a perilous decision. The Bank of United States
was massive, and its demise would throw gasoline on an economy
already in flames. But, if the Fed did step in, it could encourage the
Bank of United States, and other banks, to play fast and loose—
confident that even if they took the plunge the central bank would
dive in after them. But there were more layers yet. While Wall
Street, terrified of another downturn, was begging for intervention,
16 HOW THE FED MOVES MARKETS

the Fed was also invested in appeasing Capitol Hill, and the Fed’s
democratically elected Congressional principals sought to distance
themselves from the bankers who had lost their constituents’ hard-
earned money. Pinned between private and public interests, the
Fed let the bank capsize.
The Fed’s challenges did not end there: the question of rescu-
ing one bank quickly led to a larger question about the entire basis
for our monetary structure. By the end of 1931 much of Europe,
including the United States’ largest trade partner, Britain, had gone
off the gold standard. The Fed, bound to gold by law, needed an
act of Congress to abandon it. The Fed never asked. Instead, fol-
lowing New York’s lead, the Fed elected to pump liquidity into the
system in the most cautious way possible: lend out at high rates and
only on good collateral. In response, Congress criticized this meek
policy and suggested a bolder move by the Fed: loaning on all col-
lateral. To the Fed, this proposal was more of a populist push than
shrewd policy, and in a show of budding independence, it stood its
ground.
The central bank’s decision to stay on gold arguably not only
made the Depression much more severe in the early 1930s, but
also made the recovery equally robust. The decades to come saw a
renewed faith in the US dollar, and that faith was backed by gold.

* * *

The Fed began its journey toward centralization without a for-

mal legal mandate. The leadership of the New York Fed throughout
the 1920s and into the 1930s accelerated that evolution and pushed
the Fed away from Congressional appeals and toward economic
data analysis and technocratic policy. It would take several more
decades for this progression to come to fruition, but the steps taken
in the Fed’s first 20 years laid the essential groundwork. The Fed
was about to enter a period of protracted conflict with the Treasury,
whose power and influence weighed heavily on the central bank
throughout its youth. But conflict led to progress. The middle of
the twentieth century would witness the birth of a powerful new
central bank: centralized, independent, and technocratic.
 2

Independence: Wars,
Depression, and Politics

T he executive branch dominated the Fed through the 1940 and

early 1950s. Although Congress held sway over the board of
directors and the Fed’s relative independence mitigated the White
House’s supremacy, the executive branch’s inevitable control
sprung from the institutional design of the Fed—and the power of
a unitary executive. The Treasury provided the muscle behind this
control, and decades of conflict between Fed officials and Treasury
officials provided the political fires that forged the development of
today’s independent and transparent reserve system. This chapter
continues the account of the political battles, financial reforms,
and world wars that fostered the Fed through the Great Depression
to their independence and beyond.

* * *

In the face of 25 percent unemployment and a collapsing finan-

cial sector, Franklin Roosevelt instituted his New Deal when he
took office in 1933. Through increased government spending and
institutional reforms, the New Deal sought to stimulate demand
and provide support for the impoverished. But, like any deal,
Roosevelt’s came with price—especially for the Fed. Weakened by
the steep recession and its apparent inaction during the crisis, the
Fed could only watch as the New Deal measures came into effect—
measures that meant structural changes to the central banking
system.
18 HOW THE FED MOVES MARKETS

The New Deal unleashed a tidal wave of fiscal expenditure,

reform, and regulation, including today’s now-familiar regula-
tory organizations. Born out of the Glass-Steagall Act, the Federal
Deposit Insurance Coporation (FDIC) was created to insure private
bank deposits. The Securities Act of 1933 comprehensively regu-
lated the securities industry, and the Securities Exchange Act of
1934 created the Securities and Exchange Commission (SEC). The
SEC alleviated some pressure on the Fed to regulate financial mar-
kets and the FDIC secured individual deposits and provided a clear
mandate that the Fed was to be a systemic lender of last resort.
Glass-Steagall had a dramatic effect on the Fed as a regulator, but
it was not until 1935 that the monetary side of the Fed faced genuine
reforms. These reforms renamed the board, dropped the Treasury
secretary and Comptroller of Currency from it, and dictated that
all Board nominees would be subject to presidential appointment
and Senate confirmation. These reforms should have put the Fed in
the hands of the Senate, but the executive branch would become the
real guiding force behind US economic policy as America headed
into the next global conflict.

* * *

Shortly after Japanese bombs laid waste to Pearl Harbor, Federal

Reserve and Treasury officials convened to discuss how to finance
the war. To back American military efforts, they decided to set
rates for bonds at 2.5 percent and a range of 0.5–0.75 percent for
bills. The Fed sought to utilize open market operations to main-
tain interest rate levels, but Treasury preferred a different method:
manipulation of excess reserves. Traditionally, the Fed has con-
trolled the monetary supply through the interest rate. The interest
rate is, effectively, the price of money; the more expensive money
is to borrow, then the less money is borrowed, and, consequently,
the less money there is in the system. By the same process, cheaper
money leads to an expansion in the monetary supply. The Treasury
wanted the Fed to break with these traditional methods and con-
trol of the monetary supply by directly targeting a specific quantity.
The Fed saw the Treasury’s strategy as outside their Congressional
mandate, but they were rapidly undercut by the Treasury’s unilat-
eral decision to peg interest rates at 0.375 percent for treasury bills,
 INDEPENDENCE 19

short term, and 2.5 percent for treasury bonds, long term (Wicker
1969). By pegging interest rates, the Treasury gave the Fed only one
way of controlling the monetary supply—reserve manipulation.
The pegged rates also forced the Fed into another paradox: the cen-
tral bank had to choose between appearing unpatriotic and allow-
ing government debt to go unsupported or continuing to buy and
sell securities, despite their wishes, to maintain desired rates. With
its back against the wall, the Fed acquiesced.
Treasury’s policy, however, had unexpected consequences. By
pegging rates, the Treasury effectively took away the fluidity of
the government securities market. Because rates were fixed, bonds
became safe as cash while also providing a return, and banks con-
verted their assets to bonds. Banks used bonds, in other words,
as excess reserves with interest. Since the banks avoided Treasury
bills, the Federal Reserve was forced to buy up massive amounts to
maintain the static interest rates and the money supply expanded
rapidly (Board of Governors of the Federal Reserve System 1948).
Fed officials quickly realized that these policies were not sus-
tainable from a price stability perspective, but it didn’t matter. As
long as the war continued, they had no choice but to continue the
policy—effectively ceding control of the government securities
market, and monetary policy in general, to the Treasury. Had the
Fed pursued its independent policy, interest rates would have been
flexible. Instead of only bonds, banks would have had an incen-
tive to buy Treasury bills too, mitigating the severity of the ensu-
ing inflation. But Treasury violated their initial agreement, and Fed
officials failed to assert the central bank’s independence. Once the
Fed initially submitted to the Treasury, they could not have reversed
course without being branded unpatriotic during wartime, which
would likely have prompted Congress and President Truman to
further cripple the Fed’s already diminishing independence by
inflicting even more reforms.

* * *

Even as World War II came to a close, the Treasury’s low-rate pol-

icy remained. Forced to maintain the extremely low interest rates
set at the beginning of the war, the Fed essentially granted control
of the money supply to the Treasury. Despite meek objections from
20 HOW THE FED MOVES MARKETS

Fed personnel, the Treasury continued to expand the total amount

of monetary assets in the country with low bond and bill rates. The
1944 Bretton Woods Agreement would only make matters worse for
the Fed. By establishing a system of fixed but adjustable exchange
rates based on a 35 dollars per ounce gold price, the agreement left
the Fed with less direct control over the cost of money, making their
power over monetary policy all the more tenuous (Meltzer 2003). In
the emerging postwar world, the Fed remained subordinate to the
Treasury.
With World War II finally over, Congress began to stand up for
the Fed in 1946. Containing an early version of the dual mandate,
the Fed’s famous charge to bolster employment and price stability,
The Employment Act, granted the central bank the authority to
direct policy to achieve “maximum employment and purchasing
power” (Meltzer 2003). The Act indicated that the Fed had a differ-
ent charge than the Treasury—and should behave accordingly. It
also signaled that Congress would side with the Fed as Treasury’s
arguments for postwar fixed interest rates lost their luster.

* * *

Even as inflationary pressure built and a recession loomed,

a stubborn Treasury continued to wave the same banner. While
insisting that low interest rates were necessary to both maintain
confidence in government credit and hold down the cost of post-
war government debt, Treasury officials even went so far as to claim
that controlling the money supply was not necessarily an effective
means of reducing inflation. The Federal Reserve, however, “did
not expect to maintain the wartime rate structure after the war,”
and tensions mounted (Meltzer 2010).
Throughout the Fed’s postwar battle with the Truman Treasury,
the Republican-controlled Congress was seen as sympathetic to the
Fed’s cause, and the clash between Capitol Hill and the Democratic
White House provided just enough cover for the central bank to
allow the bill rate to rise in 1947—earning them significant interest
income. Due to the agreement that allowed them to raise the bill
rate, the Fed turned over 90 percent of the revenue it generated back
to the Treasury. This set a precedent, and the Fed has continued to
turn over income to the Treasury ever since. In 2014, for example,
 INDEPENDENCE 21

the Fed gave the Treasury almost 100 billion (Board of Governors
of the Federal Reserve System 2015b).
The end of bill targeting was another step toward independence,
but the Fed remained bound by the Treasury’s target rate for long-
term bonds. When the pegged bill rate was lifted, the market was
so far out of equilibrium that public purchase of Federal Reserve
debt shifted from long-term securities to short-term securities.
Thus, the Fed’s decreased responsibility for the short-term market
led to an increase in the long-term market. Despite greater involve-
ment in bonds, the Fed took advantage of the increased demand in
short-term securities. Unloading 1 billion dollars off their balance
sheet, the Fed reduced financial ties with Treasury, but “political
concerns continued to limit the Federal Reserve’s ability to respond
to postwar inflation” (Meltzer 2010).

* * *

Even 1946’s spring budget surplus didn’t faze a Treasury bent on

maintaining wartime interest rates in a postwar world—a policy
that stoked fears of inflation. Fed Chairman Marriner Eccles pro-
tested that the Treasury had turned the Fed into an “engine of infla-
tion”; not coincidently, he would fail to be reappointed by Truman
in 1948. Noted Fed historian and Carnegie Mellon economist Allan
Meltzer (2010) notes, “The Federal Reserve shared the widespread
concern among economists that the presence of a large, outstanding
public debt limited the role of monetary policy.” Fear that increas-
ing interest rates could lead to deflation, a fear shared by President
Truman, balanced this concern. Given the White House’s worries
about deflation, Chairman Eccles knew the political climate was
not right for such a policy. Instead, to combat inflation, Congress
passed a bill that increased reserve requirements. Forcing the Fed
to pursue contractionary monetary policy that only served as cata-
lyst to the recession, the bill backfired, crippling the economy.
The sudden economic downturn allowed the Fed to strike a deal
with Treasury. Crafted in the summer of 1948, the deal empowered
the Federal Open Market Committee (FOMC) to direct open mar-
ket operations “[ . . . ] with primary regard to the general business
and credit situation” (Board of Governors of the Federal Reserve
System 1949). Since unemployment rose between 1948 and 1949
22 HOW THE FED MOVES MARKETS

and prices slightly declined, the Fed-Treasury agreement permitted

the Fed to lower interest rates in an attempt to stimulate the econ-
omy. This easing measure did not assert Fed control over monetary
policy as Fed officials had hoped, and it remained unclear whether
the Fed would have the flexibility to raise interest rates if the prob-
lem became one of inflation (Meltzer 2003).
In this lengthy struggle between the Fed (Board of Governors
of the Federal Reserve System 2015c) and the Treasury (Board of
Governors of the Federal Reserve System 2015a), Congress again
came to the Fed’s rescue. In 1949, newly elected Democratic Senator
Paul Douglas held a series of hearings about interest rate policy. A
career academic economist, Douglas’s sympathies visibly sat with
the central bank. Finding natural allies in the opposing party,
Douglas was able to forge a strong, bipartisan interest in Fed auton-
omy. The Douglas hearings examined the extent to which the Fed’s
efforts at price stability were weakened by the Treasury’s demands.
The report stated:

Do Federal Reserve officials determine the general level of interest rates,

including yields on Governments, that they will establish so that the
Treasury in fixing rates on new issues must conform to the decisions of
the Federal Reserve? Or do Federal Reserve officials conform their gen-
eral credit policies, including their support levels for Governments, to the
pattern desired by the Treasury? The evidence presented to the subcom-
mittee indicates that there is no simple answer to these questions. Federal
Reserve and Treasury officials and staff members are in frequent consul-
tation, and many decisions are agreed upon by the two agencies without
marked differences of opinion. On some occasions when there were origi-
nally differences of opinion the Treasury has “gone along” with Federal
Reserve requests for higher interest rates. But the evidence indicates that
in a majority of the cases where the judgments of the two agencies differed
it was the judgment of the Treasury that prevailed; the Federal Reserve was
not willing to assert its independence and force market yields to rise above
the yields that the Treasury wished to set on its new issues, thereby embar-
rassing the Treasury. It appears that in the absence of strong Treasury
influence the Federal Reserve would have initiated a tighter monetary pol-
icy somewhat earlier and that this policy would have been carried further.
(Joint Committee on the Economic Report 1950, 28–29)

In essence, the hearing report indicates that pressure from the

Treasury had loosened the Fed’s monetary policy. Continuing to
back the central bank, the report also affirmed that “the primary
 INDEPENDENCE 23

power and responsibility, and cost of credit in general shall be vested

in the duly constituted authorities of the Federal Reserve System”
(Meltzer 2003). Concluding that controlling inflation trumped
controlling federal debt, the report supported granting the Federal
Reserve the freedom to raise interest rates.
Senator Douglas had demonstrated that leaders in Congress
wanted an end to fixed interest rates and, perhaps more impor-
tantly, an independent Fed (Meltzer 2010). Solidifying their oppo-
sition to Congress and the Fed, the White House and Treasury
disagreed—and ignored the report.

* * *

While the Fed may have gained a strong ally on Capitol Hill, con-
flict began growing inside its doors. At the start of 1950, a recession
had some market actors—Wall Street in particular—rethinking old
positions about Fed independence. Seeing the greater profit mar-
gins higher interest rates allowed for, Wall Street began pressuring
government officials inside and outside the Fed to respond more
directly to market conditions (Flaherty 2010). But inside the Fed
this pressure from the banking community highlighted a growing
division between former chairman—and current Board member—
Marriner Eccles and Alan Sproul, president of the New York Fed.
Eccles and Sproul both fought for an independent central bank;
they just wanted different principals. “Eccles saw the Federal
Reserve as mainly a government agency regulating the financial
industry and carrying out government policy,” while Sproul “saw
the Federal Reserve as mainly a financial institution, blending pub-
lic and private control” (Meltzer 2003). These views mirrored the
split between political and private control that had plagued the Fed
since the Aldrich Plan.
While the Korean War put the Fed’s internal debate on hold,
it set the stage for yet another standoff between the central bank
and the Treasury. Wartime spending once again ignited fears of
inflation, forcing the FOMC to take action. Instead of raising inter-
est rates themselves, the Fed requested that Treasury Secretary
Snyder make 2.5 percent bonds ineligible for bank purchase to raise
the short-term rate. Snyder refused. The Fed countered, increas-
ing the discount rate. In response, Snyder announced a bond sale
24 HOW THE FED MOVES MARKETS

at 1.75 percent, conflicting with the new Fed rate. The bond sale
was a failure, but the Treasury still refused to issue a 2.5 percent
bond. Beginning a credit restraint policy, Fed officials continuously
warned of rising inflationary pressure. Their efforts, however, were
doomed by a Board “not willing to insist on an independent policy.”
“Politics,” as Meltzer (2010) perfectly sums it up, “overrode anti-
inflation policy.”
Conflict between the Fed and Treasury continued through the
fall of 1950—with doublespeak and lies coming from meetings at
the highest level. At the conclusion of a meeting between Truman,
Snyder, and Fed Chairman McCabe, Snyder gave a speech declar-
ing that a 2.5 percent rate ceiling would remain. Snyder’s declara-
tion—violating the policy McCabe had agreed to—infuriated Fed
officials, but more lies would follow.

* * *

The rising tensions between the Fed and Treasury didn’t prevent
the entire FOMC from meeting with President Truman in early
1951. In a statement released after the meeting, the White House
reported, “The Federal Reserve Board has pledged its support to
President Truman to maintain the stability of Government securi-
ties as long as the emergency lasts” (Eccles 1951). In a correspond-
ing statement, the Treasury backed the White House, announcing
that interest rate levels would be maintained for the duration of
the Korean War. Both were false. The FOMC had never agreed to
maintain the rate. In fact, Truman had never even asked (Eccles
1951).
But the Executive branch’s deceit would backfire, providing
the central bank with new allies in the press and giving addi-
tional momentum to its push for independence. On the heels of
the deception, former Fed chairman Eccles released his personal
notes from the meeting to the press. The Sunday New York Times
and Washington Postt boldly printed that Truman and Snyder had
lied. Fed Chairman McCabe, in an attempt to reign in the growing
conflict, sent timid letters to both Truman (McCabe 1951a) and
Snyder (McCabe 1951b). But, before they could publicly respond,
the financial community spoke out. In a speech at a Pennsylvania
Bankers Association meeting, Aubrey Lanston—former assistant
 INDEPENDENCE 25

to the secretary of the Treasury—had strong words for the future

of the Fed: “We believe it is most desirable that the Federal Reserve
become more free than it has been in the past decade to follow a
restrictive credit policy at times when this is needed” (Lanston
1951). A few weeks later, the Economists National Committee on
Monetary Policy issued a press release titled “51 Members Urge
the Importance of Restoring and Maintaining the Independence
of the Federal Reserve System” (Economists’ National Committee
On Monetary Policy 1951). With bankers and economists rallying
in support for the Fed, and the Administration’s deceit exposed, it
was clear that change was in the air and the financial press knew it,
backing the Fed from that point forward.
Presidential lies weren’t the only bombshell. Just as the Fed’s
camp began to swell with newfound support, the announcement
was made that consumer prices rose at a 14 percent annual rate.
Alarmed, Secretary of Defense James Forrestal became concerned
about inflation and the rising costs of the Korean War. With
Senator Douglas and his colleagues pushing for an independent
Fed on Capitol Hill, Forrestal’s valid concerns joined the chorus of
voices calling for a Fed free of Treasury control.
Negotiations between the Fed and Treasury began almost imme-
diately—culminating in the now-famous 1951 Fed-Treasury Accord.
The Fed “agreed to share responsibility for the orderly marketing
of government debt” and to buy 200 million dollars in 2.5 percent
bonds at the next refunding. Additionally, the Fed would wait for
Treasury approval before changing the discount rates over the next
year. In return, Treasury let short-term rates rise and longer-term
debt rise above the 2.5 percent rate. The publicly released agree-
ment stated:

The Treasury and the Federal Reserve System have reached full accord
with respect to debt management and monetary policies to be pursued in
furthering their common purpose to assure the successful financing of the
Government’s requirements and, at the same time, to minimize monetiza-
tion of the public debt. (United States Treasury and Federal Reserve Board
of Governors 1951)

Although it is considered by many to be the origin of Fed

independence, the 1951 Accord was actually a meekly worded
gentlemen’s agreement. It was not official legislation or a binding
26 HOW THE FED MOVES MARKETS

contract. It did not change the legal status of the Fed or reform its
organizational structure. While ending pegged interest rates, the
Accord made no mention of optimal policy or long-term goals and,
most importantly, it did not grant the Fed complete independence.
As Douglas remarked shortly after the Accord, “It is not clear just
what this agreement means.” Although it does not actually mark
the birth of central bank autonomy, the Accord served as a cata-
lyst that led to the Fed’s ultimate assertion of independence and
strength.

* * *

Shortly after the Accord was signed, McCabe resigned as

Chairman, and Truman selected William McChesney Martin to
replace him. A Treasury Undersecretary and the top Accord nego-
tiator for the Treasury, Martin had the pedigree to bridge the gap
between the warring houses. The Treasury could breathe easy, con-
vinced the central bank was in familiar hands; Fed officials, on the
other hand, could trust the new chairman’s lineage: Martin’s father
was the long-time president of the Federal Reserve Bank of St. Louis.
As a former head of the New York Stock Exchange, Martin was a
seasoned player with the skills to calm financial markets. Martin
also understood that he was inheriting an institution “that had not
pursued an independent policy since 1933” (Meltzer 2003). With
the right mix of pedigree and politics, Martin was poised to be a
powerhouse at the helm of the nation’s banking system.
Truman, however, got a little more than he bargained for with
his dream selection. Although the Accord had reduced Treasury’s
influence, the Fed was still bound to back a handful of Treasury
efforts. In practice, this meant the “even keel” policy: the Fed held
interest rates constant for two weeks before and after the sale of
Treasury notes and bonds. Although it functionally limited the
Fed, Martin was expected to maintain this type of coordination.
However, Truman didn’t know Martin as well as he thought.
The new Fed chairman believed in “independence within the
Government,” and this, apparently, was more independence than
Truman expected—or wanted—from Bill Martin. Disenchanted,
the president would later refer to Martin as a “traitor” (Bremner
2004).
 INDEPENDENCE 27

Given Truman’s disappointment with the level of independence

Martin sought for the Fed, it is clear that the president did not expect
the Accord to actually unshackle the Fed from the Treasury—and
neither did the Treasury. The Accord, it seems, was designed to
placate the financial press, appease a few senators, and allow the
administration to continue steamrolling the Fed.

* * *

It is interesting to note that despite Truman’s anger toward

Martin, the evidence doesn’t actually support his ire. Fed policy in
1951 and 1952 was not the product of an independence-obsessed
chairman. Martin’s Annual Report of the Board of Governors of
the Federal Reserve System for the year of 1952 states:

The Federal Reserve System followed a policy of restraining the pace of

credit expansion by making it necessary for member banks to borrow in
order to obtain reserves. This put them under pressure to restrict expan-
sion of their loans and investments. Thus discount operations at the
Reserve Banks again became an effective instrument of credit policy, a
further realization of the purposes envisaged by the Treasury-Federal
Reserve accord of March 1951. (Martin 1953, 1)

The data, however, does not support the claim that the Fed tight-
ened credit in 1951. In fact, the president’s own economic report in
1953 indicates that the discount rate remained at 1.75 percent for all
of 1951 and 1952 (Council of Economic Advisers 1953). The same
report indicates that the Fed expanded both bank credit and the
money supply through 1951 and 1952:

In both 1951 and 1952, an expansion of Federal Reserve Bank credit was
one of the factors which supplied commercial banks with reserves. During
1952, borrowing by member banks provided the greater amount of reserves
from this source, while in the previous year the net increase in Federal
Reserve Bank holdings of U. S. Government securities was more impor-
tant. The average of Federal Reserve discounts in 1952 was more than
one and one-half times greater than in 1951, but Federal Reserve hold-
ings of Government obligations averaged about the same. The privately
held money supply (including the bank deposits of State and local govern-
ments) expanded almost 9 billion dollars or about 5 percent in 1952, nearly
as much as in the previous year. (Council of Economic Advisers 1953)
28 HOW THE FED MOVES MARKETS

In contrast to some accounts, Martin did not immediately assert

Fed independence or use the Accord as his shield during 1951 and
1952 (Meltzer 2010). In other words, Truman’s traitor was not the
turncoat he was made out to be.

* * *

Deserved or not, Truman’s growing animosity toward Martin

reflected the attitude virtually the entire Democratic Party, aside
from Senator Douglas, had toward the Fed—an attitude not shared
by the Republican Party. As the 1952 elections approached, the
Republican Party platform formally backed Fed independence.
They wanted a “Federal Reserve System [ . . . ] without pressure for
political purposes from the Treasury or the White House” (Wilson
1992). Although important to warring factions in the government,
the battle over central bank independence was not the conflict on
most Americans’ minds at the time. Tired of the bloody struggle in
Korea—already in its third year—the nation clamored for peace.
Leveraging this discontent, Republican Dwight Eisenhower swept
the 1952 Presidential election, carrying 39 states.
Eisenhower immediately began work on foreign and domes-
tic battlegrounds. In an effort to accelerate peace talks in Korea,
Eisenhower made peace—or nuclear war—the only options. Ike’s
atomic power play worked, and the war came to a close in July of
1953. In the battle over the Fed, Eisenhower chose a more diplo-
matic route, strategically appointing George Humphrey as Treasury
secretary and W. Randolph Burgess as assistant to the secretary.
Humphrey believed that the Fed should handle the market for gov-
ernment securities (Wells 2004) and Burgess was a former Fed offi-
cial. With Fed supporters in key positions at the Treasury, the stage
was set for Martin to “restructure the relationship between the Fed
and the Treasury” (Bremner 2004).
Noting the Accord’s important role in the long road toward Fed
independence, a 1953 report by Secretary Humphrey relates the
history of the war between the Fed and the Treasury:

In the years preceding the March 1951 accord, the Federal Reserve System,
under Treasury domination, contributed substantially to inflation by arti-
ficial manipulation of the value of Government securities. During and after
 INDEPENDENCE 29

World War II, the Federal Reserve System lost much of its independence.
It was used by the Treasury to raise unprecedented amounts of money,
and during the war this requirement completely overshadowed monetary
policy. As long as the war was on and Government controls kept wages
and prices pretty well in line, there wasn’t so much trouble: But when in
1946 direct controls were removed without also concurrently releasing the
Federal Reserve, the excesses of the war years brought inflation and hard-
ship to millions of Americans. In the years from 1946 to 1951, the Federal
Reserve was a prisoner of the Treasury policy in handling the national
debt. Instead of allowing the natural increases in interest rates, the Federal
Reserve focused major attention on making sure that the Treasury could
handle the debt at low rates. This was not in the best interests of the coun-
try as a whole. It resulted in the absence of effective monetary policy until
the accord of March 1951. As you gentlemen well know, the March 1951
accord partly restored effective monetary policy to its rightful place in our
economy. It laid the groundwork for the policy which the present adminis-
tration is pledged to continue. (US Treasury Department 1954, 248)

This same report also declared that the Eisenhower administra-

tion “assured the Federal Reserve System that it will have the prime
responsibility for maintaining the money and credit situation free
of artificial restraints in the best interests of all Americans” (US
Treasury Department 1954). These words were not hollow. In
1952, the Joint Economic Committee report on Monetary Policy
and Management of the Public Debt referenced the need for Fed
Independence 56 times in just 80 pages (Joint Committee on the
Economic Report 1952). By 1954, a comparable report from the Joint
Economic Committee referenced the need for Fed independence
just four times in 331 pages (Joint Committee on the Economic
Report 1954).
After years of embittered conflict, the Fed had finally broken
free, and the inauguration of Dwight Eisenhower was a defining
moment in that struggle. With rates allowed to rise and inflation
kept in check, the Fed’s independence helped lead America into the
most prosperous decade in its history.

* * *

The vast majority of scholarly literature treats the 1951 Accord as

the Federal Reserve’s independence day, but, as this chapter points
out, there is much more to the story. The Accord was only one link
30 HOW THE FED MOVES MARKETS

in the long chain of political events that led to a liberated Fed. By

acknowledging that Fed independence was achieved as a result of a
series of political moves, rather than a legal contract or accord, this
narrative highlights the ever-present role of politics in Fed policy.
“Politics,” as Alan Meltzer (2010) says, “was a dominant influence
on Federal Reserve policy,” and it remains so to this day.
Ultimately, the real question isn’t where to date the birth of an
independent central bank. Rather, the real question is how that
independence changes policy—and how that policy influences
markets. The survivor of a decades-long struggle over sovereignty,
the Fed learned the value of autonomy—an autonomy it would later
maintain through a policy of transparency.
 3

Centralization: The Rise of

Technocracy

E ntering the 1950s with new leadership and newfound auton-

omy, the Federal Reserve was ripe for modernization. Spanning
the next two decades, this chapter tells the story of the beginning
of that change. Central to this narrative is the newly appointed
chairman of the Fed, William Martin, and the role his influence
and leadership would have in the Fed’s transformation. During
Martin’s tenure, the slow push toward centralization that had
begun during the Fed’s infancy would accelerate, and the tech-
nological revolution outside its doors would be mirrored in the
technocratic revolution unfolding within them.
While Fed transparency is addressed in the next few chapters—
and is essential to the book as whole—it is important to note that the
institution began embracing transparency as a direct result of the
pivotal developments during this period. As educated, technically
inclined policymakers joined the Fed’s ranks during the 1950s and
1960s, the increasingly centralized, powerful, and technocratic insti-
tution appeared all the more intimidating and opaque to the pub-
lic—and to its bureaucratic principals. President Nixon’s comments
after the 1960 presidential election serve as a perfect example of cen-
tral bank ascendancy: the presidential candidate believed the central
bank and its chairman to be so powerful that he blamed Martin’s
tight monetary policy for the Republican loss (Axilrod 2011a).

* * *

Although Martin lacked formal economic training, his back-

ground as head of the Import-Export Bank and the New York Stock
32 HOW THE FED MOVES MARKETS

Exchange gave him a wealth of practical knowledge about the econ-

omy and a firm belief that economics was becoming an increas-
ingly technical discipline. According to former Fed Staff Director
Stephen Axilrod, Martin believed the Fed needed to keep pace with
economic theory and practice to maintain credibility and establish
good policy. Strong as Martin’s convictions were, the old guard was
slow to embrace new methods.
But there were changes. Regional banks began hiring young,
academically trained economists, and, by the late 1950s, punch
card computers were beginning to be used to conduct regression
analysis on economic data (Axilrod 2011b). “Working at the Board:
1930s–1970s,” a collection of writings by retired Fed officers, chron-
icles these changes, highlighting the role played by computing:

A major change that developed over several decades has been in the
way data and other information are assembled, worked on, stored,
and updated. For a large part of the Board’s history, these tasks were
handled with what today many would consider very primitive tools: the
desk calculator that was used for all data manipulation and ground out
the results of simple operations; the manual typewriter that provided
final copy only after uncounted retypings of successive drafts; the four-
teen-column card that preserved statistical data (entered and updated
by hand) and was stored in a clerk’s private file case; the nonstatistical
records usually kept on pieces of paper in someone’s desk drawer. . . . ]
Nevertheless, a relatively large force of statistical clerks and other record
keepers turned out a lot of work with these tools, though it did not need
to be, and was not, the complex and sophisticated output demanded
in recent years. With the gradual shift through semiautomatic equip-
ment to higher and higher levels of technology, employee skills have
needed to be upgraded as well, and employment qualifications have
risen. (Stockwell 1989, 2)

The usage of new data storage, aggregation, and analysis tech-

niques required a more sophisticated staff, reinforcing the need
for what Martin had already seen. The movement to improve the
Fed was gaining steam, but critics of the central bank remained
dissatisfied.
To learn from their critiques, Martin requested that Board staffer
James Knipe gather, document, and explain these criticisms in a
 CENTRALIZATION 33

report from early February of 1962. The criticisms Knipe recorded

from the Congressional Joint Economic Committee between 1959
and 1961 include:

1. Monetary policy is not very effective in three areas.

2. Monetary policy is too effective in three other areas.
3. The Federal Reserve System is not efficiently integrated into the
administration.
4. The Federal Reserve System is not organized to function
efficiently.
5. Federal Reserve operational results are handicapped by slippages,
time lags, inadequacies and ambiguities.
6. The Federal Reserve is unduly, and wrongly, influenced by private
banking interests.
7. The Federal Reserve promotes high interest rates to make more
profits for lenders.
8. The Federal Reserve shortens economic upswings and stunts
national economic growth. (Knipe 1962)

In his report, Knipe responds by pointing to the impossible

choices faced by the Fed:

The institutional structure of the American economy in 1961 is one in

which, as a result of the increased strength of highly-organized power
blocs—labor, industry, agriculture—prices will have a tendency to rise
whenever men and machines are operating at anywhere near to capac-
ity. The purchasing power of the dollar is, therefore, subject to possible
further deterioration within the next few years. As an important agency
especially interested in the integrity of the dollar, the Federal Reserve will
find itself again in the unenviable position of having to decide whether or
not to restrain what it looks on as “inflationary excesses,” at times when its
critics may regard the economy’s performance as unsatisfactory, and not
even near to “inflationary excesses.” (Knipe 1962, 68)

In essence, what critics may perceive as a central bank that “stunts

national economic growth” is actually a central bank committed to
its primary charge: “the integrity of the dollar.” Pinned between the
criticism it would face if it allowed for excess inflation and the criti-
cism it would face if it “shorted economic upswings,” the Fed was,
as Knipe puts it, in an “unenviable position” (Knipe 1962).
34 HOW THE FED MOVES MARKETS

* * *

Regardless of equity, the institution would continue to receive

targeted criticism from Congress. Beginning in the 1950s and
continuing into the 1970s, two of the most ardent Fed critics were
Democratic Congressman Wright Patman (Texas) and Senator
William Proxmire (Wisconsin). Leading their respective chambers’
banking committees and many relevant subcommittees, Patman
and Proxmire held tremendous sway: “When the Fed wanted a
change in banking legislation, it was usually through these two
chairmen that it had to proceed” (Stockwell 1989). Described by
some former Fed officers an “inquisition,” their oversight meant
a nightmarish preparation process by central bank representatives:

Patman was a populist, who regarded the Fed’s occasional tight money for-
ays as an oppression of the common man. Proxmire was a thrifty liberal,
who advocated activist government but detested spendthrift bureaucrats
and inefficient programs. Each of them found plenty of opportunities to
try to trim the Fed’s wings. A hearing before either of these gentlemen was
something of an ordeal. Word of a new invitation to testify before either
one was typically greeted around the Board with the institutional equiva-
lent of a sigh. Preparations for the appearance were strenuous. Often a
very substantial support document was required. Weeks and sometimes
months of staff time were spent in its preparation. The testimony itself
often included a good deal of grilling of the Fed witness by the committee
chairman, rather in the style of a determined prosecuting attorney. It was
a rare day when the Fed’s representative could return from such a session
and say “I got what I wanted.” (Stockwell 1989, 26)

Not only did preparation for their hearings require significant staff
hours, they often resulted in voluntary Fed budget cuts to keep
their critics satisfied:

Sometimes Patman and Proxmire would turn the tables on the Board by
introducing some proposed new legislation that would take away some
cherished Fed power or privilege. Bringing budgets of the Board or the
Federal Reserve Banks under congressional control was a favorite thrust,
and one the Fed regularly resisted. To the Fed, this breached the care-
fully crafted insulation from pressure politics that had been a key part
of the legislation that had created it. As a practical matter, the Fed was a
“cash cow” for the federal government, (a byproduct of its congressionally
given power to create money) rather than a net user of federal budgetary
 CENTRALIZATION 35

resources, and every Federal Reserve spokesman knew that. To help prove
groundless the recurrent charge by Patman and Proxmire that the Fed was
a wasteful spender of resources, the Board often turned the budget screws
as tight on itself and the Federal Reserve Banks as the Administration and
the Congress were endeavoring to do to the rest of the federal government.
Nobody on the Board staff enjoyed these episodes. In fact, the Board was
not a lavish spender to begin with, so often what resulted were marginal
spending curtailments that took nicks out of a sizable number of cher-
ished projects, programs, and perquisites, of which the most important
were undoubtedly staff salary increases. (Stockwell 1989, 27)

These cuts notably sliced into staff salaries, limiting the rate at
which the Fed was able to grow and acquire technically proficient
staff.
But the Fed would not let financial belt-tightening completely
cripple its progress. In 1963, Daniel Brill, director of Research
and Statistics at the Board, convinced Martin that the Fed needed
more “expert economists” (Axilrod 2011b), and, as a result, the
Fed hired a series of highly trained economists from top-tier doc-
toral programs to work in Brill’s division. By the mid-1960s, the
International Finance division headed by Robert Solomon had also
begun hiring technically inclined PhD economists, and, of the five
documented finalists for an appointment to the Federal Reserve
Board in 1964, four had advanced degrees: three PhDs and a JD
(Dillon 1964). By comparison, at that time only about 40 percent of
Americans had completed high school and only about 10 percent
of adults were college educated. As the technical skills and training
of the Fed’s staff increased, the education gap between the central
bank and public it served only widened, and a new, technocratic
entity was taking shape.

* * *

The shift that took place during the second half of the twentieth
century was dramatic. During the entire 40-year period between
1914 and 1954, the whole Federal Reserve System employed just 81
PhD economists and 14 MA, MBA, or JDs; there are an additional
44 people with unknown educational backgrounds. In 1931, the
Federal Reserve Board employed just ten staff members. This num-
ber had grown to 22 by 1941 and 34 by 1951. Even five years into
36 HOW THE FED MOVES MARKETS

William Martin’s tenure as Fed chairman—1956—the Board still

employed only 42 staff members. By contrast, in 2013 the Federal
Reserve Board alone employs over 450 people; 296 of them are PhD
economists (Board of Governors of the Federal Reserve System
2015c). That is, nearly four times as many PhD economists that the
entire Federal Reserve System employed over the course of its first
40 years. And these figures do not count the massive staffing shift
at regional banks.
Although staffing data from the regional banks is difficult to
obtain because they are private entities not required to comply with
the Freedom of Information Act, the available data also indicates
that broad steps toward technocracy took place at regional Fed
banks across the United States. Table 3.1 provides data on the back-
ground of regional bank presidents beginning in 1950. As this table
illustrates, since the middle of the twentieth century the regional
Fed banks have almost uniformly made strides toward being led
by a president with either vast government experience as a public
servant or a PhD.
The background of the regional bank presidents is particularly
interesting because unlike the Board staff, who are selected by
other staff for their analytical skills, the regional bank presidents
are selected by the regional bank directors who represent the local
business community in each region. This makes them the least likely
to be selected based on academic qualifications and most likely to
be selected based on business connections. Given that even these
bank presidents have shifted toward being trained economists, it

Table 3.1 Regional Bank president backgrounds

Year Banker/lawyer Economist/public servant

1950 11 1
1960 8 4
1970 6 6
1979 5 7
1987 5 7
1995 3 9
2000 1 11
2010 2 10
2012 1 11

Note: This data was collected from each regional Fed bank’s historical information.
 CENTRALIZATION 37

is reasonable to assume that the directors of the regional banks

deemed it necessary to have a technically trained bank president
so that he might be able to understand the increasingly complex
methods, models, and data presented by Board staff at Federal
Open Market Committee (FOMC) meetings.

* * *

A pivotal period during this transition, the 1960s are best

described by the staff who lived through them:

The decade of the 1960s soon brought a fresh breeze to both the nation
and the Federal Reserve. The election of 1960 put a young and vigor-
ous President in the White House. He exuded confidence in rational
thought. He arrived with some fresh ideas, and he was in the market for
more. Accordingly, in a number of his early appointments he chose highly
trained, intellectually curious individuals with forward-looking attitudes.
They brought new ideas of their own and of other thinkers into policy
circles. [ . . . ] In this atmosphere of intellectual challenge the Board staff
responded vigorously. Friendly debates on policy issues great and small
were common in the Board offices and over the cafeteria tables. The direc-
tors of the two research divisions, Arthur Marget and later Ralph Young
for the Division of International Finance and Jack Noyes and later Dan
Brill for the Division of Research and Statistics, were open to bringing in
outside experts to exchange ideas. Brill was particularly adept at drawing
thought-provoking scholars of varied backgrounds into the Board’s offices
for occasional talks or short stays. A somewhat more collegial tone came
to pervade the halls of the Board. The Board even established a panel of
outstanding academic consultants, who provided some very stimulating
exchanges in their periodic meetings around the Board table. (Stockwell
1989, 21)

As this account attests, the era was characterized by its academic

discourse, as Fed officials deliberately pursued the improvement of
the central bank’s intellectual environment. The Fed’s relationship
to the government, interestingly, is only referenced once in the pas-
sage, highlighting President Kennedy, but the narration focuses on
the spirit of open inquiry he brought with him and the technocratic
changes it helped inspire. This perspective on the Fed’s relation-
ship with the government points to the self-sufficiency the cen-
tral bank saw itself as possessing. The executive branch, the Fed’s
38 HOW THE FED MOVES MARKETS

former principal, is now pictured as a contributing partner. Times,

it appears, had indeed changed.

* * *

During the 1960s, the Fed began a long tradition of authoring

data-driven documentation. In 1964, the Fed rolled out the first edi-
tion of the “Green Book.” These reports, formally entitled “Current
Economic and Financial Conditions,” are still distributed prior to
each FOMC meeting and consist of a summary of the current econ-
omy, recent developments in the economy, and current financial
conditions. A year later, the Board staff rolled out the first edition
of the “Monetary Policy Recommendations”; like its counterpart,
this too earned a moniker and became known as the “Blue Book”
(Federal Open Market Committee 2012). Both the Green and Blue
Books originated from the Board staff—not the regional banks—a
fact that demonstrates the increased centralization of Fed policy in
the mid-1960s. Given that each region is specifically charged with
examining its own economic conditions, the Board’s responsibil-
ity for analysis of national data undercut district bank personnel—
leaving them without a technical data source to express opinions
and preferences during FOMC meetings. Although subtle, the
books were yet another sign of the future of the Fed as an increas-
ingly centralized and information-oriented institution.

* * *

With a culture of healthy intellectual debate, sophisticated, highly

trained personnel, and concrete mechanisms to convey research to
key policymakers, the Fed would enter the next era armed. The
central bank’s own records echo this sentiment, affirming that by
the end of the 1960s “the Board had equipped itself with a new gen-
eration of tools for economic analysis, a new managerial system,
and a new generation of staff leadership with which to respond to
the challenges of the 1970s” (Stockwell 1989).
 4

Transparency: Data Meets

Democracy

L ike the 1950s and 1960s, the Fed’s next era had its own defining
leader: Paul Volker. Martin had shaped the Fed into a more cen-
tralized, powerful, and modern machine, and when Volker arrived
on the scene—after two lackluster chairmen came and went—he
would continue that tradition. Under his guidance, the Fed would
continue its march from democracy to technocracy. This trans-
formation would measurably increase the central bank’s effective-
ness, but it would also obscure its processes and the motivations
behind its policy. As the previous chapter briefly mentioned, this
opacity—this mixture of complex bureaucracy, complex processes,
and complex data—made improving the lines of communication
between the Fed and the government and the public an absolute
necessity. What the Fed eventually grew to understand was the
necessity of transparency, but that understanding would not be
easily earned.

* * *

The 1970s began with the retirement of William Martin, the

Fed’s longest serving chairman. To replace Martin, President
Nixon chose noted business cycle economist Arthur Burns, but
his appointment, however, was not without complications. As the
chair of the Council of Economic Advisers under President Nixon,
he had built a rapport with the president, which led to the percep-
tion that Nixon would unduly influence policy. In addition, despite
his business cycle expertise, Burns was also known to lack strong
40 HOW THE FED MOVES MARKETS

quantitative skills. These perceptions combined with uncontrolled

inflation during his tenure meant that Burns’s legacy was a lack of
policy credibility, rather than any significant progress.
In large part, the lackluster achievements of the 1970s can be
attributed to three factors:

1. The collapse of the post–World War II Bretton Woods system

of international finance, which turned the US dollar into a
fiat currency.
2. The political pressure placed on the Fed from the Nixon
administration.
3. The new regulatory and transparency laws that increased the
Fed’s responsibilities.

Of the three, the collapse of Bretton Woods had the largest and most
direct economic impact. As a result of the famous “Nixon Shock,”
the president’s decision to unilaterally abandon the gold standard
in August of 1971, many foreign countries chose to hold dollars as
a reserve currency. This increased demand for dollars prompted
White House officials to call Fed Board Director of Research and
Statistics, Charles Partee, to the White House to emphasize that
all policy decisions should help grow M2—the government’s pre-
ferred measure of money supply (Axilrod 2011b). The dollar was in
uncharted territory as both a fiat currency and a global reserve cur-
rency, and this new status—coupled with White House pressure—
exacerbated inflation through the decade.
While Bretton Woods was certainly a powerful factor, many his-
torical and political accounts of this era focus on the role of the
Nixon/Burns dynamic in Fed policy, and the intricacies of this rela-
tionship were on full display in the period leading up to the 1972
election (Axilrod 2011a). At the time, Burns was not only the chair-
man of the Fed but the chair of the newly formed Committee on
Interests and Dividends (CID) as well. Since the CID was designed
to deal with wage and price controls, Burns’s two roles conflicted:
easing credit would make wage and price controls easier to imple-
ment, making his CID job easier, while at the same time jeopardiz-
ing the integrity of the dollar, the maintenance of which was his
primary job as Fed chairman. Even if Nixon was not directly pres-
suring Burns, by appointing him to these dual roles he pressured
 TRANSPARENCY 41

the Fed chairman to adopt an easier monetary policy. In addition,

despite post hoc Congressional criticism, Burns was encouraged to
ease monetary policy through 1972 by members of Congress from
both parties (Woolley 1986). Ultimately, the ineffective policy and
perceived lack of political independence by the Fed Chairman con-
tributed to rampant inflation—and the declining credibility of the
central bank.
Stephen Axilrod, a former Fed staff director, offers one insider’s
perspective on the leadership of Arthur Burns:

It was not that Burns . . . did not make a sustained effort to be a leader and to
influence the policy decisions made by the FOMC. He most certainly did
[ . . . ] But his actions were, as the now common expression has it, “inside
the box.” They were basically maneuvers, not grand performances that
might have persuaded an audience (his fellow policymakers, for instance,
not to mention the country as a whole) to see the economy and policy from
a paradigmatically different viewpoint. (Axilrod 2011a, 64)

Unlike his predecessor, Burns maneuvered strictly within the

existing confines of the institution, never testing its limits,
expanding its scope, or exploring new ways to solve new or old
problems.
Problematic leadership, however, did not seem to be the only
major challenge facing the central bank at the time. An internal
examination of the Fed highlights reveals a third major contribu-
tor to the Fed’s underwhelming decade: the litany of new respon-
sibilities the central bank took on. Their obligations, it seems, were
endless:

Massive data gathering, numbers crunching, and monitoring as the Fed

did its part . . . to contain inflation by freezes, controls, voluntary restraints,
and similar programs in 1971–74; adapting Board procedures and rules to
the invasive Freedom of Information and Government in Sunshine legis-
lation of 1974 and 1976; overhauling all the Board’s regulations to make
them more readable, to update them, to cut out deadwood, and to ease
regulatory burdens; adapting to an increasingly demanding series of new
reporting and recordkeeping requirements by the Congress; developing a
national network of computerized regional centers for over-night check
clearance; developing, together with other federal banking supervisors,
uniform examination procedures; and initiating a long-term squeeze on
banks and bank holding companies to improve capital ratios. (Stockwell
1989, 29)
42 HOW THE FED MOVES MARKETS

Further examination of this era reveals the enormous workload

of the Board staff in the 1970s:

The Board held an average of 139 meetings yearly during the decade. The
Governors were required to prepare for discussion of each agenda item,
involving a heavy reading and study load. The Secretary’s office had to
prepare the Boardroom for meetings, prepare the agenda, and keep the
official record [ . . . ] The Legal Division produced ninety-three proposed
and final regulations, interpretations, and policy statements in 1970; 102
in 1977, and 159 in 1978: an average of 126 a year in the 1970s. The Board’s
legal submissions to the Federal Register took up 346 pages in 1970 and 899
pages in 1979. The division counts twenty-five major pieces of legislation
passed in the 1970s affecting the Fed. [ . . . ] Production of news releases
covering proposed and final regulations, policy statements, and like sub-
stantive subjects rose from fifty-one in 1970, to seventy-one in 1975 and to
ninety-two in 1979 . . . The Chairman and other Board members testified
before the Congress seven times during 1970, an average of fifteen times a
year in the first half of the decade and an average of forty-two times a year
in the last five years, including sixty appearances in 1979. The Board estab-
lished a Freedom of Information Office in 1974 under the amended FOI
Act. The FOI office answered 3,969 queries under the act that year, 5,112 in
1979, and an average of 4,455 from 1974 to 1979, rejecting only 2.4 percent
of requests received (under FOI Act exemptions). (Stockwell 1989, 30)

This account concludes with a telling statement: “While the

Board’s work grew manifold, its staff grew during the 1970s less
than two-thirds, from 902 to 1,451” (Stockwell 1989, 30). These
figures mark enormous bureaucratic growth, but considering the
Congressional pressure limiting the expansion of the Fed’s per-
sonnel, it actually highlights the tremendous growth of the Fed’s
responsibilities during this era.
While the scope of the duties was certainly daunting, it is also
important to note the nature of what was required, specifically, the
new transparency mandates that now filled the Fed’s workload.
Because of the central bank’s inability to enact internal reform in
the face of an inflationary crisis, the Fed had effectively surren-
dered its first mover advantage—its ability to reform itself before
an outside authority could—to Congress. Impatient with tepid
progress, Congress pressured the struggling central bank to move
toward greater disclosure and greater transparency, and the Fed’s
efforts toward those ends increased dramatically. As the passage
attests, the Fed testified to Congress in the second half of the decade
 TRANSPARENCY 43

almost three times as often as it did during the first half, and in
1979, it churned out nearly twice as many news releases about its
activities as it did in 1970.
After these less formal attempts to compel the Fed toward more
transparency, Congress ultimately passed the Federal Reserve
Reform Act of 1977. The Act gave the legislature more control and
oversight in the Fed. Whereas previously the President could freely
appoint the chair and vice chair of the Board, Congress now man-
dated Senate approval for those positions and demanded quarterly
reports as well. Perhaps most important from a policy perspec-
tive, the Fed Reform Act established the explicit goal of promoting
maximum employment and price stability, making the dual man-
date a statutory obligation from that point forward. Dictating that
the Fed maximize growth, minimize inflation, and promote price
stability, the 1978 Humphrey-Hawkins Act strengthened the dual
mandate’s influence on Fed policy (Flaherty 2010). While not revo-
lutionary from a policy perspective, these pieces of legislation do
demonstrate an essential historical lesson: if the central bank fails
to reform itself, its autonomy will soon come under fire. In other
words, the Fed’s independence has been maintained by its ability
to evolve.

* * *

These reforms wouldn’t have the immediate impact Congress

intended, as Burns’s successor was an even less capable leader:
William Miller. Formerly a successful CEO, Miller held the post for
only 17 months, he then became Treasury secretary, and his brief
tenure demonstrated to many that the skills required to effectively
run the central bank were far different from those best suited to pri-
vate enterprise. Unlike the top-down, vertical integration of major
corporations, the Fed’s structure bears far more resemblance to a
wheel: a central authority uniting many smaller arms all working
toward progress. Stephen Axilrod characterizes Miller’s struggles
with the chairmanship as follows:

The whole monetary process involved a bureaucratic apparatus that was

unfamiliar and in many ways trying. Depending on whether a decision
was to be made by the board or by the FOMC, either six or eleven other
44 HOW THE FED MOVES MARKETS

people beside the chairman had equal say in it. His colleagues’ under-
lying motivations often were not clearly expressed, if expressed at all.
Implementation of a decision relied on policy levers that—because of eco-
nomic uncertainties, market complexities, unpredictable attitudinal shifts,
and long lags—were not well or clearly linked to the institution’s ultimate
objectives. Even if long-term goals might be easily stated (it took no effort
to favor price stability and growth, for example), how to approach them,
what objectives should be emphasized in the nearer term, and how best to
reconcile possible conflicts among them were always up for negotiation.
(Axilrod 2011a, 77–78)

Under Miller’s weak leadership, the Fed continued to cede its first
mover advantage to Congress, who continued to pressure the Fed
for increased disclosure.

* * *

After the ambivalence of the Burns’s chairmanship and the inef-

fectual nature of Miller’s, the Fed faced a crisis of confidence. The
American public held diminished respect for the institution, and
its inability to effectively combat inflation had fueled an increas-
ingly severe political backlash, particularly from Congress. Then in
1979, President Carter appointed Paul Volcker, former Fed staffer,
Treasury official, and sitting president of the Federal Reserve Bank
of New York, to be Fed chairman. Volcker’s tenure was marked by
a technocratic shift that encouraged new methods in monetary
policy, which helped rein in inflation and restore the central bank’s
standing. As a seasoned veteran of both the Fed and the Treasury,
Volker had a vast amount of technical knowledge, a great sense of
the bureaucratic barriers within the institution, and, unlike Miller,
a deep understanding of the consensus-building nature of the chair-
man’s position. Despite lacking a legal justification, Volcker would
utilize innovative policy, bureaucratic maneuvering, and direct
public communication to reshape the Federal Reserve (Axilrod
2011b).

* * *

Volker’s capable leadership, however, wasn’t the only ingredi-

ent to his reign’s success. Despite new responsibilities, increased
 TRANSPARENCY 45

workload, and the lack of effective leadership under previous chair-

man, the Fed’s future bubbled underground before Volker even
arrived:

In the back rooms of the research division, experimental work with the
new science of econometric modeling was going on. This was mind-
stretching work for Frank de Leeuw and the rest of the staff involved, and
practical benefits did not come quickly. It was not until the decade of the
1970s that the output from econometric models became a really important
part of the analytical material that the Board and the Federal Open Market
Committee weighed in their deliberations. Such work involved more and
more number crunching and was heavily dependent upon the developing
computer capability within the staff. (Stockwell 1989, 22)

It is this continued work “in the back rooms” that allowed the Fed
to technocratically leap forward under Volcker’s leadership.

* * *

With an unconventional methodology in mind, Volcker set his

sight on his first target: inflation. Traditional monetary policy
uses interest rates to fight inflation by making money, specifically
credit, more expensive. While this mechanism is fairly predictable,
it is slow, typically taking six months to a year to impact the sys-
tem. Instead of focusing solely on interest rates, Volker targeted the
quantity of money by refusing to inject new capital into the mar-
ket. Volker’s strategy quelled inflation and, at the same time, forced
interest rates to rise so that the deflationary pressure persisted. The
success of this innovative approach was a testament to the capabili-
ties of the central bank and its firm dedication to fighting inflation
(Axilrod 2011a, 92–93).
Although not permanent, this technical shift in policy implemen-
tation had a profound impact on the institution. Just as Martin had
centralized power through the Board staff, Volcker relied on expert
staff to institute a new and untested policy. This policy depended
on a seamless transmission of information between the Board in
Washington, DC and the personnel at the New York Fed—the act-
ing arm of the strategy. It also relied on popular support, through
open communication between the Fed chairman and the public,
to avoid political pressure from the Fed’s principals. Perhaps most
46 HOW THE FED MOVES MARKETS

importantly, the success of this new method hinged on the techni-

cal capabilities of policymakers, pushing them to be fluent in all
the levers of monetary policy—not just the Fed Funds Rate.

* * *

As researchers and Fed veterans can attest, Volcker was a man

particularly suited to his position. Former Fed alumnus Stephen
Axilrod describes Volcker’s abilities:

He was the essential man for a combination of reasons. He combined great

sensitivity to shifting trends in political economy (he could see what the
country would now accept) with a willingness to take dramatic action.
Moreover, he was technically very competent in the nuts and bolts of mon-
etary policy, which made it easier for the FOMC and the chairman himself
to feel confident that the new approach, although not risk free, had a rea-
sonably good chance of working. (Axilrod 2011a, 89)

To uncover the internal Fed dynamics of the “Volcker Revolution,”

political scientist Cheryl Schonhardt-Bailey and economist Andrew
Bailey have reviewed FOMC meeting transcripts from the era.
Volcker, they discovered, seamlessly navigated the Fed bureaucracy
by utilizing different strategies crafted to each of the various insti-
tutional constituencies in order to garner support. When appealing
to Board members, Volker’s strategy was “repentance”: the Fed had
to publicly recognize its mistakes and seek to fix them. With the
regional bank presidents, Volcker emphasized the need to commit
to a particular strategy in order to maintain Fed credibility. And
with the staff, Volcker emphasized the need for technical revision—
previous models had undervalued the role of the supply of money,
and new, more comprehensive models were necessary. A master-
ful political mover and economic thinker, Volker used a technical
“money matters” approach, which became the preeminent method
by which the Fed engaged in market behavior between 1979 and
1982 (Bailey and Schonhardt-Bailey 2008).
As political scientist Jack Knott has observed, Volker relied on
his technical expertise, connections to the Fed staff, and the cen-
tralization of power established by Martin to insure a particular
type of data was supplied to policymakers—in essence, leveraging
his expertise and connections to the technocratic staff in order
 TRANSPARENCY 47

to operate as an informational gatekeeper to the FOMC. This use

of the staff and data allowed Volcker to build a political coalition
within the Fed and outside of it, through public statements that
increased the central bank’s credibility and put pressure on policy-
makers to agree with his policy positions (Knott 1986).
Even after the inflation crisis subsided, Volcker sought to increase
the role of the staff and the technical nature of monetary policy
by further involving the regional bank personnel. In 1983 Volcker
introduced the “Summary of Commentary on Current Economic
Conditions by Federal Reserve District”—the “Beige Book.” The
expert staff of each regional bank could now issue a report to
the FOMC two weeks prior to meetings, making verbal expres-
sion of opinions about regional economic conditions by regional
bank presidents obsolete (Federal Open Market Committee 2012).
Volcker, once again, had found a way to elevate the role of the tech-
nocratic staff and the importance of data above the more pluralist
expressions of opinion about economic conditions.
Despite his successes, Paul Volcker was not reappointed again
in 1987. By the mid-1980s Volcker began to clash with the supply
side ideology of the Reagan Administration, particularly Council
of Economic Advisers Chairman Martin Feldstein and subsequent
Chairman Beryl Sprinkel. As this ideology pervaded the Treasury
and trickle into the Fed through several Reagan Board appoin-
tees, conflict mounted over the Fed’s role in financial regulation.
Administration loyalists sought a deregulated financial market-
place, while Volcker saw a need for continued regulatory action.
In fact, Republican Congressman Henry Gonzalez made three
separate, failed attempts to impeach Volcker and the entire Federal
Reserve Board (Meltzer 2003). Nevertheless, these clashes elevated
internal Fed concerns about the growth of their budget and raised
fears that they might lose the prized autonomy that had been so
crucial to the growth of their technocratic staff.
Three years before his departure, in a prescient speech at the
Cosmos Club, Paul Volcker explained, “ . . . the fundamental justifi-
cation for the structure of the Federal Reserve System is to remove
that policy to a degree from the passions of passing politics—
politics in the narrow sense—and from electoral considerations”
(Volker 1984, 17). Ultimately, it was politics that prevented Volcker
from continuing the work toward an increasingly technocratic Fed.
48 HOW THE FED MOVES MARKETS

Despite their ideological differences, his successor, noted libertar-

ian economist Alan Greenspan, eagerly continued the trend in
technocratic policymaking (Axilrod 2011a).

* * *

Crowding its halls with technically trained economists, adding

a vast array of policy tools to its arsenal, and taking on an unprece-
dented level of regulatory responsibility, the Federal Reserve System
was undoubtedly modern, but it was also incredibly complex. These
technical developments were only the newest layer of difficulty
in an institution already replete with bureaucratic complexities.
Involving a convoluted mix of votes from regional bank presidents
and Board members, the Fed’s policy processes are fraught with
procedural intricacies—intricacies that remain unclear to most
outsiders. But, as confusing as its processes are, the most complex
part of Fed policymaking is the data. Collected from a wide variety
of sources and analyzed by both the Board and regional bank staffs,
the data is almost impenetrable, rendering any technical justifica-
tion for a policy decision, to most casual observers, wholly unintel-
ligible. The Fed had become banking’s black box, and its mysterious
mechanics made outsiders, especially those in Congress, nervous.
The Fed had faced Congressional oversight in the 1970s when
its power and efficacy reached opposite ends of the spectrum—
oversight manifested in reform and greater demands for trans-
parency. As the years had passed, and the Fed’s power, indepen-
dence, and opacity only increased, so did the need for the central
bank to create some method of maintaining this progress while
appeasing skeptics ready to curtail their growing prowess. What
the Fed needed was a bargaining chip. What the Fed needed was
transparency—on their terms.
 PART II

Fed Watching: Sentiment

Analysis and Data-Driven
Investing
 5

The Briefcase Watch: Fed

Watching at Its Finest?

I n the beginning, the Fed was relatively small, and its limited
power was dispersed among a network of regional banks bound
by regional interests. With different banks setting different rates,
savvy investors played the arbitrage game, and the system started
to suffer. The banks needed a united front, and they rallied behind
the New York Reserve. But a unified system means unified mis-
takes. New York failed to interpret the market correctly, and their
mistake was compounded across the entire system. The stock
market crashed, banks failed, and the country fell into a Great
Depression. With an economy collapsing around it, the Fed held
steady, letting banks go under and sticking to gold. The strategy
paid off in the long run, but the Fed paid for it in the meantime.
The New Deal meant a new set of masters for the central bank,
and the Federal Reserve System was locked in a battle for indepen-
dence that would last two decades. The Fed achieved independence
in the early 1950s, and the chairmanship of Martin brought a focus
and purpose to the dispersed system of Federal Reserve banks. The
Fed evolved, consolidating power in the Board and voices into data.
But after 20 years, Martin left—taking progress with him. Under
Burns and Miller the Fed lost its way—prompting an all-too-eager
Congress to step in, impose reforms and demand transparency.
It did not take long, however, for the Fed to find its footing.
When Volcker took the helm, he continued the mechanistic march
Martin had started. The Beige Book joined the blue and green
tomes, data-driven methodologies became standard practice, and
52 HOW THE FED MOVES MARKETS

an increasingly educated staff manned the monetary levers. The

central bank grew ever more independent, centralized, and tech-
nocratic. It grew more powerful, too.

* * *

When Alan Greenspan took the wheel, the central banking sys-
tem that started in the mind of one politician was not fully grasped
by many others. Banking, even at a basic level, is not the most pop-
ular topic: introduce finance into a casual conversation and eyes
glaze over. But the Federal Reserve was far from basic level bank-
ing. The budding system had become a full-fledged technocratic
leviathan, and Greenspan did not break that trend. Technocratic
growth and decision making bloomed under his watch, and it
became clear that just as Arthur Burns experienced a backlash in
the 1970s over centralization and faulty policy, Greenspan could
face a similar reaction in the 1990s, but for different reasons: the
increasing technocracy of the central bank. The Federal Reserve
was just too big, too powerful, and too confusing to remain as it
was—and so a backlash loomed. It was in this era, after years of
enigmatic existence, that the Fed finally begins to let in a little light.
This chapter covers the beginnings of the era of the transparent
Fed and the interpretive analyses that have arisen out of this policy
transparency.
Long before Greenspan began implementing transparency mea-
sures, Volcker, the prescient intellect he was, discussed the delicate
balance the Fed would have to maintain to when implementing dis-
closure in Reserve operations:

Sunshine may at times be a healthy and essential antidote to festering

sores. But, carried to excess, I have seen it wilt some tender plants that
need quiet cultivation. Sometimes, when legitimate efforts to reach rec-
onciliation will be interpreted as public defeat or “selling out,” it seems
to have the practical effect of simply hardening antagonistic positions.
(Volker 1984, 10)

Transparency is a double-edged sword, to be wielded with care.

Disclose too little, and one can invite criticism, outside control and
“festering sores”; disclose too much, and one can prevent a complex
process from working as it should. But, tricky as it was, transparency
 THE BRIEFCASE WATCH 53

would become an integral part of central banking policy—not only

in the American system, but around the world.

* * *

Mired in confusion and speculation about the Fed’s role in the

economy, Greenspan-era skeptics began a public campaign to shed
sunlight on the Fed. The “briefcase watch” was an early, unin-
tentional—and rather whimsical—part of this campaign. On the
morning of a Federal Open Market Committee (FOMC) meeting,
reporters would hound Greenspan, desperate to get a glimpse of
his briefcase. The briefcase’s dimensions, it was speculated, could
hold the key to the Fed’s next moves: a thin briefcase was thought
to mean Greenspan had not been reviewing the data, and the fed
funds rate—the interest rate on overnight loans between banks—
would stay put; a thick briefcase meant that a diligent Greenspan
had been at work reviewing data and intended to change rates.
Silly as it was, the “briefcase watch” was a telling development.
The Fed had become so important to the financial world that even
speculative information on its plans was newsworthy. While illus-
trating the ascendancy of the Fed, the “briefcase watch” also dem-
onstrated how little information was available on central banking
operations: if the width of a briefcase merited airtime and print
media coverage, then clearly investors and analysts were starved
for information. For the level of influence the Fed wielded over the
economic machine, the level of secrecy it was allowed to maintain
over its processes seems quite remarkable. As the public scrutiny
over the mysterious institution mounted, Greenspan, unlike Burns,
opted to move before Congress elected to act. He provided a small
amount of transparency.
Beginning in 1994, the Fed released statements regarding
changes to the overnight Fed Funds Rate. By 1998, these press
releases were issued at the conclusion of each FOMC meeting,
even if rates remained unchanged (Crosse and Paschal 2012).
While novel in the United States, such policy was not the Fed’s
innovation. These transparency measures were part of a global
movement the Fed was joining as central banks around the world
pursued new communication methods. This widespread adop-
tion of central bank transparency was based partly on an idea
54 HOW THE FED MOVES MARKETS

derived from rational expectations philosophy about the utility of

open communication: transparency could potentially help man-
age market expectations about economic performance—thereby
working to minimize economic shocks (The Federal Reserve
Bank of Minneapolis 2015).
It is important to note that transparency is not equivalent to rep-
resentation, but as the Fed released more information concerning
its plans, public perception of the institution—particularly the Fed
chairman—changed. Popular opinion and market actors adapted
to the new resource, and the news media latched onto the storyline
that Fed communications impact markets.

* * *

Despite, or possibly because of, these transparency measures,

Fed watching after the briefcase watch only became more intense.
As the Fed released more information and officials spoke more reg-
ularly, reporters, forecasters, and financial analysts increased their
efforts to scour Fed communications in an attempt to glean some
indication about the central bank’s future policy steps. The persis-
tent belief among these Fed watchers was that the information con-
veyed by Fed officials provided a credible signal about future policy.
This belief remained despite the fact that Fed officials were known
to have developed their own linguistic style to hide information—a
language that came to be known as “Fedspeak.”
In “How Do Central Banks Talk?,” Princeton Economist Alan
Blinder and his coauthors explain the history of the Fed’s language
of concealment:

The Fed has been traditionally portrayed as tight-lipped, secretive, and cryp-
tic. Arthur Burns and Paul Volker, its chairman for most of the 1970s and
1980s, were famous for blowing smoke—both literally and figuratively—
when they appeared before Congress, and on other occasions as well.
Each of them spoke a turgid dialect of English that came to be known as
“Fedspeak,” a term which seems to connote the use of numerous and com-
plicated words to convey little if any meaning. As chairman since 1987,
Alan Greenspan is credited with raising Fedspeak to a high art. He used to
take pride in the resulting obfuscation—even characterizing his own way
of communications as “mumbling with great incoherence.” In a famous
incident, he once told a US senator, who claimed to have understood what
 THE BRIEFCASE WATCH 55

the famous obscurantist chairman had just said, that “in that case, I must
have misspoken.” (Blinder et al. 2001, 66)

Straddling the delicate line created by transparency, Greenspan

used Fedspeak to calm market reactions to Fed policy (Leonard
and Coy 2012). While Fedspeak was originally a tool of obfusca-
tion, Greenspan gradually changed his intent from confusion to, at
least, some level of clarity (Blinder et al. 2001). And “the markets,”
Blinder and his coauthors remark, “seem to be getting the message”
(Blinder et al. 2001).
Greenspan’s successors have continued this trend. In 2011,
indicating another step toward open communication, the Ben
Bernanke-led Fed began giving press conferences—giving inves-
tors and analysts access to unprecedented amounts of information.
In recent speeches, current chairman Janet Yellen has even gone so
far as to say “communications are policy” in reference to forward
guidance (Yellen 2013). With forward guidance, the Federal Reserve
website explains, “The Federal Open Market Committee provides
an indication to households, businesses, and investors about the
stance of monetary policy expected to prevail in the future” (Board
of Governors of the Federal Reserve System 2015a). Fed personnel
have spoken out as well, strengthening the ties between word and
deed. In 2012, for instance, Fed Board Governor Jeremy Stein spoke
about the value of open communication—specifically as it directly
relates to future monetary policy moves:

I believe that the LSAP component of the statement helped bolster the
credibility of the forward guidance component by pairing a declaration
about future intentions with an immediate and concrete set of actions.
And I suspect that this complementarity helps explain the strong positive
reaction of the stock market to the release of the statement. In addition to
this signaling channel. (Stein 2012)

As the Fed increases its use of open communication, the line

between communication and action continues to blur, until, as
Yellen stated, communications have become policy.
On a global scale, it is becoming increasingly clear that words
are action. The Swiss National Bank, for instance, caused panic in
the markets within minutes of announcing the elimination of their
56 HOW THE FED MOVES MARKETS

exchange rate peg. The Swiss franc moved 20 percent in a single

day before the central bank implemented any substantive change
in monetary policy. While it had not implemented policy in the
traditional sense, it had employed another market-moving tool:
transparent communication.

* * *

Domestically and globally, words and policy have become inter-

mingled, and the trend, it seems, will only continue toward more
clear, open communication—meaning, of course, words will have
greater power in the economy:

The bad old days of central bank mystique are over. All central banks
evolve, however grudgingly, towards more transparency and greater com-
munication. The process, which reflects trends in other aspects of public
life wholly apart from central banking, is far from over. Some central banks
may still believe that they can retain secrecy in particular areas (e.g. their
forecasts, the substance of their internal deliberations, the models they
use) indefinitely. But we are skeptical. Other central banks are acting as
pioneers and showing, along the way, not only that transparency does not
hurt, but that it increases the efficiency of monetary policy and enhances
credibility, independence and public support. (Blinder et al. 2001, 92)

Transparency is central bank policy, and, consequently, under-

standing central bank language is a prerequisite for understanding
central banking—and the economy as a whole.
With information pouring in from multiple streams, the task of
objectively interpreting has become daunting. Financial analysts
carefully examine central bank communications, but unfortu-
nately, their current approach fails to consider many vital aspects
of the available data and statements. Stateside, the interpretation
of central bank communication has become much like the literary
practice of close reading. In literary studies, it is common prac-
tice to draw sweeping interpretations from the granular details of
a poem or short story. For example, if an author used “devoured”
instead of “consumed” to describe the actions of character, a liter-
ary critic could use this subtle detail, along with a handful of oth-
ers, to support an animalistic reading of an entire piece. In the same
way—rather than employing expansive interpretation that takes
 THE BRIEFCASE WATCH 57

into account the whole breadth of what is now available—modern

Fed watching has become fixated on deriving significant meaning
from single words or phrases. A March 2015 article in the New York
Times provides a perfect example of this laser focus on individual
terms, rather than the entire text, spending thousands of words and
calling on an entourage of experts to elaborate on the Fed’s use of
the word “patient” in their communications (Stewart 2015).
With Fed press releases, this practice makes some sense. The
language used is remarkably consistent, and the slightest change
in verbiage could have dramatic implications on the Fed’s current
views and plans. Updates to press releases are particularly con-
spicuous because the texts are altered through track changes—a
method that lends itself to detail-centric interpretation. Despite
this consistency, the methodology falls prey to human error. While
small deviations could have significance, subjective analysis leaves
the door open for overreaction. It is incredibly difficult for indi-
vidual analysts judging minute changes in a specific press release
to objectively consider historical patterns and make a smart, evi-
dence-based prediction of what the Fed will do. The presence of
any overreactions in their interpretation, of course, has the poten-
tial to powerfully alter the intended meaning of the text. But this
is the best-case scenario for current techniques. This method has
carried over to minutes, speeches, and other crucial central bank
communications, and even other central banks that do not use
track changes at all, which means Fed watchers are skipping over
vital, market-moving information. Although analysts have far more
information than they did when some of their best leads lay in the
width of a briefcase, their techniques have not progressed as much
the central bank communications have.

* * *

The history of the Federal Reserve is a story of evolution, and

transparency is just the latest development. Since the financial cri-
sis, central bankers—struggling to head off criticism—have adopted
increasingly transparent policy; the result has been central bank-
ers constantly declaring the importance of communications to the
public—a trend that is particularly obvious in the Federal Reserve.
58 HOW THE FED MOVES MARKETS

With Ben Bernanke instituting press conferences and Janet Yellen

directly telling audiences that communications are policy (Yellen
2013), it is clear that a new era of central banking has arrived, an era
where transparent communications are just as important as direct
quantitative policy action.
Unfortunately, analysis of central banking has not kept pace
with the evolution of the institution it seeks to illuminate. Putting
a crack in its legacy of opacity, the Federal Reserve now presents
the financial world with a wealth of information; Congressional
testimony, press conferences, meeting minutes, press releases are
all easily accessible—but are evaluated using techniques that focus
on details at the expense of the larger available context. In other
words, current practices cannot see the forest for the trees—despite
the fact that the mass adoption of transparency among the central
banking community has made, for the first time, seeing the for-
est feasible. In a financial world that is increasingly impacted by
central bank policy, accurate interpretation of communications has
become more vital—and more valuable—than ever before.
 6

Data-Driven Fed Watching:

Comprehensive, Unbiased,
and Quantitative

T he days of an unknowable Fed are over. Advisors, financiers,

and financial professionals of all levels no longer need to
speculate about the width of a briefcase or spend valuable hours
teasing apart elusive—or perhaps nonexistent—kernels of policy
embedded in Fedspeak. The Fed has embraced transparency, and
the financial world is better for it. But, the abundance of central
banking data now available to financial professionals does not
do much good unless accompanied by effective analysis. Current
Fed watching certainly supplies abundant analysis—and has even
created a rigorous approach to press release interpretation—but
the overall effectiveness of this methodology is questionable in a
world where central banks use multiple important lines of com-
munication. Even at their best, modern methods provide projec-
tions based on qualitative opinions—not quantitative data—when
identifying the Fed’s current policy position. Current Fed watch-
ing techniques simply do not provide the strongest analysis of the
Fed’s outlook and future policy for financial professionals. If an
accurate assessment of central bank communication is important
to understanding the market—and it undoubtedly is—analysts
ought to stop treating central bank communications like poetry
when attempting to zero in on policy: “close reading” may be great
for unlocking Shakespeare’s sonnets, but it’s not the best method
of understanding essential, market-moving data. This chapter
tackles the serious question facing investors, portfolio managers,
60 HOW THE FED MOVES MARKETS

and anyone else for whom the Fed’s policy is vital information: In
the modern era of the Fed transparency, what is the best means of
interpreting central bank communications?

* * *

To fully realize the potential of the data available, financial pro-

fessionals need analytics—but not all analytics are created equal.
In the current climate of big data and analytic super tools, it can
be difficult to separate the wheat from the chaff. As Harvard pro-
fessor and director of the Institute for Quantitative Social Science
Gary King can attest, even experts can overlook the biggest meth-
odological errors. When these experts, according to Professor
King, wanted to put big data to work to help forecast unemploy-
ment, they chose to tap social media. By keeping track of words like
“jobs” and “classifieds” in the Twittersphere and beyond, the group
hoped to discover a relationship between the monthly unemploy-
ment rate and the tagged terms. As research progressed, there was
a huge jump in the one of the key terms—“jobs”—potentially sig-
nalling a dramatic uptick in unemployment. At least, that was the
hypothesis. Instead of serving as a tool of prediction, the method,
as it turns out, had only echoed front-page news—entirely unre-
lated news at that. “What they hadn’t noticed,” Gary King explains,
“was Steve Jobs died” (Armerding 2013). The innovator’s unfortu-
nate departure was responsible for the jump in the key term, not
any coming wave of unemployment. The lesson is clear: a wealth
of data coupled with cutting-edge methods don’t necessarily equal
success. It is easy to get swept up in the latest technological trends
without applying appropriate, detailed scrutiny—and many have
fallen prey to the promise of analytics without taking a closer look
under the hood.

* * *

What is needed is a new method of Fed watching: an interpre-

tive technique that draws upon expert judgment while minimizing
the human errors that mark current practices, one that leverages
the advantages of analytics without falling prey to unsound meth-
odology. Seeing this need, we developed a better means of textual
 DATA-DRIVEN FED WATCHING 61

analysis. Drawing on literature across the social sciences, statistics,

data science, and computing, we have developed a process—under
the company Prattle—engineered to navigate these challenges and
produce comprehensive, unbiased, and quantitative analysis of
vital, market-moving central bank texts.
The process begins with a foundation of reference texts. These
texts are central bank communications that have led to discrete,
identifiable market reactions, and the type and intensity of these
market reactions allow the texts to be scored by those with ade-
quate expertise. For central banks, this score is an indication of the
“hawkishness” or “dovishness” of a central bank’s position on the
economy. A hawkish central bank views the economy as strong and
growing and, because of this perception, will soon implement con-
tractionary monetary policy—raising interest rates to insure credit
is less available—in an attempt to keep the market from overheat-
ing. A dovish central bank believes the economy is struggling and
takes the corresponding strategy: lowering interest rates to encour-
age growth through a climate of easier access to credit. Directly
connected to varying degrees of market reaction, these reference
documents are firmly rooted in history—making them an excellent
foundation for comparison.
Using these reference texts, we have been able to reliably corre-
late specific words, phrases, sentences, paragraphs, and whole com-
munications to market reactions. This is possible, in part, because
the Fed has an established lexicon. The deliberate nature of their
communication habits means that the communications themselves
can be evaluated based on the reactions they have historically elic-
ited since transparency has become a significant component of Fed
policy. In this case, the institutional transition toward transpar-
ency during the mid-to-late 1990s means that Fed communications
beginning in 1998 meet the necessary conditions for our purposes.
Using our domain expertise, we have ordinally ranked not just
words, but also phrases, sentences, paragraphs, and entire commu-
nications as positive or negative based on nature of the reaction
incited. Terminology linked to hawkish policy and corresponding
market reaction is awarded positive numbers based on the level of
the response. Conversely, dovish terms are awarded negative num-
bers. This lexicon of hawkish and dovish terminology is the back-
bone of the process.
62 HOW THE FED MOVES MARKETS

Provided with this context, it now becomes possible to accu-

rately evaluate current central bank communications. Aggregating
text from all the streams of Fed communication within the desired
timeframe, our process then generates a score for the sample
in light of the pool of hawkish and dovish communications. The
score generated is the average rating of all the hawkish and dovish
expressions embedded within the selected documents. This method
allows Prattle to generate the Fed’s “mood”—their current position
on the economy, and their inflation expectations specifically, rela-
tive to an established history of communications and market reac-
tions. The outcome of this entire process is the Fed Index, the only
comprehensive, unbiased, and quantitative data analysis method in
existence on the central bank’s economic outlook.

* * *

It is important to note that our analytical process differs signifi-

cantly from the methods employed by standard automated inter-
pretation processes known as sentiment analysis. Like our method,
sentiment analysis produces a quantitative assessment, but it does
so in a distinctly different manner. Generalized sentiment analysis
commonly works by first predefining a list of positive and negative
buzzwords, then subtracting the sum value of the negative buzz-
words that appear in a given text from the positive buzzwords. In
more sophisticated iterations of sentiment analysis, whole phrases
are included in a dictionary of buzz terms and are used in the scor-
ing of texts. But the application of either of these versions of sen-
timent analysis to Fed communications would be inappropriate
because of the method by which the list of buzz terms is created.
The production of the set of term values is not only subject to selec-
tion bias, but it is often carried out by those lacking the subject-
matter expertise to properly identify and rank the terms. Given the
esoteric and constantly evolving nature of Fed communications, it
is clear that any program built to interpret these texts would need
a high level of fluency and objectivity to create scientifically valid
assessments.
Instead of selecting and predefining the lexicon that we use as
a basis of evaluation, we generate values through an algorithmic
assessment of the central bank terminology’s actual connection to
 DATA-DRIVEN FED WATCHING 63

market reaction. Using our domain expertise, whole documents are

paired with the market reactions they elicited. After this an auto-
mated analytical process evaluates these documents’ relationships
to the separate market reactions they individually elicit. Then, the
scores of each word, phrase, sentence, and paragraph of these com-
munications that have bearing on the market are produced accord-
ing to their actual relationship to financial fluctuations. As more
documents are analyzed, the texts are more accurately oriented to
one another and, consequently, the relative values of each expres-
sion become increasingly accurate. By utilizing our subject-matter
expertise to make broad connections between the documents and
the market, and using an automated process to identify the natu-
ral connections that emerge between specific expressions and the
market, our methodology leverages the deep domain expertise
provided by economists and the speed and objectivity afforded by
automation.

* * *

While holding an edge over generalized sentiment analysis,

this process also has several distinct advantages over current Fed
watching methods.
Instead of viewing a text, or only specific words within a text,
apart from other relevant streams, our score is derived from the
totality of the Fed’s public discourse. By relying on the entire scope
of what is available, our inherently comprehensive methodology is
entirely free from selection bias—a methodological drawback of
not only the buzzword-based approach to sentiment analysis dis-
cussed above, but orthodox Fed watching as well. When selecting
texts or key terms, analysts, whether they are aware of it or not, are
inevitably influenced by past experiences or underlying—possibly
underhanded—ulterior motives. These influences translate into
undue analytical attention toward specific texts and words, skew-
ing the accuracy of the interpretation. By remaining indiscrimi-
nate and inclusive, our process systematically hedges against this
bias. The inclusivity of the process also allows it to make a far more
credible claim to being an accurate (and precise) estimation of
the Fed’s current position. Individual communications are inher-
ently incomplete, meaning that any analysis derived from just one
64 HOW THE FED MOVES MARKETS

source, even a few sources, clearly has less claim on reflecting the
position of the institution than an analysis based on the sum of all
available sources.
This diagnosis is not meant to fault modern analysts for their
selectivity. Given the sheer volume of communication output across
all the Fed’s channels, it would be infeasible for individual analysts
to simultaneously keep in mind all current Fed communications
when giving their assessment. Humans can only handle so much
bandwidth, as it were, and this cognitive limitation makes selectiv-
ity the best means of securing higher-quality analysis. Our process,
however, has no such limitation.
The strength of our methodology compared to traditional Fed
watching practices is further bolstered by its objective scoring pro-
cess. It is incredibly challenging for Fed watchers to evaluate cen-
tral bank communications with respect to an accurate, historical
representation of what specific words mean. Just like with docu-
ment selection, any number of irrelevant influences and human
errors can come into play during textual interpretation. An analyst
could have a momentary mental lapse, could have just had an argu-
ment with a spouse, or could have an upset stomach. An analyst
could have ulterior motives for desiring a certain Fed text to be
understood by the market in a particular way, or could be swayed
by unknown political purposes. In any case, human interpretation
is constantly subject to a variety of impulses, moods, and errors;
and in the financial world, such biases can easily translate into seri-
ously flawed business decisions. Our system removes these possi-
bilities from the interpretive process. By grounding every score in
historical, causally connected market reactions, our process makes
sure the only source for each interpretation is the breadth of avail-
able evidence.

* * *

The Fed Index is not the only source of quantitative analysis of

the Fed. By predicting the date that the Fed will raise rates, tradi-
tional Fed watching also produces its own quantitative data from the
central bank’s communications. However, our methodology is the
only source of a quantified assessment of the central bank’s current
position. Contemporary Fed watchers write qualitative appraisals of
 DATA-DRIVEN FED WATCHING 65

the Fed’s disposition and then follow that assessment with an asso-
ciated projection. Qualitative assessments are, however, inherently
difficult to pinpoint. Phrases like “very hawkish” or “fairly dovish,”
for example, can give a reader a general feel for the Fed’s attitude,
but that reader can only evaluate those descriptions in light of their
own understanding of “hawkish” and “dovish”—as well as “very”
and “fairly.” This interpretive dilemma means a plurality of Fed
moods can be derived from the same words by different readers.
When it comes to generating investment strategies in light of such
qualitative assessments, the incorporation of these interpretations
is more art than science—leaving substantial room for error. By
assigning the Fed’s current mood a specific numerical value rela-
tive to previous communication, our process gives a discrete value
to textual data, removing the ambiguity qualitative assessments
allow for. How hawkish is “very hawkish”? Who knows? But 1.5
hawkish on a scale of negative 2 to 2 offers a more precise picture
of the Fed’s outlook.

* * *

While the comprehensive, unbiased, and quantitative data our

method produces represents the frontier of Fed watching, there are
two additional advantages that merit discussion.
The scoring process itself is very rapid, assessing a text in as little
as seven to ten seconds. By comparison, an analyst using traditional
methods could conceivably read and write a response to a commu-
nication in 15 or more minutes, which, in the world of quantitative
finance, is a lifetime. Speed, as MIT Professor Kevin Slavin notes,
is everything in business:

The algorithms of Wall Street are dependent on one quality above all else,
which is speed. And they operate on milliseconds and microseconds. And
just to give you a sense of what microseconds are, it takes you 500,000
microseconds just to click a mouse. But if you’re a Wall Street algorithm
and you’re 5 microseconds behind, you’re a loser. So if you were an algo-
rithm, you’d look for an architect like the one that I met in Frankfurt who
was hollowing out a skyscraper—throwing out all the furniture, all the
infrastructure for human use and just running steel on the floors to get
ready for the stacks of servers to go in—all so that an algorithm could get
close to the Internet. (Slavin 2015)
66 HOW THE FED MOVES MARKETS

If gutting a skyscraper sounds like an extreme measure to gain

a handful of microseconds on the competition, Slavin follows this
example with an even more dramatic case, further emphasizing the
primacy of speed in trade:

And you think of the Internet as this kind of distributed system—and of

course it is—but it’s distributed from places, right? In New York, this is
where it’s distributed from—the Carrier Hotel, located on Hudson Street.
And this is really where the wires come right up into the city. And the real-
ity is that the further away you are from that, you’re a few microseconds
behind. But if you zoom out, you would see an 825-mile trench between
New York City and Chicago. It’s been built over the last few years by a
company called Spread Networks. This is a fiber-optic cable that was laid
between those two cities to just be able to traffic one signal 37 times faster
than you can click a mouse—just for these algorithms. And when you
think about this, that we’re running through the United States with dyna-
mite and rock saws so that an algorithm can close the deal 3 microseconds
faster. (Slavin 2015)

As enormous as the gap between 15 minutes and 10 seconds is, that

is the best-case scenario for traditional methods: most analyses are
published hours or even days after the communication is released.
Additionally, unlike human analysis, which tends to decline in
quality as the amount of available time decreases, the scores pro-
duced by our methodology are always the product of the spectrum
of available evidence. This means that our methodology provides
not only speed, but smart speed as well.
The second advantage is the ease with which Fed Index data
can be integrated into existing financial models. As mentioned
earlier, qualitative assessments are necessarily resistant to specific-
ity. Unfortunately for finance professionals, this lack of specificity
translates into a lack of usability when it comes to financial model-
ing. “Very hawkish” just isn’t a very useful input. A concrete num-
ber, however, is far easier to handle: quantitative data is a natural fit
for existing multifactor investment models. This ease of integration
means money saved. And, as opposed to qualitative assessments,
our data allows financial professionals to accurately estimate how
much of a dollar difference our information will actually make.
Another salient point concerning investment model integration
is the unique nature of our data. Our data demonstrates a very low
 DATA-DRIVEN FED WATCHING 67

correlation to other data streams used as inputs for multifactor

investment models, which indicates that our methodology captures
novel economic cues not accounted for by other analytics. Not only
is this a guarantee of low redundancy when our data is included in
such models, but it would also strongly suggest that the resulting
projections would have improved accuracy.
With unique, evidence-based evaluations generated at a blister-
ing pace and integrated directly into their financial models, users
can make the most informed decisions possible on the Fed’s mar-
ket-moving policies, and they can do so more quickly and effec-
tively than those reliant on traditional methods. This allows users
to avoid the losses that can result from delayed analysis. In other
words, instant data means that users know the precise position of
the Fed at that very moment—allowing for the best moves—while
standard practice would necessitate post hoc hedging: corrective
financial moves made in light of new information. By eliminating
the need for post hoc hedging, our data enables financial profes-
sionals to actually trust their models—even when central bankers
are making market-moving policy statements.

* * *

As the Fed has ramped up its transparency efforts, pushing out

more data through more channels than ever before, it has become
increasingly difficult to offer accurate, comprehensive assessments of
its economic position through traditional, qualitative methods. The
central bank’s current communicative practices present traditional
Fed watchers with an unprecedented task, requiring unprecedented
analytical tools. All its aspects considered, our process offers a suite
of features that push Fed watching into the digital age. Rooted in
history, unfettered by bias and offering clear, measurable appraisals
based on comprehensive examination of historical and current Fed
documents, the Fed Index keeps stride with the ascendant central
bank that has emerged since the financial crisis: a central bank that
does far more than set the discount rate. The modern Fed influences
all facets of the economy, and those with any interest in succeeding
as an investor cannot afford anything less than the best data on the
biggest market mover of them all, the Federal Reserve.
 7

Fixed-Income Investing: Fed

Sentiment Drives Bonds

T he Fed and fixed-income investments have a long history:

buying and selling bonds and bills to maintain the price of
money is a traditional domain of the Fed. Through wars and
financial crises, the central bank and this market have forged
a deep connection, and, with this history, it’s no wonder that
when the Fed speaks its words ripple across the fixed-income
markets.
The undisputed market heavyweight, the central bank’s role
in fixed income is essential for market players to understand,
and its actions, now conflated with its words, are the fundamen-
tal driver of trade. This chapter begins by reviewing the funda-
mentals of the market—bonds, bills, and general fixed-income
trade—and then shifts to a discussion of our work interpret-
ing Fed communications and its relevance to the study of this
nuanced market, particularly Treasury bonds. This relevance
is investigated through a pair of compelling analyses. First,
we examine a backtest performed with a fixed-income portfo-
lio that was managed using our Fed sentiment data—and only
that data—as the trade signal. Then a more comprehensive
perspective is offered, analyzing how our signal, which is an
interpretation of Fed communications, can be compared to the
Fed’s action, using the federal funds rate (FFR) as an economic
barometer. The notable performance of this portfolio and the
strong relationship between our data and the bond market are
70 HOW THE FED MOVES MARKETS

two more testaments to the power the central bank’s language

wields over fixed-income markets.

* * *

Fixed income is a term used for a security that gives the investor
a regular income on fixed terms. Generally, there are a few types
of fixed-income securities: government bonds, municipal (local
government) bonds, and corporate bonds. In essence, they all take
the form of a loan. Essentially, an investor, in the form of a bond
purchase, allows the seller to borrow money, and the seller agrees
to pay the investor back at some later date, either in lump sum or
a series of payments. This series of (interest) payments is known
as coupon payments. Shorter-term bonds, frequently referred to
as bills, rarely have coupon payments, while longer-term bonds
almost always do.
There are two separate markets for debt in these forms. The first
is the primary market, where purchasers can buy debt directly from
the original seller. An investor can, in fact, directly buy government
bonds from the US Treasury—as well as most other debt issuers. A
significant portion of the fixed-income market is directly invested
as debt holders for a variety of actors.
Next is the secondary bond market. In this space, bonds pur-
chased on the primary market are resold. Investors, desiring a
return on their investment sooner than the bond’s maturity, seek
fair market value for the asset they currently hold. Naturally, since
the face value of the bond is guaranteed, investors can, with mini-
mal risk (Greece is a recent exception), see returns in the secondary
market. And also, since this guarantee is in place, bonds are easily
sold and resold many times (Greece is an example of an exception
to this rule here as well). This ease of convertibility to and from
cash makes bonds a liquid asset.
While fixed income is now one of the lowest growth areas of
investment, it is also, by design, the lowest risk—if the bond issuer
is stable. Strictly holding onto long-term bonds is theoretically a
no-risk investment—only in the case of government or corporate
default, or debt restructuring, is the investment in real trouble. As a
concept, fixed income is rather simple, but these simple mechanics
regulate an enormous amount of wealth: literally trillions of dollars
 FIXED-INCOME INVESTING 71

are regularly at stake in this market. Because the stakes are so high,
even minor shifts have outsized consequences: movements in a
hundredth of a percent can be the difference between success and
failure. A multitude of influences play into market shifts, but in
this space, the Federal Reserve’s decisive role deserves and receives
more attention than any other factor.

* * *

In order to comprehensively backtest fixed income, we’ve

decided to use an ETF—an exchange-traded fund. ETFs operate
much like a stock on the open market. They are also backed by a
specific set of securities, like government bonds, and generally are,
in comparison to normal bonds, a riskier investment. But, since
the underlying asset is very low risk, ETFs based on bonds are typi-
cally less prone to extreme volatility and commonly represent good
“buy-and-hold” opportunities.
We have also chosen to use an ETF instead of, for instance, the
bond price on the secondary market on an exchange for reasons of
mathematical clarity. There are many complexities to buying and
selling bonds on the secondary market—like the synthetic nature
of price for any given security or the difficulty of tracking coupon
payments—and these intricacies make for a poor test candidate.
The ETF effectively captures much of the underlying information
contained in the price movements of the securities and, therefore,
represents a solid asset to test. The specific ETF we used for our
backtesting is the iShares 20+ Year Treasury ETF (ticker symbol
TLT), and it is indexed to 20- and 30-year US Treasury bonds.
The backtest works as a full paper-trading example from 2004 to
2014. By paper trading, we mean that the example only considers
data prior to the start of 2004 as we make our first trading decision
in 2004. As we move forward, we update our information about the
basic parameters between the Fed Index data and the price levels of
the ETF. In short, each day’s trade is only informed by the data that
would have been available to us on that day. The simulation pro-
gresses through this 10-year span. After making the initial invest-
ment decision, we take either a long or short position. There is no
cash withholding, and we assume there are no transaction costs (in
a highly liquid ETF like the TLT, transaction costs are usually quite
72 HOW THE FED MOVES MARKETS

low). Additionally, this test is performed daily. We take one (and

only one) position each day.
Long positions imply we are simply buying the asset and holding
on to it as (hopefully) it increases in value. Short positions are the
opposite. We actually take out a short-term loan, paid back in the
asset itself, and hold on to cash as we wait (again, hopefully) for the
asset to drop in value. After the price lowers, we buy the asset at a
now lower price than we sold it for, and pay back the original loan
in the shares of the asset that we now temporarily possess.
The data used was our own proprietary Fed watching data (Fed
Index), and the price and dividend information on the TLT from
Yahoo Finance for the entire history of the ETF, which had a date
of inception on July 22, 2002. The data prior to the start date of
the paper-trading simulation is used to calculate parameters rel-
evant to the backtest, such as the optimal lag structure (which is
how far back we look at our data to consider the trading decision
made on any given day) for the Fed Index and trading thresholds.
Specifically, the data used is the daily close price of the TLT.
We use a fairly simple momentum-based strategy to make
trading decisions. Generally put, we look at a moving average of
the Fed Index, and, if we detect a significant upward or down-
ward trend, we take a long or short position, respectively. More
formally, we are looking at a moving average of the price level,
and, considering the average deviation from the moving aver-
age, if we detect a large enough change in the numeric deriva-
tive across time, we reconsider our position. If we detect a large
upward shift, for example, and are already in a long position, we
do not change. On the other hand, if we are long and detect a
downward shift, we move to a short position. These are the basics
of our backtesting settings, but the entire process merits a more
detailed explanation.

* * *

The Fed Index in its raw form is simply a collection of scores

attached to information released at specific times, and these scores
are not necessarily released on consecutive days. In order to calcu-
late the daily value of the signal, we have to transform the scores.
 FIXED-INCOME INVESTING 73

First, we average communications on a daily level. While there are

days without communications, there are also days with multiple
communications. In order to consider the position of the Fed in
between communications, we perform a linear approximation
between communications. A line is drawn from one communi-
cation to the next, and the value of that line on a day without a
communication is recorded. This is because we believe that the
unofficial policy position of the Fed on any given day is actually
a bargain between all the institution’s relevant decision makers.
Given this, the policy the Fed is likely to choose at any moment
is actually located within the space defined by outlying hawkish
and dovish scores in any stretch of time. A common alternative to
linear approximation when constructing signals such as this is to
carry forward the last nonmissing value, but we have found that
this leads to an inaccurate portrayal of the real flow of the Fed’s
policy orientation across time.
Next, the optimal level of correlation between the pretest—and,
as the simulation progresses, previous test—data is used to find the
exact number of days the Fed Index should be lagged to optimize
the correlation between the TLT and the Fed Index. In both pretest
and progressing data, we found that the highest level of correlation
occurs at 193 days. This lag is consistent with conventional mon-
etary economics, which states that markets take at least six months
to react to monetary policy. In this case we found that the mar-
kets take just over six months to appropriately react. Given this lag
structure, we only made trading decisions on information released
193 days before the date of the simulation trade day. That is, only
if a communication occurred on that date, do we consider making
a trade.
After lagging the data, we calculate a moving average—and this
is recalculated for every day of the study. This averaging is necessary
to convert the Fed Index into a smooth, readable signal. Without
averaging, the lines connecting the scattered Fed Index values cre-
ate a chaotic landscape, dipping and diving among the disparate
values. By means of a ten-day moving average, this data is reduced
to a smooth slope. The score for any given day then becomes the
average of the last ten days, and this average is calculated daily,
moving with each trade day.
74 HOW THE FED MOVES MARKETS

Finally, we calculate the daily momentum of the signal. The

momentum is the direction of the signal. This direction is the dif-
ference between the value of the smoothed average of the signal at
the beginning of the day and the value of the smoothed average of
the signal at the end of the day. If this difference begins to change
dramatically, we know that the mood of the Fed is beginning to
shift. (Remember, the mood that informs our trading positions is
actually the position of the Fed 193 days before the trading day.) By
examining the history of the signal, we were able to determine what
indicates a shift in momentum by first determining what the average
rate of change in the ascent (towards hawkish) or descent (towards
dovish) of the Fed Index was. We then noted the range of rates of
change that consistently signalled a significant shift in momentum.
The thresholds of these rates of change were on the far low and high
ends of the rate of change values—in the bottom and top quintiles
(20 and 80 percent to be exact)—and these thresholds informed
our trading decisions. If the Fed Index’s momentum passed these
thresholds, we changed positions; if it stayed within them, we held
our position. The criteria for what constitutes a threshold was also
constantly updated as our data on the Fed’s sentiment continued
to pour in. This allowed our understanding of the attitude shifts in
the Fed to become, at least in theory, increasingly accurate, which,
in turn, translated to better trading decisions as time passed.

* * *

The results of our backtesting, using only the Fed Index as the
trading signal, were extremely positive. With an initial investment
of 100,000 dollars, our simulated portfolio grew significantly, land-
ing at a final value of 157,911 dollars on December 31, 2014—repre-
senting a 8,788 dollar alpha over a control buy-and-hold portfolio.
Over the course of the 12-year trading period, 127 positions were
taken, with an average of just over 16 days per position. Guided by
the central banking sentiment, the portfolio was able to navigate
the tremendous pitfalls of the financial crisis—avoiding the severe
losses suffered by nearly every market index and trading strategy.
It is remarkable that this level of performance (see Figure 7.1) was
possible given the simplicity of our trading model, but it speaks to
 FIXED-INCOME INVESTING 75

160

140
Portfolio Value in Millions

120

100

80

60
Jan 02 2004 Jul 01 2005 Jan 03 2007 Jul 01 2008 Jan 01 2010 Jul 01 2011 Jul 02 2013 Jul 01 2014

Buy-and-Hold FED Index Backtest

Figure 7.1 Performance of a Fed Index-driven simulated portfolio.

the increasing power of the Fed’s word—both as a predictive text

and a market mover.

* * *

As the reliable performance of the backtested portfolio would

suggest, there seems to be a significant relationship between the
Fed Index and this market. Figure 7.2 illustrates how closely our
Fed sentiment data is correlated to fixed-income pricing from 1998
to 2012.
The correlation between the Fed Index and the ten-year
Treasury bond—a market benchmark—is noticeably greater
than the correlation between the FFR and the ten-year bond. At
no time is this disparity more obvious than since the financial
crisis: since the recession, the FFR has been pinned to the zero,
effectively decoupling it from the treasury; the Fed Index, on the
other hand, has continued to oscillate in tandem with the bond.
This development reinforces the importance of the Fed’s official
76 HOW THE FED MOVES MARKETS

7
7 0.2

6 6
Portfolio Value in Millions

5 0.0
5

Fed Index
FFR

4 –0.2
3

3
2
–0.4

2 1

0
–0.6
98

99

00

01

02

03

04

05

06

07

08

09

10

11

12

13

14

15
19

19

20

20

20

20

20

20

20

20

20

20

20

20

20

20

20

20
Fed Index 10yr Yield FFR

Figure 7.2 Fed Index, FFR, and a ten-year bond yield.

communications regarding the economy, as opposed to its actions.

The FFR is recognized as a standard lever of economic control,
and its manipulation is a direct demonstration of central bank
action. Transparency, as this book has chronicled, is a relatively
recent development, and, in comparison to directly implemented
policy, the relationship between it and market action might seem
less consequential. Figure 7.2 paints runs contrary to expectations,
portraying a market moved more by word than by deed. The data
only reinforces what Janet Yellen has been telling Fed watchers: in
the modern era of central banking, “communications are policy”
(Yellen 2013).
But Fed communications do not only impact the market; they
also reveal trends that most investors could not see in advance. Fed
policymakers are privy to a wide variety of macroeconomic infor-
mation—far beyond that which most market actors have access to.
The Fed communications are, therefore, an indicator for a wide
variety of macromarket drivers in addition to Fed policy itself.
Given this relationship to coming trends, central bank sentiment,
interpreted properly, would be expected to serve as an excellent
predictor. And with the Fed Index, that is exactly what is seen: in
 FIXED-INCOME INVESTING 77

the majority of instances the rises and falls in the Fed Index predate
movements in the bond market. This relationship, of course, was
the reason we had to calculate a lag in our implementation of the
Fed Index into our portfolio management and also a reason for our
trading model’s steady performance.

* * *

Drawing numerous threads of esoteric market data into their

estimations, while simultaneously affecting markets they appraise,
the central bank presents Fed watchers with loaded words. Distilled
into a single signal, these communications become an easily digest-
ible, eminently actionable, and undoubtedly valuable data stream,
arming financial professionals with vital information on the fixed-
income markets. The Fed Index is that signal. Even taken as the
lone trade signal, absent complex trading models or standard risk-
reducing metrics, the Fed Index served as an extremely reliable
portfolio manager, more than doubling the initial investment in a
backtest that traversed the financial crisis. Portrayed graphically,
this level of success is not too surprising. The Fed Index has a con-
sistent, predictive correlation with the bond market, thereby serv-
ing as leading indicator of market fluctuations.
With the value of interpreting Fed communications as they relate
to the fixed-income markets established, the next chapter moves to
explore the increasingly powerful—but less apparent—connections
that have developed between central bank communications and the
equity markets.
 8

Equity Market Investing:

Macro Matters

T he connection between central bank policy and fixed-income

markets is clear, but the Fed’s actions and words also find
traction outside of bonds and bills. Equity markets, just like fixed
income, also react to Fed communications. As Marcel Fratzscher,
the former head of policy analysis at the European Central Bank,
and Michael Ehrmann, the head of economic and financial research
at Bank of Canada, have asserted, “Central bank communication
is a statistically and economically important driver of financial
markets” (Ehrmann and Fratzscher 2007). Economists and finan-
cial professionals have observed the budding ties between central
bank dispatches and the equity markets in recent years, and our
work integrating textual analysis with market reaction sheds addi-
tional light on this trend. Diving into the world of equities, this
chapter explains the fundamentals underpinning equity markets.
After covering the essentials, it then highlights the deep connec-
tions that have developed between central banks and equity move-
ments—and the reasons behind this growing relationship. Finally,
this chapter investigates the application of our central banking
data to this space, demonstrating how our methodology could
provide deeper insight into the ebb and flow of the modern equity
markets.

* * *

Before exploring the connections between the Fed and these

markets, a review of equities might be helpful. Almost every
80 HOW THE FED MOVES MARKETS

investment—fixed income, equities, or currencies—is structured

like a loan. While the structure largely stays the same, the terms
of repayment are what differentiate investment types. For fixed
income, the terms are fairly straightforward: an investor pur-
chases the instrument and, at some later date, gets cash back per
the details of the agreement. Currencies are also relatively simple:
an investor provides money to a bank, asking them to hold on to it
in a foreign currency until the investor decides to take their money
back at the value of that particular currency. Equities, however, are
a bit more complex: the investor gets a piece of collateral—a share
in the company—in exchange for their money, but the company is
not ever explicitly required to pay the investor back unless a certain
set of events occur. This commonly happens when a company is
liquidated by sale or default. A shareholder is often entitled to a dis-
bursement from the company as well (at the company’s discretion),
in proportion to the number of shares held. These practices hold
true in nearly all cases for companies, private or public. Equity, as
an asset class, is defined by receiving a stake in a company for your
transaction.
Equity markets, by extension, are markets where shares of com-
panies are bought and sold. In particular, the companies are pub-
licly held; that is, shares of the company can be bought and sold by
members of the general public. There are many exceptions to this,
but the general rule is that shares of publicly held companies can
be bought and sold on the open market. Typically, this occurs in
an exchange—for instance, the New York Stock Exchange—which
serves to simplify the transactions.
As with bonds, investors can purchase shares directly from
companies. However, it is nearly always the case that companies
only make their stock available through an exchange. Compared
to bonds, there is essentially no distinction between primary and
secondary markets. Additionally, companies typically only make
a set number of shares available for purchase and, in most cases,
an investor purchasing shares on the open market does so from a
private individual or firm, not the company itself.
The buying and selling of equities is governed by bidding. Buyers
list a bid price they are willing to pay for a share. Sellers offer up an
ask price, the amount they are willing to accept for an offer. The
 EQUITY MARKET INVESTING 81

gap between the two is referred to as the bid-ask spread. Prior to the
digitization of the financial industry, traders on the exchange floor
explicitly matched up buyers and sellers with matching bid and
ask prices. Remember the scenes from movies where traders are
shouting for attention? They are literally shouting prices and try-
ing to find another trader with a potential customer at a particular
price. The computerization of the process is a digital translation of
this activity. The only major change is that there is now an explicit
queuing mechanism as well, in which bids and asks are processed
in the order they come into the system. Traders still do act on the
floor, however, when unusual requests come in. The vast majority,
however, is done electronically—a trend that translates to a quieter
trading floor.
The price of equities is determined by market action, and market
action is the conflation of an enormous collection of actors. There
are, however, major players—players with huge wallets, vast port-
folios, and influential voices. These are also powerful players who
sway the equity markets, even if they do not often invest directly in
them. And who are they? Central banks, of course.

* * *

The central bank tracks macroeconomic indicators to capture

the state of current and potential future growth, and it adjusts pol-
icy accordingly. In most cases, the central bank is the single most
informed expert on the health of the economy. As such, when it
speaks of the health of the economy, its comments can reveal rela-
tively unknown information. Reacting to this take on the state of
the economy, investors make trading decisions, and scholars—
along with the central banks themselves—have become increas-
ingly interested in this connection. Referencing the conclusions of
Fratzscher and Ehrmann, a recent paper by the Bank of Canada
notes the impact of the Fed’s word on equities: “The empirical
results [ . . . ] also confirm that financial stability communications
have a significant impact on asset prices [ . . . ] Equity markets move
in line with the views in FSRs, and market volatility diminishes”
(Vayid 2013, 16). Just a single communication from the Fed indicat-
ing contractionary monetary policy, as Ehrmann and Fratzscher
82 HOW THE FED MOVES MARKETS

have observed, was impactful enough to affect the US, UK, and
eurozone equity markets (Ehrmann and Fratzscher 2007). And
this relationship, especially since the financial crisis, has only
deepened.
The reasons for this heightened connection are numerous. To
begin with, the nature of central bank investment and its role in
the market has dramatically evolved. In an attempt to support a
struggling system, the Fed expanded its interests beyond treasuries,
their traditional domain, and became a serious player in other asset
markets. The Fed has pumped 4.5 trillion dollars into the economy
over the last few years, and when such an enormous injection of
liquidity floods into the economy, it will inevitably inflate asset val-
ues. These new moves by the central bank mean that the Fed also
has more sway over the equity markets, making it highly improb-
able that any new policy will not have been rigorously evaluated in
light of its impact on those markets. Beyond increasing their stake
in the economy at large, their investments also give them another
substantial form of leverage which they could use to powerfully
influence the fortunes of other financial institutions with a vested
interest in equity markets.
In addition to these new factors, the leadership shown by the
central bank during the financial crisis has also bolstered the Fed’s
influence in this sphere—and the market as a whole. Even though
more than half a decade has passed since the peak of the crisis,
the confidence investors have in the entire system still depends
largely on the actions the central bank takes. This dependency is,
at least in part, the product of a market that has yet to fully regain
its footing.
Another growing connection between Fed communication and
the equity market lies in industry valuation methodology. It has
now become standard practice for major financial institutions
to take the central banks’ moves into account when generating
asset assessments. The “Fed model,” which integrates data on the
Federal Reserve’s interest rate into equity evaluations, is a com-
mon tool for institutions like J. P. Morgan, ING, and Prudential—
among others. As financial journalist Theo Casey wrote in 2010,
“The fact is, influential market players embrace the Fed model
[ . . . ] The net result is that the Fed model is a significant valuation
tool which prominent investors use to check whether they should
 EQUITY MARKET INVESTING 83

be buying stocks or bonds” (Casey 2010). Given this trend, it only

makes more sense for equity market players to take a closer look at
Fed dispatches: central bank communications foreshadow interest
rates, which eventually bleed into equity attractiveness. Getting a
good grasp of Fed communication puts them further up the chain
of causality, allowing them to better anticipate future market
conditions.
Taken together, these developments have afforded the Fed an
unprecedented position, suggesting that financial professionals
ought to pay closer attention to what an emerging market heavy-
weight has to say. As the Bank of Canada’s Ianthi Vayid concluded
in Central Bank Communications Before, During and After the
Crisis: From Open-Market Operations to Open-Mouth Policyy, “The
fact remains that central bank talk on financial issues has attracted
broad attention in the recent past and will be watched even more
closely following the global crisis” (Vayid 2013, 17).

* * *

The Federal Reserve is, however, far from the only central bank
that influences the equity markets. While it is rare that central
banks directly invest in the equity markets, they are regularly affili-
ated with sovereign wealth and/or pension funds that are heav-
ily invested in both fixed income and equity market assets. It is a
well-known fact that sovereign wealth and public pension funds
around the world have become large holders of company shares.
One of the best-known examples is the Norwegian sovereign fund,
Norges Bank Investment Management, with 880 billion dollars
under management, of which more than 60 percent is invested in
equities. The fund owns on average 1.3 percent of every globally
listed company—and 2.5 percent of listed companies in Europe.
As the biggest overall public-sector investor, the People’s Bank of
China (PBoC) wields tremendous influence over the equity mar-
ket. The State Administration of Foreign Exchange, a division of
the PBoC, has an astounding 3.9 trillion dollars under manage-
ment, with investments that include significant holdings in Europe.
(Recently, it appears that the PBoC itself has been directly buy-
ing minority equity stakes in important European companies;
Marsh 2014.) The Bank of Japan (BOJ) and Japan’s Government
84 HOW THE FED MOVES MARKETS

Pension Investment Fund also represent substantial—although

indirect—players in the equity markets, each with 1.3 trillion
dollars invested. A major reason Japan’s stock market has not col-
lapsed (despite 20 years of flat economic growth) has been the resil-
ience of its bond market (despite negative yields)—a market largely
upheld by the constant influx of capital from Japanese institutional
investors led by the BOJ. Another large public-sector equity owner
is Swiss National Bank, ranked the world’s No. 10 on the Global
Progress Indicator by market assets, with 480 billion under man-
agement (Marsh 2014). Stateside, Calpers and Calsters represent
the largest public pension funds in the nation and invest heavily in
fixed-income and US equity markets. These are just a handful of the
available examples—all of which point to the same conclusion: cen-
tral banks around the world, and public funds associated with them,
have tremendous sway in markets across asset classes, even equity
markets. So, it should come as no surprise that what central bankers
say is of vital importance to anyone operating in those spaces.

* * *

In light of these developments, understanding central bank

communications has never been more important for market
actors—a trend that translates directly into the relevance of our
methodology.
As Figure 8.1 demonstrates, the Fed Index strongly correlates
with the equity markets—in excess of 0.7 on a –1 to +1 scale. This
means that more than 70 percent of the time equity markets are
moving in lock step with our Federal Reserve sentiment data. As
might be expected from the Fed’s increasing influence and its
simultaneous to unprecedented levels of transparency, the correla-
tion between the Fed Index and the equity markets has been espe-
cially strong since the onset of the financial crisis. Of particular
interest to investors, our Fed sentiment data is a consistent leading
indicator with large Fed Index declines predating major market
sell-offs, and thus, the data serves as a strong sell (or short) signal.
In fact, the raw trend data demonstrates that the Fed Index was a
consistent leading indicator for stock prices in the financial crisis.
To give a more detailed picture of the Fed Index’s correlation
with equity markets, the correlation graphs in Figures 8.2 and 8.3
 EQUITY MARKET INVESTING 85

1200 0.2
2000

1800
1000 0.0
1600
Russell 2000
S&O 500

Fed Index
1400 800
–0.2

1200
600
1000 –0.4

800 400

–0.6
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
19
19
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
Fed Index S&P 500 Russell 2000

Figure 8.1 Fed Index, Russell 2K, S&P 500, and NASDAQ from 1997 to 2014.

break down the level of correlation within market indexes and indi-
vidual equities.
These correlation graphs break down the markets into indexes
and individual equities. In Figure 8.2, each individual bar repre-
sents a different index. In Figure 8.3, each individual bar represents
a different equity. The strength of the correlation between our data
and each of the indexes and equities is demonstrated in Figure 8.2
and 8.3 by the length of each bar. The possible correlation scores
run from zero to 100—with 100 being perfect correlation and zero
being no correlation. The data used to create these graphs spans
2007 to 2014.
The high level of correlation seen across the market and the
extremely high correlations found in certain sectors and indexes
reveal that the Fed Index is not only a good measure for looking at
the market as a whole, but it also could prove useful for targeted anal-
ysis and developing sophisticated investment strategies. For example,
Apple, Inc. (in the bottom third of Figure 8.3) shares over a 70 percent
correlation to our sentiment data over the sample period. This means
Apple moved in lockstep with the Fed more than 70 percent of the
time from 2007 to 2014, despite numerous product releases, lawsuits,
and other developments. This suggests that for investors interested
 Correlation Score, 2007-2014

Average

Wilshire US Mid Cap Growth

Wilshire 5000 Total Market Index

Wilshire US Large Cap Value

Wilshire US REIT Index

Wilshire US Small Cap Value

Russell 2000 Index

S&O Small-Cap 600 Index

NYSE ARCA Major Market Index

Russell 3000 Index

S&P 500 Index

NYSE AMEX Pharmaceutical Index

PHLX Semiconductor Index

MSCI US REIT Index

NYSE Composite Index

NASDAQ Financial 100 (IXF)

0 10 20 30 40 50 60 70 80 90 140

Figure 8.2 Correlation of Fed Index with standard market indexes.

Average
American Express
United Health
Visa
Pfizer
DD
Boeing
Merck
Verizon
United Technologies
Home Depot
Travelers Companies Inc
3M
Disney
Coca-Cola
Chevron
Nike
Microsoft
Intel
Proctor & Gamble
Caterpillar
Johnson & Johnson
Apple Inc.
JP Morgan Chase
IBM
McDonalds
Wal-mart
General Electric
Cisco
Goldman Sachs
0 10 20 30 40 50 60 70 80 90 100

Figure 8.3 Correlation of Fed Index with industrial sector indexes.

 EQUITY MARKET INVESTING 87

in Apple stock, the Fed Index represents a powerful means of under-

standing that investment. Such targeted analysis is made even more
effective by the speed at which the data is available: the Fed Index
can be generated in real time (typically less than ten seconds after
the issuance of a communication). Fast, high-quality signals are
exactly what traders need to make the best decisions possible, and,
with detailed, actionable data available in real time, the Fed Index
represents the cutting edge in investor information.

* * *

As we did with fixed income, we also backtested the Fed Index

as the manager of an equity portfolio. Using a 100 percent equity
portfolio with standard sector weightings and no leverage, we ran
a long-only simulation from 2007 to 2014. The portfolio yielded
70 percent returns, beating major market indexes by over 30 per-
cent, and Figure 8.4 illustrates its performance.

160

140
Portfolio Value in Millions

120

100

80

60

40
07

08

08

09

09

10

12

3
1

1
20

20

20

20

20

20

20

20

20

20

20

20

20

Portfolio Dow Jones Industrial Average Nasdaq Composite

S&P 500 Index Russell 2000

Figure 8.4 Fed Index-driven simulated stock portfolio value, compared to

major indexes.
88 HOW THE FED MOVES MARKETS

As with the fixed-income backtest, our portfolio sidestepped the

market crash by serving as a vital sell indicator and highlighting
the Fed Index usefulness as a wealth preservation tool. Our port-
folio never went down more than 18 percent—even when equity
indexes suffered losses greater than 50 percent. Leveraging recent
developments in the Fed’s economic role, the Fed Index is not only
insightful financial data—but could be put to work as high-level
decision maker as well.

* * *

Traditionally, equity analysts left Fed watching to the fixed-

income folks, but recent years have seen a consistent impact of
the Fed’s dispatches on equity markets. This means that for those
interested in understanding the flow of these markets, central bank
communications have become essential data. By rapidly aggregat-
ing and objectively interpreting central bank texts in real time,
the Fed Index allows market players to get a detailed picture of the
central bank’s influence on equity markets. The next chapter will
expand on the utility of the Fed Index, elaborating on its perfor-
mance as a forecasting tool.
 9

Forecasting Policy:
Market Response to Fed
Communication Trends

I s it possible to foresee the future of the financial market? Initial

analysis does not offer much hope. The thought of the nearly
infinite factors at play in any market fluctuation would seem to
immediately stifle even the most sophisticated techniques. But,
regardless of how overwhelming prediction may be, it is a necessary
precondition to action—financial or otherwise. Every investment
decision financial professionals make is predicated on a projec-
tion, impossible as it may be, of what economic developments lie
ahead. So the question is not really whether or not it is possible,
in a strict sense, to predict the future of the financial markets. Its
possibility is secondary to its necessity. The question is, instead,
“what is the best way to tackle the impossible?”
In finance, the business of tackling the impossible is known as
forecasting, and this chapter tackles this topic head on. Beginning
with a discussion of what forecasting is, the following pages discuss
how an accurate assessment of the Federal Reserve’s attitude—in a
world where its voice is an increasingly powerful market driver—
might serve as an incredibly valuable forecasting tool.

* * *

Forecasting is an extension of a theory or trend into the

future. The foundation of any (credible) forecast is an exten-
sive set of observations—a wide breadth of data about whatever
90 HOW THE FED MOVES MARKETS

circumstance is under investigation. In finance, that data set

could include prices, interest rates, fixed-income and equity mar-
ket trends, gross domestic product estimates, capital-asset ratios,
etc. These observations, naturally, lead to a hypothesis—an edu-
cated model of how something works. The historical data that was
the source of the hypothesis at once becomes its best means of
assessment. In other words, the efficacy of any model can easily be
measured against the test of history: given a restricted data set—
observations all made before a specific date—can that model pre-
dict what will happen next? Naturally, the most successful models
are those that are best able to project the “future” outcomes of
historical circumstances.
These models are not meant to reflect the full complexity of the
processes and systems upon which they are based. Instead, the best
models are an efficient distillation of these mechanics, bringing
accessibility to the real-life processes that are otherwise too dense
and unwieldy to understand. In finance, the necessity of modeling
is obvious. The financial markets produce a deluge of data, and it
quickly becomes incredibly difficult to differentiate useful signal
from useless noise. Strong models capture the movement of the
essential gears of the system, presenting an intelligible picture of
the present and, even more powerfully, a handle on the future. That
is a forecast.

* * *

The advantages of effective forecasting tools are numerous. In

finance, these advantages all orbit the same concept: maximiz-
ing resources. Perhaps the most immediately apparent of these
advantages is the ability to leverage opportunities and avoid dan-
gers that others do not—or cannot—see. If an investor can get
a sense of the future landscape, this prescient perspective would
allow that investor to allocate resources to create the best possible
return. While boosting gains, effective forecasting also serves as
a valuable risk management tool, helping investors minimize the
inevitable losses that attend any sustained market activity. In the
ever-increasing opacity of the modern financial system, losses
can occur for any number of reasons—not the least among these
 FORECASTING POLICY 91

being poor forecasting. A recent article in the New York Times

recounted the high cost of erroneous predictions:

In October, the World Bank estimated that the costs associated with
Ebola for West Africa as a whole may be as high as $32.6 billion, an esti-
mate that was revised down this month to be at most $6 billion. When
the public anticipates bad times, they cut back on discretionary purchases
and save more, compounding the effects of the shock [ . . . ] collectively
focusing on worst-case scenarios can make people fatalistic, damaging
efforts to prevent the disease from spreading. It also has a negative effect
on the economy and makes it harder for those seeking to raise money for
future crises. Independent data sources and assessments are vital to our
understanding of and response to the crisis. (Glennerster, M’cleod, and
Suri 2015)

While projections are a necessary for any endeavor, not all fore-
casts are created equal. Preparing for the worst-case scenario can
seem like a safe bet, but it actually can—as in the case of the Ebola
outbreak—cause an even greater problem than would have other-
wise developed. Quality forecasting can minimize the costs asso-
ciated with overestimating future challenges, allowing any sort of
plan—investment plans certainly included—to appropriately skirt
the dividing line between caution and risk.
Effective forecasting methods further compound their efficiency
by being able to generate accurate predictions with less data than
other models might require. Gathering data can be an expensive
proposition—research does not come cheap—and the best fore-
casting tools are able cut down on these costs by operating more
efficiently.
All these advantages translate into a strong platform for confi-
dent, successful leadership. The better the grasp any leader has on
what could happen, the more assured they can be that the decision
made was the best possible, allowing them to more convincingly
impart their vision to those around them. In the financial world,
this confidence could manifest itself in any number of ways. For
executives, it could increase their effectiveness communicating
the company’s stability to their employees. For wealth managers,
it could bolster their confidence during client-facing meetings. In
any case, sound projections arm their receivers with the kind of
92 HOW THE FED MOVES MARKETS

data-backed assurance that financial professionals need to take the

lead when facing the unknown.

* * *

The Fed is certainly accustomed to attempts at forecasting their

policy—however questionable these forecasting methodologies
have been. The briefcase watch was an early attempt at predicting
the central bank’s next steps. The modern practice of Fed watching
is inundated with forecasting attempts. Analysts scrutinize meet-
ing minutes and press releases to build a case for a certain policy
projection (stating, for example, that in six months the Fed will
begin to increase interest rates) and this practice can, at times, pro-
duce accurate predictions.
Built on a foundation of historical market reaction to Fed com-
munications, our methodology is also capable of producing predic-
tions. This foundation is part of what distinguishes our forecasting
from the rest of an already large industry actively engaged in mon-
etary policy speculation. Our predictions are generated within the
framework of the Fed Index, allowing us to produce complete sta-
tistical forecasting of future monetary policy and, based on estab-
lished correlations to various assets, forecasts of asset prices.
Inside the Federal Reserve, monetary policy emerges from col-
laborative effort. Multiple actors submit information relevant to
decisions, and the Federal Open Market Committee (FOMC) meets
as a group to consider future monetary policy. When central bank-
ers communicate, their speeches and press releases emerge out of
this collaboration and reveal a very particular set of data: the infor-
mation they used to set current policy and, based on what they saw
before, how they expect their policy to change. Since there appears
to be a regular relationship between past and current information,
we can use statistical tools to bridge that gap, and make predic-
tions about their future position. In essence, our process not only
allows us to understand the relationship between the words the Fed
chooses and the market, but also the relationship these words have
to each other. From here, we are now able to map what a central
bank has done in the past onto what they are doing in the pres-
ent and, most importantly, with what they will do in the future.
 FORECASTING POLICY 93

Our forecasts are made, in short, by generating a future sentiment

analytic from the previous sentiment scores.

* * *

The Fed Index data has allowed us to consistently and accurately

predict the sentiment of upcoming FOMC meetings. Figure 9.1 rep-
resents a backtesting run assessing precisely that ability—forecast-
ing FMOC scores—and the results confirmed our methodology.
Each of the dots in Figure 9.1 are the actual FOMC meeting scores
and the lines intersecting the dots are our projections. The differ-
ence in the line width is representative of our level of confidence.
The thicker portions of each line indicate that we have 80 percent
confidence that the coming score will fall within that space; the
thinner portions indicate that we are 95 percent sure that the future
meetings mood will be captured in that line. Each prediction is
made a week before the meeting, utilizing only what information
would have been available to us at that time. Most of the dots are

0
FPSI

–2

–4
8

10

14
0

1
20

20

20

20

Figure 9.1 FOMC meetings forecast, one-week lag.

94 HOW THE FED MOVES MARKETS

in the middle of our prediction range, indicating that our forecasts

consistently anticipate the correct values of upcoming meeting.
Even in the rare cases (2 out of 53) where the actual meeting scores
fall outside our forecasted values, they—without exception—fall
back inside our projections by the next meeting. As the results—
covering an almost eight-year period—attest, our forecasts can be
called upon as reliable predictors of the Fed’s mood.

* * *

But, beyond efficiently projecting the central bank attitude, the

Fed Index also allows us to forecast complex, even seemingly unex-
pected, policy decisions. In September of 2013 the market expec-
tation was that the Federal Reserve would begin “tapering” asset
purchases (see Figure 9.2 for details).
The Fed Index indicated sentiment was rising at that time, and
this rise indicates a trend toward a more hawkish position. The
tapering of asset purchases is a hawkish policy by the central bank
because it curbs capital injection into the economy, thereby cool-
ing the economic engine. But, within the context of recent his-
torical data, it was obvious that the Fed would not begin tapering

2
Score

–2

Apr May Jun Jul Aug Sep Oct Nov Dec Jan

Figure 9.2 Fed Index six-month moving average, April–September 2013.

 FORECASTING POLICY 95

yet. The six-month Fed Index trend demonstrates that although

sentiment was rising in September, it remained below highs from
April and May. Even during those months tapering was still seen as
unlikely, and because the current score—while rising—remained
below those highs, we projected that it was unlikely the Fed would
begin tapering. While contradicting popular market opinion, our
policy predictions were validated: the Fed did not begin taper-
ing in September; they waited until December of 2013 to initiate
tapering.
In reference to the December 2013 tapering meeting, our fore-
cast of that meeting’s score serves as yet another example of the
reliability of our forecasting methodology. Four days ahead of the
meeting, we correctly predicted (trend line) the sentiment of the
FOMC meeting (indicated on graph) (see Figure 9.3 for details).
The near-perfect correlation between the forecasted score and
the actual score exemplifies the high level of forecasting accuracy
our methodology can generate—an accuracy made all the more
impressive by the limited data required to generate it. As was dis-
cussed above, an essential aspect of a powerful forecasting technique

–.5
FPSI

–1
FOMC

–1.5

Nov 25 Dec 02 Dec 09 Dec 16

Figure 9.3 Fed Index projection as of December 14, 2013, and actual FOMC
sentiment.
96 HOW THE FED MOVES MARKETS

is efficiency (cost effectiveness), and our projections, which emerge

purely from our analysis of central banking texts and the market,
represent a powerful marriage of thrift and accuracy.
The accuracy of our forecast—and inaccuracy of mainstream
projections—reinforces a particular strength of our process—and,
conversely, a particular weakness of others. As has been discussed
in earlier chapters, human analysis consistently falls prey to human
errors, one of which is an unjustified prejudice toward recent events
and trends. It seems understandable, given the central bank’s trend
toward hawkish communications in August and September, that
analysts might have predicted tapering. Those predictions, it seems,
were the product of a recency bias—and possibly groupthink as
well. It is not uncommon, after all, for an initial prediction to gain
undue credibility from bandwagon support. When the larger, more
objective picture comes into focus, a picture that the Fed Index
is the product of, the true improbability of that forecast becomes
apparent. The central bank is a creature of habit and history, and,
as such, its policy moves should be predicted using processes that
take that full context into account.

* * *

Even without using past values of the Fed Index to project future
values of the signal—and therefore future market reactions—the
signal can be used as a forecasting tool. This is possible because
central bank communications (or more accurately, our proprietary
interpretations of them) have a fundamentally predictive relation-
ship with the market. Fed communications are digested by the
financial markets at varying speeds and the individual markets
each react in different ways, but, in any case, it takes time—rang-
ing from nanoseconds to years—for the Fed’s words to act on the
economy. Therefore, if current communications can be evaluated
in light of historical market reactions, the interpretation produced
is not just a snapshot of what is—it is a vision of what’s to come. As
is the case with every portfolio in every market we’ve backtested, a
lag has to be engineered into the process precisely because of this
fact: our central bank sentiment data is, inherently, a projection
of the future economic landscape, making virtually every signal
we produce a leading indicator (from which a forecast can also be
generated).
 FORECASTING POLICY 97

And this projection can yield significant foresight. For instance,

in the fixed-income backtesting covered in an earlier chapter we
discovered that the market took 193 days to align with the Fed’s
sentiment. This means that the Fed Index generated a six-month
leading indicator on the fixed-income market—a full two-quarters
in advance.
This projection can also yield significant alpha (returns in excess
of benchmark). Even without sophisticated forecasting based on
correlations to particular assets, the Fed Index is an incredibly
effective portfolio management tool when simply used as a leading
indicator. We ran tests using the Fed Index as a four-week lead-
ing indicator and the only buy/sell signal with a sample long-only
portfolio holding 80 percent equities, 20 percent fixed income with
standard sector weightings, and no leverage. Running from 2007 to
2014, our sample portfolio yielded a 50 percent return, outperform-
ing major market indexes by roughly 30 percent. The results are
presented in Figure 9.4.
Closer analysis only makes the portfolio’s performance more
notable. While markets plummeted during the throes of the

140

120
Portfolio Value in Millions

100

80

60
07

08

08

09

09

10

10

11

11

12

12

13

13
20

20

20

20

20

20

20

20

20

20

20

20

20

Portfolio S&P 500 Index Dow Jones Industrial Average

Figure 9.4 Fed Index-led portfolio, the S&P 500, and the Dow Jones.
98 HOW THE FED MOVES MARKETS

financial crisis, with benchmarks like the S&P 500 and the Dow
Jones Industrial suffering losses in excess of 50 percent, our long-
only Fed Index-driven portfolio declined, at the very worst, by only
12 percent. For financial professionals, the Fed Index’s prescient
relationship with the market could become an effective means of
mitigating downside risk—or even capitalizing on it via a long-
short strategy.

* * *

Forecasting is a tricky business. There are numerous signals

from which to divine information, vast amounts of historical data
to sort through, and endless competing models to evaluate based
on various combinations of all this information. Taken all at once,
the tools and data available can seem as daunting to process as the
unknown that each forecasting method seeks to demystify. Given
all the noise and clutter, it makes sense to boil down an over-
whelming process to its essentials, and, for financial profession-
als, those essentials are fundamental market movers. The Fed is
the preeminent market mover, and its central role in the modern
financial landscape means that a good grasp of the central bank’s
processes can enable a rational and effective forecast of the future
of the entire economy. Using a detailed and comprehensive history
of the central bank, the Fed Index allows for such predictions and,
as statistical testing has validated, those predictions are remark-
ably accurate. For investors, traders, financial advisors, portfolio
managers—or anyone interested in finance—these forecasts repre-
sent a powerful tool for strengthening their handle on the future of
financial markets.
 10

FOREX Investing: Central

Bank Sentiment Data
across the Globe

W ith command over the Treasury’s dollar production (which

are called Federal Reserve Notes) and interest rates, the
Fed directly influences both the quantity and price of money
more than any other actor. Given its central role in upholding
the integrity of the currency, it makes sense to regard the central
bank’s words not only as authoritative assessments of the state of
the dollar, but also as catalysts for market movement themselves.
As sensible as this deduction seems, it is surprising to note how
little this connection has been researched. Although numerous
scholars—especially since the financial crisis—have evaluated the
role of central bank communications in the financial markets and
the effect of those communications on currencies, money itself, as
noted German economist Marcel Fratzscher explains, has yet to be
widely explored:

While there is broad agreement that actual [foreign exchange] purchases

or sales may affect exchange rates under certain conditions [ . . . ], hardly
any work has been done on the issue of whether oral interventions may be
effective, apart from [Jansen and de Haan’s work] and [Fratzscher’s work].
(Fratzscher 2008, 1652)

For financial professionals, the better handle they have on the

relationship between central bank dispatches and money, the bet-
ter their understanding of the FOREX market. Our work analyz-
ing the relationship between central bank communications and the
100 HOW THE FED MOVES MARKETS

financial markets has ideally positioned us to assess this relation-

ship. This chapter begins with an in-depth discussion of the impact
central bank policy has on money, and, then, leveraging the insight
afforded by our sentiment analysis data, it explores the significant
role central banking dispatches play in FOREX.

* * *

With a suite of monetary levers at hand, the Fed is obviously a

central figure when it comes to money—but the details of the inter-
play between institution and currency are harder to appraise than
might be expected. This analysis does not get any easier when the
entire FOREX market is examined. The sheer number and variety
of players who have a hand in determining the value of one cur-
rency vis-à-vis another can make the task of assessing the full mea-
sure and nature of the Fed’s hand in this sphere a daunting task,
but, details aside, there is no denying the intervening hand of the
central bank:

We find contemporaneous positive correlation between the direction of

intervention and the conditional mean and variance of exchange rate
returns. We show that sustained and large interventions have a stabilising
influence in the foreign exchange market in terms of direction and volatil-
ity. Without these interventions, the market would have moved further
and exhibited more volatility. (Kim and Sheen 2002)

University of Michigan Economics Professor Katherine

Dominguez has also noted the power of the central banks on
FOREX, finding that between 1977 and 1994 interventions by the
Fed were responsible for more than 40 percent of the exchange rate
volatility between the US dollar and the Japanese yen (Dominguez
1998). The fact that the Fed contributes to the volatility of the cur-
rency should not be confused with lack of control: the central bank
may increase the change in value to achieve a desired outcome—
often steadying the currency in the long run. Instead, what the
Fed’s contribution to volatility does communicate is the impact the
Fed has on the currency market.
Recently, the power central banks have over this market has
been a hot topic in the mainstream financial media, as the brewing
 FOREX INVESTING 101

“currency wars” are, according to the Wall Street Journal, “driven

by central banks”:

Half the central banks representing the Group of 20 developed and large
emerging economies, whose top monetary and finance officials meet to
discuss the global economy this week in Istanbul, have taken easing steps
so far this year. The moves—mainly in the form of interest-rate cuts but
also asset purchases—have ricocheted through foreign-exchange markets,
driving the currencies of some countries down and those of others, pri-
marily the U.S., up. (Blackstone 2015)

As central banks continue to play their integral role as the guard-

ians of currency, their voices represent critical market informa-
tion—informing and influencing the tide of currencies around the
globe.

* * *

How influential are central banking communications on

exchange rates? Marcel Fratzscher calculates that in G3 (United
States, Europe, and Japan) economies, the “effects of oral inter-
ventions are, on average, around 0.15–0.20% on the level of the
US dollar—euro and yen—US dollar exchange rates” (Fratzscher
2008, 1671). While the numbers may seem small, it is important
to correctly place these percentages in context. When taking into
account that the FOREX market sees daily trading volume in the
trillions of dollars, fluctuations in the tenths of a percent means
could mean billion dollar shifts. As Fratzscher notes, communica-
tions seem particularly influential when they run contrary to the
rest of policy:

As an order of magnitude, for the US an oral intervention against the man-

tra has the same effect on the US dollar exchange rate as a USD 1.2 billion
actual intervention against the euro and USD 1.9 billion actual interven-
tion against the yen. Overall, the results emphasize the remarkable effec-
tiveness of oral interventions if they occur against the prevalent policy
stance. Finally, actual interventions have mostly increased the conditional
variances of the exchange rates on the days following interventions. By
contrast, oral interventions have in most cases decreased the volatility.
(Fratzscher 2008, 1671)
102 HOW THE FED MOVES MARKETS

Not only can “oral interventions” (guiding central banking

communications known as forward guidance in the United States)
have the same impact on the market as billions of dollars, but the
effect words have (as opposed to enacted policy) seem preferable—
soothing volatility. Wielding this level of power, communications
have become an ascendant tool of policy for central banks looking
to make their mark on FOREX:

Exchange rate policies in many economies have undergone a fundamental

regime change since the mid-1990s. Monetary authorities in the United
States and the euro area have basically abandoned actual interventions in
1995 and have shifted towards the use of communication, or oral interven-
tions, to convey their stance on exchange rates to the markets. (Fratzscher
2008, 1651)

This trend not only makes understanding central bank commu-

nications important for analyzing the FOREX market, it actually
makes these speeches required reading. But, as Fratzscher (2008) has
observed, the details of the relationship remain relatively untouched
by economic research, which, for those with a vested interest in
understanding the market, is an unfortunate coincidence.

* * *

In order to get a clearer look at the connections between com-

munications and exchange rates, at least two following data streams
are needed:

1. A history of FOREX rates.

2. A history of central banking communications in terms of
market reactions.

The first of these is readily available, and the second could be sup-
plied by our methodology. Ideally, the data on central banking
texts should extend beyond one side of a currency pair. In other
words, the Fed Index may help unlock the connection between the
Fed’s language and the dollar, but, when it comes to FOREX, it is
obvious that the connection between other central banks’ com-
munications and their respective currencies would have enormous
bearing on the final relationship among the multitude of currencies
 FOREX INVESTING 103

interacting in this market. Fortunately, the Fed Index is not the

only data set our process has allowed us to generate. Using the same
market-reaction-to-communication relationship that allowed us to
produce the Fed Index, we have been able to create historical and
real-time sentiment data streams on nearly every major central
bank in the world.
With this information in hand, the connections that exist
between these institutions and the FOREX market become easier
to spot.

* * *

For a fuller picture of these dynamics, the next few pages dive into
a more detailed, particular analysis by walking through different
currency pairs as they interact with central bank communications.

USD, Basket of Currencies, and the Fed

In Figure 10.1, the solid black line is the Fed Index. The broken
line is the exchange rate between the USD and a weighted average of

110

0.2

100

0.0
DTWEXM

Fed Index

90

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80

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Fed Index DTWEXM

Figure 10.1 USD-basket of currencies with Fed Index.

104 HOW THE FED MOVES MARKETS

major world currencies. As this line reaches higher or lower values,

it indicates that the dollar is, respectively, reaching higher or lower
values. From the early months of 2009 onward, the slow (albeit vol-
atile) ascension of the solid line indicated that the Fed has become
more hawkish—a trend that peaks in early 2014. As a hawkish
central bank is looking to increase the value of their currency, the
Fed’s brooding hawkishness could be expected to later manifest in
a climbing dollar. Interestingly, Figure 10.1 illustrates exactly that,
as the value of USD gradually travels from approximately 70 units
in the middle of 2008 to almost 95 units in early 2015.

USD, EUR, the Fed, and the ECB

In Figure 10.2, the broken and dotted line is the value of the
euro in dollars; the broken line is the sentiment of the Fed, and
the solid black line is the sentiment of the European Central Bank.
As noted above, since the beginning of 2009, the Fed has trended
toward hawkishness. The ECB’s attitude in the same period, on the
other hand, has orbited the same dovish values, oscillating from
approximately 0.2 to negative 0.8. The Fed’s hawkish communica-
tions would encourage a deflationary dollar—increasing its value;

1.6
0.2

1.4 0.5
0.0
ECB Index
EUR-USD
Fed Index

1.2
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ECB Index Fed Index EUR-USD

Figure 10.2 ECB-USD with bank trends.

 FOREX INVESTING 105

conversely, the ECB’s dovish dispatches would inspire the euro to

inflation. Given the sentiment data, it might be predicted that the
value of the euro relative to the dollar would begin to plummet,
and, once again, when Figure 10.2 is consulted, that is exactly what
is seen: as the Fed becomes more hawkish and the ECB remains
dovish, the euro rapidly loses ground to the dollar. These attitudes,
in turn, give the currency a higher value relative to the euro.

USD, GBP, the Fed, and the BOE

The pound (GBP) in dollars is represented in Figure 10.3 by the

dotted and broken lines, and the solid black and broken lines are
sentiments of the Bank of England (BOE) and the Fed, respec-
tively. In general, since the financial crisis the Fed and the BOE
seem to move in tandem toward an increasingly hawkish atti-
tude, with the Fed’s attitude showing the most dramatic fluctua-
tions. The synchronization of the banks’ sentiment might lead to
the expectation that the value of the pound relative to the dol-
lar would stay relatively steady, and Figure 10.3 largely bears out
these expectations with the pound holding between 1.4 and 1.7
dollars since 2009.

0.2

2.0 0.5

0.0

1.8
BOE Index
GBP-USD
Fed Index

0.0

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BOE Index Fed Index GBP-USD

Figure 10.3 GBP-USD with bank trends.

106 HOW THE FED MOVES MARKETS

0.2 0.013 0.5

0.012
0.0

0.011 0.0

BOJ Index
Fec Index

JPY-USD

–0.2
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BOJ Index Fed Index JPY-USD

Figure 10.4 JPY-USD with bank trends.

USD, JPY, the Fed, and the BOJ

In Figure 10.4, the dotted and broken line represents the yen
(JPY) in terms of the dollar. The mood of the Bank of Japan (BOJ)
is reflected as the solid black line—the Fed’s mood by the bro-
ken line. From 2008 to 2011, the BOJ and the Fed seem to have an
inverse relationship: as the BOJ’s hawkishness peaks, the Fed is in
a dovishness dive and vice versa. This dynamic seems to have a
direct bearing on the value of the yen relative to the dollar; during
this period, for instance, every time the Fed becomes strongly dov-
ish and the BOJ more hawkish, the dollar value of the yen begins to
climb sharply. Before 2011, the Fed’s hawkish highs are still lower
than the BOJ’s, and this difference seems related to the continual
rise of the yen until the end of 2012, when the hawkishness of the
Fed causes the dollar to jump in value and, simultaneously, the
BOJ’s massive monetary stimulus devalued the yen.

CAD, USD, the Fed, and the BOC

In Figure 10.5, the broken and dotted line indicates the value
of the Canadian dollar (CAD)—also known as the loonie—in
 FOREX INVESTING 107

1.1
0.2
0.5

1.0

0.0

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BOC Index
CAD-USD
Fed Index

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BOC Index Fed Index CAD-USD

Figure 10.5 CAD-USD with bank trends.

terms of the US dollar; the solid black line is mood of the Bank of
Canada, and the broken line is the mood of the Fed. From 2009 on,
the sentiment of the two banks seems closely correlated—only sig-
nificantly decoupling in the middle of 2014 when the Fed’s hawk-
ishness abruptly climbs and the BOC’s drops. From this data, it
could be projected that the value of the loonie relative to the dol-
lar would generally steady from after the crisis until 2014, when
its value should suddenly drop. This forecast is largely vindicated
in Figure 10.5, where from the end of 2009 on the exchange rate
hovers around 0.9 from 2010 until 2014, when value of the loonie
begins to rapidly decline.

USD, CNY, AUD, the Fed, and the RBA

At first, the lumping of AUD, CNY, and USD together may seem
like an odd combination, but there is method to the madness. Of
the central banks we study, the PBoC is one of the most impor-
tant (it oversees the second largest economy in the world)—and one
of the most opaque (which is the reason that the sentiment of the
PBoC is not reflected in Figures 10.6 and 10.7). And this opacity is
 0.2 7.0

0.5
6.5
0.0

6.0
0.0

RBA Index
AUD-CNY
Fed Index

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RBA Index Fed Index AUD-CNY

Figure 10.6 AUD-CNY with bank trends.

0.2 1.1

1.0 0.5

0.0
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0.0
RBA Index
AUD-USD
Fed Index

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Figure 10.7 AUD-USD with bank trends.

 FOREX INVESTING 109

also present in the official data regarding the Chinese economy as

a whole. To work around this opacity, it becomes necessary to use
other financial institutions as a proxy to understand the Chinese
economy. This proxy, as might have been guessed, is the Reserve
Bank of Australia (RBA). Over last couple of decades, RBA move-
ments have been tied to China, and this relationship, as Bloomberg
explains, is one born from dependency:

Australia is the most China-dependent developed economy in the world,

with exports to the nation accounting for 5.3 percent of gross domestic
product, according to Commonwealth Bank of Australia, as two-way trade
reached about A$150 billion ($132 billion) in 2013. Policy makers want
to rebalance growth drivers from resources to other areas like services,
which account for 70 percent of GDP but just 17 percent of exports. (Heath
2014)

As of 2015, Australia has secured a free trade agreement with

China, so it can only be expected that this dynamic will continue
(Heath 2014)—a dynamic captured in Figures 10.6 and 10.7.
In Figures 10.6 and 10.7, the Fed is represented by a broken line
and the RBA by a solid black line. In Figure 10.6, the broken and dot-
ted line is the Australian dollar (AUD) in terms of the Chinese yuan
(CNY); in the second, the broken and dotted line is the Australian
dollar in terms of the US dollar. Since the recession, the RBA has
made a steady climb toward a more hawkish position through the
beginning of 2013. Therefore, it would be expected that the cur-
rency would appreciate in value over the same period. Against both
the USD and the CNY, the Australian dollar made significant gains
during that time span—peaking at about 1.1 USD and 7 CNY per
AUD in mid-2011 (immediately after the RBA’s peak hawkish score
of almost 1). But while it seems that the RBA has maintained its
relatively hawkish mood to keep pace with the yuan, it appears that
PBoC’s disinflationary measures have been too rapid to catch. This
development can be clearly seen from 2011 on, during which time
the gap between the yuan and the AUD has dropped by a third
(from 7 to 1 to almost 4.5 to 1). The sentiment and exchange rate
trends portrayed in Figures 10.6 and 10.7 would seem to point to
decelerating growth in the Chinese economy.
110 HOW THE FED MOVES MARKETS

It is noteworthy that in both Figures 10.6 and 10.7, the correla-

tion between the RBA’s sentiment and the exchange rates (again,
since the financial crisis) is high, and this is especially true in
Figure 10.7. The AUD–USD seems to reflect RBA (and, by exten-
sion, the Chinese economy) very closely, with sentiment peaks and
valleys mirrored in the exchange rates approximately a month later.
This steady relationship could serve as a useful indicator for future
fluctuations.
As a whole, these observations only represent the very begin-
ning of what could be learned from closer examinations of cen-
tral bank communications. As we—and others—continue to build
more effective analytical tools and dive deeper into the patterns
that emerge in the data we have already generated, the significance
of the role of central banks will more fully come into view.

* * *

While it seems clear that better understanding of central bank

sentiment affords FOREX players additional insight into market
flows, the importance of this data extends beyond currency trade.
For investors, currency dynamics play an important role through-
out the financial landscape—including equity and fixed-income
investments. Both equities and fixed income move in their native
currencies; thus, foreign currency moves play directly into equity
values. For example, if an equity is priced at 10 euros, and the dol-
lar is roughly the same value as the euro, then that equity is worth
approximately 10 dollars. But if the dollar appreciates relative to
the euro, then the equity is now priced at 9 dollars—even though
it is still worth 10 euros. This obviously translates to a tremendous
opportunity for those looking to buy with dollars—an advantage
that only increases as the scale of the transaction grows. Similarly,
currency fluctuations should be taken into account when dealing
with fixed income investments—especially when holding signifi-
cant foreign debt. If China, for instance, holds 1 trillion dollars of
US fixed income bonds purchased for 7 yuan per dollar and the
yuan begins to appreciate relative to the dollar—5 yuan now equal-
ing a dollar—China will have lost trillions of yuan. In other words,
where a trade would have earned China 7 yuan per dollar, it now
will earn 5 yuan, and that difference, multiplied by a trillion, would
 FOREX INVESTING 111

result in a loss of 2 trillion yuan. With both fixed income and equi-
ties, the more predictable currency fluctuations are for financial
professionals, the better they will be able to navigate the complexi-
ties of relative value trades in international investing.

* * *

Processing almost unfathomable sums on a daily basis through

countless split second transactions, the FOREX market stands as
one of the most complicated and influential systems on the planet.
As money is the means by which the value of goods and services
is quantified, FOREX tremors carry consequences throughout the
global economy. For many studying this space, any new insight
into the gears of this vast machine is undeniably useful. As cen-
tral banks continue to turn toward communications as a method
of influencing exchange rates, the data we have begun to produce
could not only give some additional insight into the market—
especially considering the data we generate on both sides of many
currency pairs—it could also provide a window into the biggest
drivers of currency movements.
 PART III

Global Monetary Policy:

Analyzing Central Banks
around the World
 11

ECB Sentiment: Decoding a

Complex Monetary Union

T ransparency, and the implications it has for those who study

the world of finance, is the central thread of this book. From
the origin of the Fed to the financial crisis and beyond, the last
two parts have tackled the development of this central banking
strategy, discussing the attempts that others and we have made
to interpret the wealth of text that now flows from the Federal
Reserve. But, as has been discussed in early chapters, transparency
is a trend that far exceeds American borders. Although the first
experiments in central banking transparency were the product of
the Volcker era, transparency began in earnest overseas, when, in
the mid-1980s, the Bank of England began issuing press releases.
In short, transparency has been an international movement for
several decades. Part III of this book examines the state of this
global phenomenon—an account that begins with Europe’s levia-
than, the European Central Bank (ECB).
But our account is not limited to the rise of open central bank-
ing policy around the world—the relevance of our work in textual
analysis is an additional, essential storyline to this narrative. Just
as transparency has been, in equal parts, a blessing and a chal-
lenge for Fed watchers, central bank analysts the world over are
also grappling with a mounting cascade of market-moving infor-
mation and the tremendous potential this data represents for the
financial community. We believe that these data streams can
afford more objective, quantifiable, and actionable information
than they currently do, and a sophisticated implementation of
116 HOW THE FED MOVES MARKETS

sentiment analysis might be the key to deciphering these largely

untapped texts.
Because central banks have broad influence over the entire mar-
ket, our examination will cover more than the fixed-income space
or the equity markets. This bigger picture will allow us to better
portray the breadth of influence central banks wield over the mar-
ket with their words. By virtue of engaging in such an expansive
investigation, these chapters afford an informed perspective, pre-
senting a catalogue of data on the many of the world’s biggest mar-
ket movers.
In a post-crisis world, central banks as whole—not just the Fed—
have taken on an unprecedented position of economic leadership
and market power. Fortunately, this power and position have come
hand in hand with transparency, a trending strategy that not only
frames the increasingly powerful moves central banks make but is,
in its own right, policy itself. Transparency is here to stay, and the
financial professionals that are best able to build their operations
around its impact add an essential element to their understanding
of global finance.

* * *

Born in 1957, the European Union (EU) was formed to unite

the European economy, a cohesion its founders hoped to achieve
through the creation of “ a ‘common market’ for trade” (European
Commission 2015). It wasn’t long, however, before the EU mem-
ber states realized that as powerful as the potential this vision held
was—actual realization would be a lengthy process (European
Commission 2015). As the European Commission’s official account
elaborates, “Over time it became clear that closer economic and
monetary co-operation was needed for the internal market to
develop and flourish further, and for the whole European economy
to perform better, bringing more jobs and greater prosperity for
Europe” (European Commission 2015).
Their solution? The euro. In the early 1990s the EU decided
that the missing piece was “a strong and stable currency for the
21st century” (European Commission 2015). While it would take
more than a decade for the physical manifestations of Europe’s
 ECB SENTIMENT 117

innovative currency make their way into wallets, the euro became
tradable on the markets within eight years. As the euro phased in,
the EU became united under one currency, and the eurozone was
afforded a more robust, efficient unit of exchange. The European
Commission’s own words echo these sentiments: “Single currency
makes the euro area an attractive region for third countries to
do business, thus promoting trade and investment. Prudent eco-
nomic management makes the euro an attractive reserve currency
for third countries, and gives the euro area a more powerful voice
in the global economy” (European Commission 2015). Backed by
the diversity—and strength—of the entire European market and
guided by some of the region’s best economic minds, the euro is a
currency that channels the character of a continent.
In order to develop this new currency, in 1998 the European
Monetary Institute (EMI) was replaced by the ECB. Just like the
Fed, the ECB was built to maintain a new currency. Also, just like
the Fed, politics played a constant role in creation and governance
of the ECB. For example, as the ECB took over the EMI’s role in
the late 1990s, controversy soon broke out over who should be the
new central bank’s president. As agreed upon by governors of the
national central banks, Willem F. Duisenberg, a former Dutch cen-
tral banker and head of the EMI, emerged as the first president of
the ECB. The president of France, Jacques Chirac, had different
ideas. Chirac felt that because the new central bank was located in
Germany, it would only be fair for the new central bank president
to be French. Opposing Duisenberg’s nomination, he backed Jean-
Claude Trichet—the head of the Banque de France—as ECB presi-
dent. The Netherlands, along with Belgium and Germany, wanted a
strong euro, and they felt that Duisenberg could be trusted with that
charge. As the conflict mounted—especially between Chirac and
Helmut Kohl, the German Chancellor—an unofficial agreement
was struck: at some time during his eight-year term, Duisenberg
would step down and allow Trichet step in—which he did in 2003.
Beyond demonstrating the integral part politics played in the birth
of this central bank, the incident also offers valuable insight into
challenges that attend the management of the ECB: in addition
to the challenges that all central banks face, the ECB is charged
with the unenviable task of navigating the numerous historical,
118 HOW THE FED MOVES MARKETS

cultural, and economic intricacies of a continent (Centre Virtuel de

la Connaissance sur l’Europe 2012).

* * *

The ECB is managed by the Governing Council, which is com-

prised of the presidents of the central banks of each of the EU mem-
ber states and an Executive Board. Each state gets one representative
on the Council, but the president, vice president, and the Executive
Board members do not go toward this count. For instance, Mario
Draghi was the Bank of Italy’s president, but because Draghi is
the ECB’s current president, Italy has an additional Council mem-
ber: Ignazio Visco. As of 2015, 6 Executive Board members and 19
representatives from the other central banks in the EU populate
the council. Like in the Fed, the Executive Board members have
more direct influence over monetary policy than do the 19 repre-
sentatives. The guiding hand behind the eurozone’s economy, this
Council discusses and implements new monetary policy and sets
the rates at which financial institutions can borrow money from
the central bank (European Central Bank 2015a).
Interestingly, the ECB shares some structural similarities with
private companies. For instance, shares in the central bank can be
purchased; ECB stock, however, can only be purchased by states.
The total value of the ECB’s capital stock is 10.8 billion euros, and
national central banks both within and outside the EU own stock
in the ECB. Of this, the majority is owned by euro nations, some
nations owning more than others—Germany owns almost 18 per-
cent of the stock and France owns just over 14 percent. These own-
ership percentages are fixed, as the stock in the ECB is meant to
reflect each nation’s position in the euro area. The population and
economic production of each member state relative to the entire
area, weighted in equal parts, are what determine this percentage.
For example, if a country’s gross domestic product (GDP) and total
population represented, respectively, 30 and 20 percent of the euro
area, then that country would be allowed to maintain a 25 percent
ownership of the ECB’s capital stock. This policy insures that the
ECB is truly representative of the economic and social realities of
the region it serves and that the central bank is secured from “polit-
ical influence” (Deutsche Bundesbank 2014).
 ECB SENTIMENT 119

While the Fed has its dual mandate to keep inflation low and
employment at a maximum, the ECB (like most other central banks)
only has one primary objective: to maintain price stability. Price sta-
bility, in terms of the ECB’s charge, is defined as euro inflation rates
that approach, but do not exceed, 2 percent (a target that is likely
more politically than economically motivated). The ECB relies on
what they call refinancing operations—main refinancing opera-
tions (MROs) and long-term refinancing operations (LTROs)—to
achieve this stability. The monetary levers the ECB manipulates to
accomplish its ends are quite similar to some of those that the Fed
employs to guide the US economy: the main refinancing rate, that
will be touched on now, and the marginal lending rate, that will be
discussed later, that power MROs are much like the Fed funds rate
and the Fed discount window, respectively.
The ECB regularly conducts MROs in order to, according the
ECB, “steer short-term interest rates, to manage the liquidity situ-
ation and to signal the monetary policy stance in the euro area”
(European Central Bank 2015b). In an MRO, the ECB allots capital
in an auction where banks compete for the short-term loans, and
those banks offer higher rates receive funds until the total amount
offered for auction is exhausted. Through its own analysis of mar-
ket conditions, the ECB determines the amount it should offer up
in these auctions. The ECB executes LTROs as a complement to
its MROs, by providing “additional, longer-term refinancing to
the financial sector” (European Central Bank 2015b). While MRO
loans come in two-week and one-month terms, LTRO loans range
from three months to three years (Financial Times 2015b). By alter-
ing the supply of capital to banks, the ECB uses these loans affect
interest rates and liquidity, while simultaneously communicating
the economic aims of the ECB.

* * *

The ECB has been active in the aftermath of the global financial
crisis, cutting interest rates by injecting an unprecedented amount
of capital into the system in an effort to push the euro market out of
the recession. After a short stint of interest rate hikes in 2011—the
first since 2008—the ECB began to dramatically cut rates in the fol-
lowing years. From 2012 to 2013 the ECB sharply lowered interest
120 HOW THE FED MOVES MARKETS

rates to encourage economic growth, reaching the historically low

0.25 percent in November 2013. Historic as that rate was, the bar
would continue to drop. Soon after the rates were cut to 0.15 percent,
and then, in September of 2014 the central bank reduced the rates
by two-thirds from 0.15 percent to 0.05 percent, the lowest rates on
record—one that the ECB has held since as of this writing.
To accomplish its record-setting interest rates, the ECB has
expanded the tools in its policymaking toolbox. Usually, MROs,
like those mentioned above, offer a limited amount of capital to
competing financial institutions, but the depth of the crisis has
required unusual tactics: to increase liquidity depleted by the
subprime mortgage crisis, the ECB lowered interest rates to lev-
els before unseen in the euro area and provided substantial credit
support through the Securities Markets Programme (European
Central Bank 2010).
This diffused tension in several markets, the money market
included. As such, since October 2008, the ECB has conducted
several MROs on a fixed basis where amounts are fully allotted
at a fixed interest rate—the marginal lending rate. The additional
funds provided via the marginal lending rate by the ECB come at a
higher interest rate than what is available in the interbank market,
but it allows financial firms to overcome problems engendered by
scarce liquidity without facing the high costs associated with near
or full insolvency.
Most recently, even these generous liquidity injections haven’t
served to stir a sluggish European economy out of the doldrums,
and the central bank has moved to take even more direct, dramatic
action. Lifting a play straight from the Fed’s game plan, the ECB
has embracing quantitative easing (QE) as part of their continued
rescue efforts. In early 2015, the ECB began implementing the 1 tril-
lion dollar initiative, but even before the policy’s tires met the road,
the announcement of the plan sent stock markets into ecstasy, pro-
pelling the FTSEurofirst 300, an index of the 300 largest European
companies ranked by market cap, to its highest close since before
the financial crisis (Robinson 2015).
The primary objective of the recent QE initiative is to combat a
disinflationary euro by pushing inflation back up to near 2 percent
to catalyze consumption. The trillion euro prescription will come
 ECB SENTIMENT 121

in monthly injections of 60 billion euros until the fall of 2016, each

wave set to buy up swathes of troubled sovereign debt (Buttonwood
2015). Initial signs, beyond the announcement excitement, are
positive: “Growth forecasts have been continually revised up since
January when the program was announced: the International
Monetary Fund said this week it now expects the eurozone to grow
by 1.5% in 2015. Business and consumer confidence are the highest
since 2007. Bank lending is finally picking up” (Nixon 2015).

* * *

It’s important to note that the reason the ECB has taken so long
to implement QE measures is due to particular scope of the cen-
tral bank’s powers. When it comes to open market operations,
the ECB’s toolbox is—compared to banks like the Fed—limited.
Consequently, the legality of the asset purchasing needed to imple-
ment QE was unclear, and, because of this, the ECB has had to inch
toward these policies.

* * *

Along with groundbreaking and sweeping monetary policy,

transparency is another staple of a post-crisis ECB. In no uncer-
tain terms, Mario Draghi has recently asserted the centrality—and
continued expansion—of the role of open communication in the
central bank’s ongoing strategy:

More recently, we have decided to go one step further and to publish regular
accounts of Governing Council monetary policy discussions, starting with
the meeting on 21–22 January 2015, the account of which was published
last Thursday. Through these accounts, we are enriching the communica-
tion of the rationale behind our monetary policy decisions and seek to give
a sense of the discussion that has taken place among Governing Council
members and the main arguments that were exchanged. We believe that
this will enable members of the public and markets to improve their under-
standing of our assessment of the economy and our policy responses in the
light of evolving conditions, our so-called “reaction function.” In the cur-
rent circumstances, it will also underpin our forward guidance on interest
rates. It will thereby further enhance the effectiveness of our monetary
policy. (Draghi 2015)
122 HOW THE FED MOVES MARKETS

Given the history of market reaction to central banking communi-

cations—the stock market reaction to the QE announcement being
just one example—European central bankers are looking to lever-
age transparency as tool to bolster the other elements of their mon-
etary policy.
This development is especially significant given the power the
ECB wields. In fact, the singularly prominent position the ECB
holds in the eurozone (collectively the largest economy in the world)
gives their word more impact on the economy it oversees than, per-
haps, any other central bank outside of the Fed. This power is, in
part, the product of the nature of the currency it commands. As the
guardian of the euro, the ECB holds the keys to the currency that
to unite the European market and, therefore, is the salient force
behind the financial fate of the continent.
But the ECB’s authority extends far beyond the European econ-
omy. If, for example, the ECB decides to pursue inflationary pol-
icy, devaluing the euro in relation to outside currencies, it becomes
less expensive for foreign buyers to purchase European goods and
services because their dollar, yen, yuan, etc., go further—and it
simultaneously becomes more costly for Europeans to buy outside
their market. If the converse is true, and the ECB enacts disinfla-
tionary monetary policy, then eurozone goods become compara-
tively more expensive—dissuading exports—while the stronger
euro makes foreign goods cheaper—encouraging imports. Thus,
the ECB has a broad influence on the both economy of the EU
member states—which have total population exceeding 330 mil-
lion (US Census Bureau 2014; European Union 2015)—and the
economies of any other nation that would aspire to do business
within the eurozone.

* * *

That said, how does the data bear out this influence? Capturing
the ten-year bond yield and our sentiment data on the ECB,
Figure 11.1 provides an illustration of the effect ECB communica-
tions have on the European fixed-income markets.
In Figure 11.1, the ten-year bond yield is portrayed in dots and
dashes, and the ECB Index is represented by the broken line. The
 ECB SENTIMENT 123

220

240 0.0
210
S&P EZ 7-10yr Index

S&P EZ 1-3yr Index

220 200
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190

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09

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ECB Index S&P EZ 7-10yr Index S&P EZ 1-3yr Index

Figure 11.1 ECB Index and the ECB ten-year bond yield.

ECB’s sentiment and fixed income do seem to share a correlation—

but an inverse correlation. As the central bank’s sentiment trends
upwards from dovish to neutral, the bold yield declines, and each
data stream seems to hit its high just as the other hits its low. The
end of 2011 to the beginning of 2014 is a particularly illustrative of
this inverse relationship: late 2011-to-early 2011 sees the ECB Index
trend rise sharply, and this spike is inversely manifested in the bond
yield’s steep downward shift; 2013 sees both trends reverse simulta-
neously, culminating in an intersection that occurs late in the year.
This mirroring dynamic suggests that there could be a causal rela-
tionship between the central bank’s economic position and the fixed
income market, and this relationship could be used by financial pro-
fessionals as an indicator for market development—an upward trend
in the ECB Index would seem to suggest an incoming downward
movement in the ten-year bond yield—and could also be indicative
of movements in the fixed-income market as a whole.
In the fixed income markets, the ECB’s mood does seem to have
a recognizable effect on market outcomes. Given these promising
results, further investigations leveraging the insight afforded by
124 HOW THE FED MOVES MARKETS

our methodology could certainly help shed additional light on the

complex fluctuations in the eurozone economy.

* * *

As the ECB’s mood seems to illuminate aspects of fixed-income

market activity, perhaps a similar relationship can be found between
the ECB Index and the European equity markets. As Figure 11.2
demonstrates, the ECB’s mood clearly impacts equity markets.
In Figure 11.2, the S&P Euro 350 is represented by the broken
and dotted line, the Euro STOXX 50 by the broken line, and the
ECB Index by the solid black line. The movements of the ECB
Index—while more volatile than the market—share a predictive
relationship with the indexes, climbing and diving with market
fluctuations. For instance, market highs like those seen in mid-
2011, late 2013 and mid-2014 are consistently correlated with or
anticipated by Index peaks, demonstrating the utility of central
bank communications as an indicator of market developments.
This notable relationship seems perfectly reasonable once the
nature of ECB communications and open market activity is con-
sidered. If, for example, the ECB communications begin trending

0.2
1400
12
1300
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11
1200
DJ Euro Stoxx 50

S&PEU 350

ECB Index

–0.2
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1000
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900

8
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09

09

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ECB Index DJ Euro Stoxx 50 S&PEU 350

Figure 11.2 ECB Index and European equities indexes.

 ECB SENTIMENT 125

more hawkish, two signals are sent to market actors. The first signal
is that inflation is on the rise—a trend that usually signals acceler-
ated economic growth. A firm will use this first signal to react to
increasing inflation, which may include capitalizing on the increase
or preventing losses due to the increase, depending on the firm’s
strategy and risk tolerance. This could be a reason why we still see
market growth after hawkish statements. The second signal is that
the ECB may soon contract the money supply to stymie inflation. A
firm will react to this signal separately—ECB action contracting the
money supply may induce divestment from equity, and investment
in currency hedged assets as the euro begins to appreciate. This pol-
icy implementation is likely why the market contracts within a four-
to six-month window after the communication. The question in the
second case is, then, if or when the ECB will actually take action,
and the ECB Index can serve as a leading indicator of these future
actions. The sentiment indicator discriminates between degrees of
hawkishness—as the index becomes more extreme, action will be
imminent or more severe. This same dynamic works in the opposite
order for dovish policy. This means ECB communications can be
expected to have a predictive relationship with the equity market,
and these expectations, like many others that have been discussed
in this book, seem to be vindicated by the data.

* * *

While a relatively new player on the global stage, the ECB is an

unquestioned leader among its peers, because what the ECB lacks
in legacy it makes up for in power. Its authority over the euro—
the money that unifies a population and economy larger than that
of the United States—grants the ECB this clear sway (and say) in
this robust and diverse economy and, by connection, the rest of
the world. As it has been with the Fed, this authority finds itself
increasingly expressed through communications, and, as it also
was with the Fed, these (escalating) developments suggest the need
for hard data on the role ECB communications play in financial
markets. Utilizing our proprietary method of sentiment analysis,
we have been able to generate this hard data on the market-mov-
ing behemoth, producing a quantitative analysis of ECB texts that
could serve as the standard for central bank watching in Europe,
just as it does in the United States.
 12

BOE Sentiment: The Origin

of Modern Central Bank
Communications

B anking history is, as a rule, not the most commonly researched

topic, but even a casual investigation reveals that central bank-
ing has a long tradition maintaining financial stability, and the Bank
of England (BOE) stands as exhibit A to that point. Chartered in
1694, the BOE is one of the oldest central banks on earth, and this
established institution has, like many central banks, only gained
authority and economic prominence over its reign. This chapter
begins by looking into the long history of one of the first central
banks in the world, tracing the evolution of an institution—from
monetary lightweight to undisputed powerhouse—that helped
build an empire. Like with the Fed and the ECB, the BOE’s rise
to financial authority has been followed by an equally significant
measure of transparency, and it is this thread, as in other chapters,
that is examined the most in this one. In its entire history, the
BOE has never looked so lively—or been so vocal—a simultaneous
development that makes what the central bank has to say more
consequential than ever before.

* * *

The history of any central bank is ultimately tied to the history

of its currency. Federal Reserve notes were born with the Federal
Reserve System. The European Central Bank was created to over-
see the fledgling euro. Almost any account of a central bank is
128 HOW THE FED MOVES MARKETS

incomplete without first examining the story of the money with

which it keeps account, and, therefore, our introduction to BOE
doesn’t begin with buildings or bricks; it begins with pounds.
The pound gets its name from a very logical source: its weight. In
the ancient Anglo-Saxon world—over 1,200 years ago—silver coins,
later known as “sterlings,” were the common money (Dawnay 2001).
Two hundred and forty sterlings weighed a pound, and the measure-
ment became an easy title for what is now the world’s oldest active
currency (Dawnay 2001; Rendall 2007). Almost 1,000 years later
the BOE was established to help manage the pound, produce bank-
notes (guarantees used for money and backed by precious metals),
and finance England’s war against France (Dawnay 2001). While
certainly wielding significant monetary authority, the central bank
did not, at first, have a monopoly on currency production; banks in
Ireland, Scotland, and Wales also had the legal authority to produce
paper money, and it would be more than 100 years before the BOE
became the exclusive producer and guardian of English money
(Dawnay 2001). The Bank Charter Act in 1844 made the BOE the
sole monetary authority in the United Kingdom and established
firm standards for the currency that the central bank would now
have exclusive power over. Backing every note with gold, the BOE
would maintain the integrity of the pound, guard the gold reserves,
and be the lender of last resort for banks in trouble. What followed
was a period of remarkable prosperity for England, as the strength of
the currency powered the golden hue of Victorian England’s global
reach (Dawnay 2001). But the expenses of World War I saw the gold
standard wobble, and, by the early 1930s, England fully abandoned
it (Dawnay 2001). Even though the pound was listed alongside dol-
lar as a reserve currency by the Bretton Woods Agreement, by that
time it was clear that the currency’s best years were behind it—the
title of “reserve currency” was more of a political gesture than an
actual indication of economic reality.

* * *

Today, the BOE and its operations are managed by an Executive

Team and several committees. The Executive Team, which serves
as the most powerful guiding hand in the institution, is composed
of a governor, four deputy governors, a chief operating officer,
 BOE SENTIMENT 129

and a crew of executive directors. The deputy governors are each

assigned specific charges that account for the majority of the
BOE’s mandated tasks: there are deputy governors for Monetary
Policy, Markets and Banking, Financial Stability, and Prudential
Regulation Authority. The deputy governors work hand in hand
with the governor, who oversees—and is responsible for—the prog-
ress of the entire bank. While attending to these fundamental BOE
duties, the governors are the bank’s ambassadors, speaking on a
wide variety of economic issues before local and global audiences
(Bank of England 2015). Interestingly, the BOE has a longstanding
tradition of having a foreigner serve as one of the deputy governors
to insure legitimacy—a practice which has its roots in the pound’s
former place as a global reserve currency. Responsible for the man-
agement of human resources, IT, and security, the COO directs the
operational essentials of the BOE, while the executive directors, the
final part of the Executive team, head up communications, human
resources, finance, and the many other departments integral to a
modern central bank.
The BOE has four important committees—the Court, the
Monetary Policy Committee, the Financial Policy Committee, and
the Prudential Regulation Authority—and the governor of BOE is
integral member of all these committees. The Court, which is the
BOE’s board of directors, is responsible for all the bank’s operations
outside of monetary policy, handling matters like the budget, risk
management policies, and the bank’s objectives (Bank of England
2015). The Monetary Policy Committee determines and sets inter-
est rates to reach the BOE’s inflation targets; the Financial Policy
Committee works to strengthen the United Kingdom’s economy
by targeting and eliminating risk in the financial system; and
the Prudential Regulation Authority—much like the FDIC in the
United States—oversees and regulates banking (Bank of England
2015). Together, these committees help protect the British financial
system through the implementation of calculated measures to cul-
tivate growth and mitigate economic crises.

* * *

When it was founded 1694, the BOE was charged to “promote

the public good and benefit of our people” and its current statement
130 HOW THE FED MOVES MARKETS

of purpose—“to promote the good of the people of the United

Kingdom by maintaining monetary and financial stability”—is
not, as the BOE has noted, all that different from the motto that
christened it over 300 years ago (Bank of England 2015). The BOE
cultivates financial stability by maintaining the efficient flow of
funds in the economy and upholding the public’s confidence in
their financial institutions, and it pursues these ends through its
standard financial operations, oversight of financial market infra-
structures (FMIs), and management of its major committees. A
standard duty of any central bank is to support the market by oper-
ating as a lender of last resort. By offering loans to banks that can-
not meet the demands of depositors or their reserve requirements,
the BOE backs not only these important institutions but their cus-
tomers as well, bolstering the pillars of the financial system. Along
with securing these economic moorings, the BOE also monitors
the mechanisms of trade. FMIs, like payment and securities set-
tlement systems, are integral to the smooth movement of money
through the economy. To insure that these systems are running
properly with the appropriate attention to risk management, espe-
cially in regards to the wider scope of the entire financial system,
the BOE closely supervises their operation (Bank of England 2015).
Committed to combating the numerous dangers that plague eco-
nomic enterprise, the Financial Policy Committee (FPC) has been
“given tough powers to tame systemic risk by clamping down on
loose credit, overheated sectors and previously unregulated parts
of the financial system” (Bank of England 2015). The final piece
of this arsenal, the Prudential Regulations Authority, compliments
the FPC’s oversight of the Financial Market Infrastructures with its
supervision of over 1,500 financial institutions like banks, credit
unions, and investment firms (Bank of England 2015). Through its
thorough vetting of fundamental market mechanics and its power
to extend emergency financing, the BOE is the watchdog of the
United Kingdom’s economic stability.
To accomplish its charge of monetary stability, the BOE seeks
to maintain both price stability and confidence in its currency,
and the bank attempts to fulfill both through the careful control
of the inflation rate. This rate, which has been set by the govern-
ment, is 2 percent—a target chosen because it is believed to avoid
 BOE SENTIMENT 131

the overheating that excess inflation can cause while providing a

cushion from the economic stagnation that can come from a defla-
tionary currency. The 2 percent rate, in other words, is thought to
keep inflation low enough to maintain consumer confidence in the
pound as a useful means of trade and wealth preservation, while,
at the same time, to be depreciative enough to stimulate the pur-
chase of goods and services and catalyze economic growth. While
the relatively straightforward thinking behind inflation targeting
seems sound, the unpredictability and complexity of the global
economy cast strong doubt on whether such policies can deliver
on their stated goals (Schnidman 2012). In reality, such targets are
more political moves than actual policy.

* * *

By attempting to encouraging economic growth—bolstering

trade and employment—and maintaining price stability, the BOE’s
objectives are reminiscent (though less explicit) of the Fed’s own
dual mandate, and the BOE’s most recent initiatives also run par-
allel to the US central bank. In early 2009, the BOE began its own
round of quantitative easing because interest rates were already low,
and the central bank needed another means of hitting their goal
of 2 percent inflation. In order to support these novel initiatives,
the BOE has made a concerted effort to use forward guidance to
improve the lines of communication between itself and the public.
This resurgence in the central bank’s commitment to transparency
could give the impression that open communication is a recent
development BOE, but nothing could be further from the truth. In
fact, the BOE, as was mentioned with an earlier chapter, was actu-
ally among the first to incorporate this strategy into its operations:

Before it was fashionable, the Bank of England (Bank) was an early pio-
neer in the pursuit of transparency. In 1993, the institution became the
first among its peers to publish an inflation report. The Bank renewed its
transparency efforts after it was granted operational independence from
Her Majesty’s Government in 1997. The newly created Monetary Policy
Committee (MPC) was determined to build a strong public constituency
in support of its price stability mandate. In the aftermath of the global
financial crisis, the Bank’s policies and practices were subjected to even
132 HOW THE FED MOVES MARKETS

greater scrutiny, not least in the realm of transparency. In its 2014 Strategic
Plan, the Bank reaffirmed its commitment to openness and accountability,
and expressed its aspiration to enhance its transparency further. (Warsh
2014)

Just as it is the case with Federal Reserve and the European Central
Bank, transparency has become a critical asset for the BOE as it
attempts to handle the economic challenges and criticisms that have
accompanied its decisions—especially since the crisis. As empha-
sized by the passage above, this openness has been especially inte-
gral to the BOE’s price goals as the institution attempts to mitigate
misinterpretation and, therefore, negative outcomes by informing
the public of underlying strategy of economic balance. Since July of
2012, the BOE has ceased quantitative easing (QE) asset purchasing,
and, by that time, the BOE had injected more QE funds per capita
than any other central bank in the world through the financial cri-
sis. The BOE has continued to aggressively implement monetary
stimulus in their policy, and forward guidance has remained firmly
in place as a powerful tool of policy to shape public perception and
implement these vital initiatives.

* * *

These developments make the BOE an ideal candidate for our

proprietary method of sentiment analysis. Because the BOE was
a pioneer of transparency, we have access to a much larger set of
documents than we do with most central banks, and this abun-
dance of material affords our analytical program with the breadth
of history needed for it to achieve a higher level of scoring accuracy.
This long history of open communication also means that the BOE
itself has had more time to hone its reporting practices, making
them more likely to utilize a carefully curated vocabulary when
explaining their economic aims. This also directly affects the qual-
ity of the signal our interpretive methods are able to produce: the
more consistent any central bank is with its terminology, the more
reliable our scoring becomes.
While transparency has certainly had a significant history in
the BOE, in the greater picture, the central bank is treading into
uncharted economic territory. The coupling of incredibly low
 BOE SENTIMENT 133

interest rates with equally low inflation rates along with the BOE’s
relatively recent use of QE and increasing emphasis on forward
guidance have, altogether, created a brave new world of finance
in Britain. These developments have changed the game for finan-
cial analysts, who can no longer draw upon familiar resources to
inform their projections (Peters 2014). All this means that financial
professionals with a vested interest in the UK market are in need of
new signals anchored in these recent developments—developments
that are increasingly involved with central bank policies.

* * *

But can analytics on BOE communications really offer insight

into the UK economy? Our sentiment data on the central bank
serves affords a means appraisal. Figure 12.1 lays the BOE Index
alongside the indexes of the Financial Times Stock Exchange and
the NASDAQ, demonstrating the relationship between BOE com-
munications and the equities market.
If BOE communications are, in part, responsible for market
fluctuations, how can this dynamic be expected to play out? If, for

7000
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Figure 12.1 BOE Index, FTSE 100, and NASDAQ.

134 HOW THE FED MOVES MARKETS

example, a BOE communication reflects a hawkish mood—indi-

cating the incoming implementation of contractionary monetary
policy—it could be expected that in the immediate to near future
equity markets would rise and then, as the wheels of policy take
effect, begin to fall. The markets—or at least those segments influ-
enced by watchful market actors—could be predicted to rise after a
hawkish communication because a hawkish stance is indicative of
a growing economy and an inflationary currency, and some market
actors, in light of these circumstances, would likely want to trans-
fer their asset holdings from currency hedged assets to domestic
equities to ride the market expansion. As contractionary monetary
policy begins to be implemented, however, currency begins to gain
value relative to other assets and the opposite strategy becomes pref-
erable; holders of domestic equity might want to sell these assets in
order to gain from the ensuing spike in the value of money, nega-
tively impacting the performance of the stock market.
In Figure 12.1, the BOE Index is the solid black line; the NASDAQ
is the broken line; and the Financial Times Stock Exchange 100
Index (FTSE) is the broken and dotted line. (Despite the fact that
Britain is a technologically advanced economy, it doesn’t have a sub-
stantial tech index; however, the close ties between British and US
economies make the NASDAQ a useful proxy). Upon review of the
figure, the expected relationship between BOE sentiment and the
market performance seems to play out. In almost every instance,
a peak in the BOE Index (indicating a strong market and a weak
currency) is shortly followed by an uptick in market performance
and, within a three-to-six-month time horizon, a dip, as market
actors shift strategies in response to monetary contraction. This
same relationship is seen, as might also be expected, as the BOE
trends dovish. Sentiment declines are predictive of market dives—
and later gains.
It may seem odd at first that the NASDAQ and the BOE Index
are correlated just as the FTSE and the BOE Index are, but upon
deeper reflection, this dynamic seems justified. Because (as was
mentioned above) the British and US economies are tightly linked,
the fact that the NASDAQ also seems to share a relationship with
BOE dispatches shouldn’t come as a surprise. In fact, this could
also be in part due to an interaction between the communications
 BOE SENTIMENT 135

of the banks themselves. Still, this only underscores how useful the
BOE Index can be when predicting changes in the equities mar-
ket—especially when combined with other sources of sentiment
data, such as the Fed Index.

* * *

To further test the effectiveness of the BOE Index, we ran a back-

test using the data as the sole trade indicator for an entirely equity
portfolio. As a means of comparison, we have set the BOE Index-
driven portfolio alongside a control: a buy-and-hold portfolio com-
prised of identical assets.
In Figure 12.2, the BOE Index-managed portfolio is represented
by the solid black line; the buy-and-hold portfolio is represented
by the broken line. Like earlier backtests, our trading decisions are
informed by momentum-based strategy with thresholds adjusted
to suit the particular history of the central bank communication

200
Portfolio Value in Millions

150

100

Jan 01 2004 Jul 01 2005 Jan 01 2007 Jul 01 2008 Jan 01 2010 Jul 01 2011 Jan 01 2013 Jul 01 2014

BOE Index Backtest Buy-and-Hold

Figure 12.2 BOE Index portfolio against buy-and-hold.

136 HOW THE FED MOVES MARKETS

trends in use. In this case, momentum changes at or above the

70th percentile would prompt a long trading move and momen-
tum changes at or below the 40th percentile would prompt a short
trading move. Beginning with an initial value of 100,000 dollars
in 2004, the BOE index-managed portfolio landed at a final value
of 208,161 dollars in 2014. This final value represents a remark-
able return over the buy-and-hold portfolio, outperforming the
control by 61 percent. Furthermore, the risk-adjusted returns dem-
onstrate a sharp ratio of 2.289. The BOE Index’s superiority over
buy-and-hold is particularly evident from 2008 to 2010, when the
sentiment-driven portfolio hits highs—overcoming the financial
crisis—while the buy-and-hold portfolio plummets. This indicates
that portfolios that the BOE Index can not only generate significant
investment gains in growing market, but also withstand (and even
perform) in the harshest of economic conditions.

* * *

Both in theory and in practice, the connection between the

BOE’s words and the economy that it serves is significant. As the
BOE takes on an even greater position of market leadership and
continues to push toward higher levels of frank discourse about
its monetary policy, it can only be expected that this impact will
continue to grow. For financial professionals, academics, or anyone
looking to understand the economy, this development has made
it imperative that they get a handle on the burgeoning role BOE
communications play. By providing quantitative data on these texts
bolstered by the bank’s history of transparency, our methodology
can help unlock the world’s oldest central bank for today’s forward-
thinking finance minds.
 13

BOJ Sentiment: Monetary

Clues in Lost Decades

J apan and industry are almost synonymous. Home to Toyota,

Mitsubishi, Honda, and Hitachi, Japan’s list of major companies
seems almost endless. And so does the nation’s commitment to
work: so many Japanese have died from their workload that the
tragic circumstance has been given its own word. While the level
of dedication shown by some of its workforce is almost unfath-
omable, what is very concrete is the country’s place in the global
market: the tiny island nation is home to the world’s third largest
national economy. As familiar as it may be today, Japan was cer-
tainly not always the economic powerhouse it is today. In a historic
economic achievement that can, perhaps, only be described as
miraculous, over hundred years ago, over the course of a handful
of decades, Japan transformed its insular, fledgling market—one
far outpaced by much of the developed world—into an undisputed
engine of production.
The push that accelerated the Japanese economy also birthed
the institution that now leads it: the Bank of Japan (BOJ). Like so
many of the economies this book has investigated, Japan’s is guided
by the watchful hand and careful words of its central bank, and
the main thrust of this chapter is an exploration of its mechanisms
of monetary manipulation—with emphasis, of course, on the role
its communications play. Serving as a trusted voice over almost
two decades of economic struggle, BOJ communications deserve
a dedicated investigation. Leveraging the same methodology we
have used to examine the market-moving texts of the Fed, the ECB,
and the BOE, this chapter subjects the BOJ’s communication to the
138 HOW THE FED MOVES MARKETS

same scrutiny to discover if its language holds the same signifi-

cance for financial professionals.

* * *

In 1882, the BOJ was established as part of the nationwide push

towards modernization. The BOJ, which is called the “Nippon
Ginko” in Japanese (“Nichigin” for short), is primarily overseen by
the Policy Board. The Policy Board has nine members—the governor,
currently Haruhiko Kuroda (2013–present), two deputy governors,
and six additional members—and is the highest decision-making
body in the Nichigin. The Policy Board “determines the guideline
for currency and monetary control, sets the basic principles for car-
rying out the Bank’s operations, and oversees the fulfillment of the
duties of the Bank’s officers, excluding Auditors and Counsellors”
(Bank of Japan 2015). To assist the governors, the BOJ has six exec-
utive directors that are charged with handling the business opera-
tions of the BOJ and, along with the deputy governors, overseeing
the Management and Compliance Committees. The Management
Committee examines, contains, and solves bank-wide issues, and
the Compliance Committee insures that Nichigin officers operate
with due respect to relevant laws and regulations. Like the ECB, the
BOJ issues stock, 55 percent of which is required to be government
owned—the rest, unlike the ECB, can be privately held and is traded
publicly on the JASDAQ (The Bank of Japan Act 2007). Like most
central banks, the BOJ attends to a laundry list of economic chores:
it issues and manages bank notes; it provides settlement services;
it compiles data, research, and economic analysis; and it insures
the stability of the financial system through the implementation of
monetary policy. As it currently stands, the BOJ is one of the most
organized and progressive central banks on earth—a truly remark-
able status given that when it was established, Japan was only just
breaking free of feudalism and lagged far behind the political and
industrial progress seen in the West.

* * *

In 1854, the Japanese economy was first fully opened to West-

ern commerce by the Tokugawa Shogunate—the final military
 BOJ SENTIMENT 139

government of feudal Japan—and education was an integral part

of this transformative process. Sending students to the United
States and other Western universities, Japan imported the thought
capital—along with the weapons, technologies, culture, and life-
style—of the Western world. The introduction of modern methods
into the long insulated empire revolutionized their economy, rock-
eting into the nation into industrialism. It seems fitting that was
during this period of rapid growth and modernization, a period
referred to as the Meiji Restoration, that the BOJ was founded.
As a military power and machine of production, Japan continued
its aggressive expansion until World War II. The unprecedented
violence that this global conflict produced leveled Japanese cities,
killed hundreds of thousands of citizens, and crippled its economic
productive capacity. After the war was lost in 1945, the United
States occupied the nation until 1952, during which time the Diet,
the Japanese legislature, was established. This period of intense
rebuilding—an effort that was significantly bolstered by US aid—
allowed Japanese economy to regain traction and grow throughout
the following decades. Japan was becoming an economic power-
house, and their success had made them the envy of West.
This ascension was formally recognized by their participation
in 1985’s Plaza Accord. During the first half of the Reagan admin-
istration, Volker’s stagflation fighting monetary policy had caused
the dollar to appreciate dramatically against the Deutsche mark,
the French franc, the British pound, and the Japanese yen (Brook,
Sedillot and Ollivaud 2004). While a strong dollar has some upsides,
this development had hurt the performance of American industry
globally, and a meeting was arranged among important global
economies. After the wreckage of World War II, Japan’s inclusion
in this process was a clear signal that the island nation had become
a vital global market player.

* * *

In the 1990s, in a period known as the Lost Decade, Japan’s

economy nearly collapsed due to a bevy of financial issues—not
the least of were morbidly overvalued assets—and the nation
continued to struggle well into the 2000s. On the heels of 2011’s
Tōhoku earthquake and tsunami—a devastating pair of disasters
140 HOW THE FED MOVES MARKETS

that rocked Japan and cost tens of thousands of lives and hundreds
of billions of dollars—the BOJ was called upon by the Japanese
government to be part of a sweeping vision to revitalize a strug-
gling nation (Ishiguro and Kitamura 2011). Abenomics, as the plan
was referred to, was
the name given to a suite of measures introduced by Japanese prime minis-
ter Shinzo Abe after his December 2012 re-election to the post he last held
in 2007. His aim was to revive the sluggish economy with “three arrows”: a
massive fiscal stimulus, more aggressive monetary easing from the Bank of
Japan, and structural reforms to boost Japan’s competitiveness. (Financial
Times 2015a)

As an integral part of this latest suite of economic measures, the

Nichigin is obviously moving toward inflationary monetary policy,
and quantitative easing, like every central bank discussed in this
book up to this point, has become an essential tool for the BOJ.
Initiated in 2015, the BOJ will increase its balance sheet by 15 per-
cent of Japan’s gross domestic product (GDP) per year and extend
the average duration of bank purchases from 7 to 10 years. This
aggressive employment of quantitative easing (QE) will continue to
make the Nichigin the largest central bank, in terms of assets as a
percentage of GDP, in the world.
These bold steps demonstrate the BOJ’s serious commitment to
fighting deflation—an unusual commitment in the world of central
banking, where most institutions battle inflation instead. Regardless
of its atypical nature, this effort, along with price stability, has become
an essential rallying point for the central bank. But QE is not the
only emergent trend in the BOJ’s policy strategy. Transparency, one
of the bank’s two guiding principles since 1997, is also a vital facet
of the modern BOJ (Bank of Japan 2015). Open communication, the
BOJ’s website explains, has become the essential means by which the
bank maintains its independence and power:

Regarding monetary policy, Article 3, paragraph 1 of the Bank of Japan

Act stipulates that the Bank’s autonomy regarding currency and monetary
control shall be respected. On the other hand, considering the influence
of monetary policy on the daily lives of the public, Article 3, paragraph
2 of the Act stipulates that the Bank shall endeavor to clarify to the cit-
izen the content of its decisions, as well as its decision-making process,
 BOJ SENTIMENT 141

regarding currency and monetary control. (Institute for Monetary and

Economic Studies of the Bank of Japan 2004)

In accordance with their commitment to transparency, the BOJ

regularly publishes a variety of texts on their monetary policy activ-
ities, releasing their meeting minutes, monetary policy goals, eco-
nomic reviews, and various other communications to insure that
the public is given a solid understanding of Nichigin policy and
the conclusions that drive it (Institute for Monetary and Economic
Studies of the Bank of Japan 2004). While in past years the stan-
dard policy lever was interest rates, the BOJ now finds itself turning
to communication and alternative policy. As is the case with many
central banks, these communications are the product of a wealth
of economic data and informed opinion. Consequently, these texts
are a source of considerable insight into market developments—
one whose relevance continues to grow. Considering the country’s
25-year economic drought and the increasingly complex and pow-
erful monetary policy that has been put in place to deal with it,
a strong handle on BOJ communications would likely to become
an increasingly valuable asset to financial professionals looking for
direction in a discouraging landscape.
If the Nichigin, like other major central banks, employs com-
munication as multilayered tool of monetary policy—providing
insight into the market and their incoming measures while simul-
taneously shaping the market it diagnosis—then can an intelligi-
ble connection between these texts and the market be made? Our
method of central bank text analysis affords us the unique position
to look into this pressing question, and a comparison between the
BOJ Index and the Tokyo Stock Exchange (TSE) could serve as illu-
minating start to this investigation.
In Figure 13.1, the BOJ Index is represented by the solid black line
and the Nikkei 225—a standard TSE index—is represented by the
dotted and broken line. In general, the BOJ Index fluctuations cor-
relate highly (positive 0.545) with the Nikkei 225, but, not only are
the BOJ Index movements in line with Japanese equities, its peaks
and valleys are nearly always predictive of (or in step with) the mar-
ket’s direction. This prescient relationship begins from the start of
the timeline represented in the figure. In early January of 2009, as
142 HOW THE FED MOVES MARKETS

18000

0.4
16000

14000 0.2
Nikkei 225

BOJ Index
12000
0.0

10000

–0.2
8000
09

09

10

10

11

11

12

12

13

13

14

14

14
20

20

20

20

20

20

20

20

20

20

20

20

20
BOJ Index Nikkei 225

Figure 13.1 BOJ Index and the Nikkei 225.

the Nikkei is still trending downward, the BOJ Index begins almost
year-long path of ascent, an upward trend that breaks only in the
latter months of 2009. Approximately three months after the BOJ
Index began its ascent, the Nikkei begins its own climb until the
end of spring 2010, after which it descends until autumn, then once
again ascends until early the following year. This entire sequence
of fluctuations spanning early 2009 to the beginning of the 2011 is
smoothly anticipated by the waves created by the BOJ Index, and
this correlation only grows as time progresses: from the spring of
2012 onward, the BOJ Index maintains a nearly perfect four-month
lead on market movements. The especially tight correlations seen
in since 2012 could perhaps be linked to the adoption of Abenomics
that occurred during that year, an initiative that called upon the
central bank to be even more central to the economic activity of
Japan. The predictive and increasingly correlative dynamic between
the BOJ Index and the Nikkei suggests that BOJ communications
may in fact have a pull on Japanese equities market and, in any
case, suggest that the BOJ Index seems to be a valuable data stream
for understanding this space.
 BOJ SENTIMENT 143

0.4 1.4 0.4

1.2
0.3 0.2

BOJ Index
10yr Yield
2yr Yield

1.0

0.2
0.0
0.8

0.1
0.6 –0.2

0.0 0.4
09

09

10

10

11

11

12

12

13

13

14

14
20

20

20

20

20

20

20

20

20

20

20

20
BOJ Index 2yr Yield 10yr Yield

Figure 13.2 BOJ Index and Japanese government ten-year bond yield.

While this evidence seems to point to a tangible connection

between the BOJ communications and equity market activity, does
it suggest that a similar dynamic may exist between Nichigin texts
and fixed income? An examination of the BOJ Index in relation to
the benchmark ten-year Japanese Government Bond may be a use-
ful source from which to draw observations.
In Figure 13.2, the yield on the ten-year bond is represented by
the broken and dotted line and the mood of the Nichigin by the
solid black line. At first glance, the relationship between the BOJ
Index and the bond yield may seem weak, but a closer examina-
tion of the trends stays flash judgment. The BOJ Index is, in fact,
a great indicator of future movements in the bond market—what
makes that connection initially more difficult to spot is the often
exaggerated nature of BOJ Index fluctuations in comparison to
the rather reserved movements of this fixed-income asset. This
muted market reaction could be linked to the unique dynamics
of the Japanese fixed-income market. Unlike the bond markets
of other major developed economies, Japanese bonds are, by and
large, held domestically. This, coupled with the notoriously cau-
tious nature of Japanese investors, could cause this market to react
144 HOW THE FED MOVES MARKETS

more slowly—and with more restraint—than other markets do

toward their central bank dispatches. This dynamic is illustrated
throughout the timeframe covered by the graph. For instance, from
the second half of 2009 to the fall of 2010, the bond yield falls from
1.6 percent to about 0.9 percent; and, after this, the rate shoots to a
high of nearly 1.3 percent in the spring of 2011 and then proceeds
to gradually decrease until late 2014. The BOJ Index anticipates
each of these momentum changes throughout this stretch; only
its movements appear more radical. This magnified relationship is
particularly noticeable from the beginning of 2011 until the middle
of 2012, where the BOJ Index’s trend slope is markedly steeper than
the measured decline seen in the bond yield. But, for those looking
for reliable market signals, the ability to project the precise angle of
descent or ascent is not as important as the ability to project a com-
ing shift in direction, and, by this criterion, the BOJ Index excels.
Like with the equity markets, the comparison of BOJ Index trends
to bond yields seems indicative of a relationship—but can the same
said of foreign exchange markets? While the BOJ Index and the Fed
Index’s relationship to the FOREX rates were covered in an earlier
chapter, the potential relationship between only the BOJ Index and
significant currency pairs alone has yet to be examined. A review
of Figure 13.3, which sets the BOJ Index alongside the euro-yen and
the USD-yen, might shed some light on that query.
The BOJ Index is represented in Figure 13.3 by the solid black
line, the yen-USD by the broken and dotted line, and the yen-euro
by the broken line. The yen-USD and the euro-yen closely mirror
each other, with yen-euro exaggerating the movements in the yen-
USD, and the BOJ Index highly correlates with the both values—
0.506 with the yen-USD and 0.461 with the yen-euro to be specific.
The correlation is extremely tight from early 2009 until spring-
2011, when the BOJ Index dives until the beginning of 2012—serv-
ing as a leading indicator of the 2012 dive in exchange rates for
the yen-euro. This ascent is shortly followed by a series of furrows
and crests: the signal falls until spring of 2013, climbs until winter,
falls again until just before summer of 2014, dips slightly, climbs
until the late summer of 2014 and then falls sharply for the rest of
the year. Impressively, each of these exaggerated movements in the
BOJ Index effectively forecast (or moved with) market fluctuations.
 BOJ SENTIMENT 145

0.013
0.4
0.010

0.012

0.2
0.009
0.011

BOJ Index
Yen-EUR

Yen-USD

0.0
0.010
0.008

0.009 –0.2

0.007
09

09

10

10

11

11

12

12

13

13

14

14

14
20

20

20

20

20

20

20

20

20

20

20

20

20
BOJ Index Yen-EUR Yen-USD

Figure 13.3 BOJ Index, yen-USD, and yen-euro.

Perhaps even more than it did with the equities market, the momen-
tum shifts in the BOJ Index serve as reliable indicators of market
fluctuations in the currency markets.

* * *

Do the Bank of Japan’s communications move markets? Our

examination of the BOJ Index’s relationship to equity, fixed-in-
come, and FOREX markets certainly gives that impression. Of
course, the performance of any economy—especially one as mas-
sive as Japan’s—is the product of innumerable moving parts, but
parts that move 15 percent of GDP are about as powerful as factors
come. With such an enormous economic presence, is it any wonder
that when the BOJ speaks the market listens?
Indeed, when the recent trends in Japanese policy are considered
together—the plan to inject the market with a massive stimulus,
employ monetary easing, and engage the public through transpar-
ency measures—it seems little surprise that the data points to a cen-
tral bank whose words and actions have become one. That being
the case, a familiar corollary can be iterated here: understanding
146 HOW THE FED MOVES MARKETS

the modern financial landscape of Japan requires an understand-

ing of the economic impact of BOJ’s communications. But, to get
a true handle on that requires a system that is able to transform
Japanese characters and sentiments as they relate to market move-
ments into meaningful, objective data points, and the program we
have developed produces just that. Armed with this kind of data,
financial professionals who look to engage this complex market in
an informed manner have found an increasingly relevant means
of coming to grips with the fluctuations of the Japanese economy
and have, consequently, a greater chance to successfully navigate
its ebbs and flows as they continue to push on in an environment
unlike any in the country’s history.
 14

RBA Sentiment: Australia

as a Proxy for China

T his book, so far, has covered the Federal Reserve, the European
Central Bank, the Bank of England, and the Bank of Japan.
The economies these banks preside over all fall within the top five
worldwide and, consequently, their significance to the global mar-
ket is obvious. Sitting at 13th, the Australian economy has pull, but
it still lags far behind the production power of the European Union,
the United States, the United Kingdom, and Japan (Economy
Watch 2010). With this in mind, at least one question immediately
arises: why examine the Reserve Bank of Australia (RBA) along-
side these other central banks when seven other, larger economies
stand in line between Australia and this group? The answer lies in
Australia’s close ties to a market that shares the thin air occupied
by that cadre of heavy-hitters: China. Beginning with a short his-
tory of the RBA, this chapter explores the relationship between
the Australian and Chinese economies, highlighting how a close
examination of RBA communications could provide valuable
insight into two of the most powerful economies in the world.

* * *

The modern RBA evolved out of the Commonwealth Bank, an

institution created just before the modern Federal Reserve—but
with very limited powers (Reserve Bank of Australia 2015). Upon
its founding in 1911, the Commonwealth Bank was not structurally
much different from any other bank; it could not, for example, issue
148 HOW THE FED MOVES MARKETS

money or enact monetary policy. It would take several decades

before the institution was fully empowered with the authority and
charge that is now standard for central banks (Reserve Bank of
Australia 2015), and, by the time all these powers had been granted
and the bank’s structure began to settle, the Commonwealth Bank
had a new name as well: the RBA.
The RBA has a three-part mission: uphold the integrity of the
Australian dollar, maintain full employment in country (which,
outside the Fed, is an uncommon mandate), and promote the eco-
nomic prosperity and welfare of its citizens. The central bank’s two
governing boards—the Payment Systems Board and the Reserve
Bank Board—are responsible for approximating these aims. As
the RBA’s economic policy arm, the Reserve Bank Board gener-
ates monetary policy and maintains the stability of the Australian
economy. Like many central banks, the RBA aims to maintain
financial stability largely through a targeted inflation rate, which is,
in this case, between 2 and 3 percent. By keeping inflation within
that relatively low range, the Reserve Bank Board fights to keep
the Australian dollar secure, while devaluing the currency just
enough to encourage sustainable economic growth and meet their
employment mandate. Along with inflation control, the other lever
of monetary policy that the Reserve Bank Board utilizes is the cash
rate, which, like the federal funds rate (FFR), is the interest rate on
overnight loans between banks. With this rate, the RBA can work
toward easing or tightening credit. The second half of this bipar-
tite system, the Payment Systems Board, oversees the monetary
rails that make transaction possible and works to insure the flow
of funds between accounts is safe and efficient. By attending to the
underlying plumbing of the financial system while it manipulates
the monetary streams that drive economic progress, the RBA seeks
to fulfill its charge as the guardian of the Australian prosperity.

* * *

But there is another (unofficial) target for the RBA that must be
mentioned: the Chinese economy. Throughout the rapid expansion
of the country’s infrastructure, China has been in desperate need
of the raw materials needed to create the buildings, roads, power
 RBA SENTIMENT 149

supplies, and pipelines for a country of well over a billion. Because

of this, China has become a massive consumer of Australian iron,
coal, gold, and petroleum—the list goes on—accounting for a stag-
gering 29 percent of country’s imports (Observatory of Economic
Complexity 2015). The Australian government’s own economic
assessment demonstrates the depth and importance China plays in
the Australian economy:

As China moves into its next phase of development, its demand will shift
from raw materials to elaborately transformed manufactures, services, and
expertise. Australia has some potential advantages in the supply of these,
but they are not the clear advantages possessed by the resources sector.
Few other countries had Australia’s huge supplies of iron ore, which were
close to the sea and easily developed, and proximity to China for shipping
minerals (of which transport costs are up to 10% of the value). But many
developed countries have the education and technical expertise to meet
China’s new demands. (Holmes 2015)

The vitality of the Australian economy is, therefore, powerfully

linked to China’s, and the RBA’s monetary policy is, consequently,
powerfully shaped by this dependence. So, for those hoping to
understand the Australian central bank’s monetary policy, the per-
formance of the Chinese market is an essential data stream to have
on hand. But this dynamic has further implications: not only is the
Chinese market an important tool for understanding the think-
ing that drives the policy positions of the RBA, but the attitude of
the RBA is essential to understanding the Chinese market and the
ever-opaque Chinese central bank.
While there is data available on the Chinese financial market
performance (for instance, the performance of their equities mar-
ket and their government’s ten-year bond yields are readily avail-
able), data on the fundamentals of the Chinese economy reflect the
Chinese government’s secretive stance toward the rest of the world.
Nowhere is this lack of openness more apparent than in the policy of
the People’s Bank of China (PBoC): they are the only major central
bank in the world that continues to be intentionally nontranspar-
ent. This leads to the question: how can we ascertain the intentions
of a central bank or the true performance of the economy it over-
sees when both have been purposefully obscured? For this, a proxy
150 HOW THE FED MOVES MARKETS

is needed—a role that the Australian economy and the RBA are
both well suited for.
If, for example, China begins importing vast amounts of
Australian commodities, then the conclusion can be logically
made that the Chinese economy is growing rapidly. In other words,
Australian exports become a useful—and less biased—indicator
of Chinese economic performance. From recent developments, it
appears that this dynamic is here to stay (for the foreseeable future)
and, therefore, can continue to be reliably counted for its use as an
economic spotlight into an otherwise murky economy. This can
be seen clearly in the significant investment that firms are mak-
ing in Australia’s booming natural resources sector—a sector that
is booming in large part, if not wholly, because of its exports to
China. For instance, the Export-Import Bank of the United States
recently authorized a 2.95 billion dollar loan for a liquefied natural
gas project in Queensland (Congressional Research Service 2013),
a joint venture between enterprises from Australia, China, and the
United States. This success of this project hinges on the strength
of the Australia-China relationship: the United States invests in an
Australian business to reap the benefits of Chinese demand, while
the Chinese invest to further supply needed materials to their
economy. As such, we can continue to look to Australian economic
change as a proxy of Chinese economic change.
The relationship that exists between Australian economy and the
Chinese economy is also present between the RBA and the Chinese
economy. The RBA’s monetary policy, including its communicative
practices, is strongly influenced by the pull of the PBoC. In fact,
China exerts a direct influence on Australia’s interest rates—some-
thing normally within the purview of a nation’s central bank. As
the Australian government points out, “Australian businesses have
benefited from low interest rates [ . . . ] driven by the large amount
of Chinese savings available for lending, both directly to Australia,
but also internationally” (Holmes 2015). Moreover, the Australian
government anticipates that “as these are reduced, interest rates
will rise, putting downward pressure on the profits of Australian
businesses, revenue and growth” (Holmes 2015). Indeed, there is
a case to be made for the influence of China in the RBA’s deci-
sions and, thus, communications. For financial professionals, this
 RBA SENTIMENT 151

dynamic magnifies the importance of the RBA, making it one of

the most important central banks in the world.

* * *

If current RBA monetary policy is so important—and so con-

nected to China—what has recent monetary policy been? In the
early months of 2015, the Australian central bank began tapering
off some of its easing measures due to fears that continued easing
might lead to an overheated economy. Because communication
is also a tool of monetary policy, the position of RBA sentiment
also serves as a useful metric for understanding the central bank’s
recent positions. As shown in Figure 14.1 alongside the standard
Australian equities index—the Australian Securities Exchange
(ASX) 500—the Reserve Bank of Australia Index (RBA Index), like
the tapering measures, points to a hawkish RBA.
The RBA Index, represented by the solid black line, rose dramati-
cally from 2009 to the beginning of 2011—and continues to hover
in hawkish values afterward. But, considering the situation, this

5500 1.0

5000
0.5
RBA Index
ASX 200

4500

0.0

4000

–0.5
3500

–1.0
9

12

14

4
0

1
20

20

20

20

20

20

20

20

20

20

20

20

20

RBA Index ASX 200

Figure 14.1 RBA Index, the ASX 500, and SSE Composite Index.
152 HOW THE FED MOVES MARKETS

hawkishness seems out of place. If exports to China are so vital to

the Australian economy, then this hawkish position would seem
to run contrary to that end: hawkish policy, after all, is essentially
contractionary and leads to disinflationary pressure, and, for coun-
tries strongly reliant on foreign demand for commodities, a weak
currency is vital for economic growth. That being the case, why did
the RBA trend hawkish? The immediate answer to that question lies
in the scale of this trend. While the RBA did trend hawkish from
2010 to 2015, the upward limit of this hawkishness is positive 0.5.
Whether hawkish or dovish, any score that falls so close to zero is
actually closer to neutral than anything else, and, with that taken
into account, the hawkish fluctuations can be understood better as
subtle modulations—perhaps even small moves to keep in line with
another trend. Given the Australian economy’s relationship with the
Chinese market, it would seem plausible that these small movements
could be connected to an effort to maintain that delicate balance.

* * *

While the recent, relatively granular fluctuations in the RBA

Index may point toward a China-centric communication policy,
its points of divergence with the Australian economy may also be
rooted in this connection. For example, definitive points of diver-
gence are seen in Figure 14.2, which compares RBA Index trends to
the Australian fixed-income market.
The RBA Index, represented by the solid black line, often exhibits
a predictive relationship with the ten-year bond yield, represented by
the broken line. For instance, from the middle of 2010 to the middle
of 2012 the RBA Index and the ten-year bond share similar paths—
with the ten-year bond reflecting RBA market sentiments within
three to four months—and this period of predictive movement is
bookended by similarly connected trends in both data streams.
But could trends in RBA communications have bearing outside
the Australian economy? The answer to this question lies in the
relationship between Australia and China that has been central
to this chapter: perhaps, along with the Australian economy, the
RBA is reacting to the China. When the RBA Index is compared
to the Chinese stock market—instead of Australian equities—this
hypothesis seems to be borne out by the facts in Figure 14.3.
 1.0
5.5

5.0
0.5

4.5

RBA Index
10yr Yield

0.0
4.0

3.5
–0.5

3.0

–1.0
09

09

10

10

11

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12

12

13

13

14

14
20

20

20

20

20

20

20

20

20

20

20

20
RBA Index 10yr Yield

Figure 14.2 RBA Index and Australian government ten-year bond yield.

5000

0.8
4.5 4500

4000 0.6
CNY 10yr Yield

RBA Index
SSEC

4.0 3500
0.4

3000

0.2
3.5
2500

2000 0.0
10

10

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15
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20

RBA Index CNY 10yr Yield SSEC

Figure 14.3 RBA Index and Chinese benchmarks.

154 HOW THE FED MOVES MARKETS

The Shanghai Stock Exchange Composite (SSEC) is depicted in

Figure 14.3 by the broken and dotted line and the RBA Index by
the solid line. Figure 14.3 suggests that the RBA Index shares a very
strong—seemingly prescient—relationship with the performance
of the Chinese stock market, as the peaks and valleys of the central
bank’s mood are soon mirrored in the market’s fluctuations. This
dynamic can be seen throughout the five-year span chronicled by
the figure. In early 2010, when the SSEC is still on a downward
trend, the RBA Index starts to rise sharply, and this ascent is mani-
fested nearly six months later in the SSEC. The RBA Index then
peaks and begins to dive from early 2011 to early 2012 and, over
the same time period, the Chinese stock market experiences the
same movements—albeit a few months after the RBA Index. From
the beginning of 2012 to the end of 2014, the RBA Index climbs to
a peak in the summer of 2012, dives off from then to late 2012, then
peaks again in mid-2013 and descends until early 2014. Once again,
the SSEC reflects these changes (with less drama) a few months
later: from late-2012 to spring 2013, the market climbs to a peak;
after this the SSEC descends—only to peak again later in 2013 and
descend once more until 2014.
Along with its relationship to the Chinese stock market, the RBA
Index also can serve as a leading indicator (0.245 correlation) for
the Chinese bond yields (represented in Figure 14.3 by the broken
line). This is particularly evident from the middle of 2010 until the
beginning of 2011, where the bond yield’s jumps are anticipated by
the upward trending RBA sentiment. When not clearly leading,
RBA Index movements still correlate closely with the Chinese fixed
income. The RBA Index trends from early 2012 to early 2014 track
closely with income fluctuations—a dynamic that is clearly notice-
able in the RBA Index peak that occurs in mid-2014 and 2015 and
mid-2014 and 2015’s bold yield peaks.
In both the Chinese fixed-income and equity market bench-
marks, every substantial market movement is either correlated—or
anticipated and correlated—by the movements of the RBA Index.
This data presents an interesting—and perhaps foreseeable—con-
clusion: the RBA’s communications seem strongly influenced by
the projected performance of the Chinese economy and, therefore,
the RBA’s mood may be leading indicator of the Chinese market
 RBA SENTIMENT 155

fluctuations and the Australian economy. This, of course, strongly

supports the use of the RBA—specifically the sentiment of RBA
texts—as a window into Chinese economic activity.
This technique is further justified when currency trends pre-
sented in Figure 14.4 are examined.
The RBA Index, the solid black line, and the Australian dollar-
Chinese yuan, the broken and dotted line, share similar fluctua-
tions from 2003 to 2009, but, from 2009 onward, their movements
are extremely tight. The RBA Index breaks out of the 2008 crisis
in early 2009, pulling itself from negative 1 on the Index scale to
neutral over the course of less than a year. The AUD-CNY moves
with the central bank’s sentiment, beginning its own upward climb
just months afterward. In 2011, they both hit their highs—with
the RBA Index leading—as the RBA Index approached positive 1
and AUD-CNY just exceeding a 7-to-1 exchange rate. The ensuing
downturn and ascent in the RBA Index are, once again, in concert
with market movements.
Interestingly, if a less-smoothed average of the RBA Index is
employed—allowing the sentiment be more powerfully swayed by

1.1
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RBA Index AUD-USD AUD-CNY

Figure 14.4 AUD-CNY and RBA Index.

156 HOW THE FED MOVES MARKETS

1.1
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RBA Index AUD-USD AUD-CNY

Figure 14.5 AUD-CNY and RBA Index (less smoothed).

the day-to-day positions of central bankers—then an even tighter

dynamic emerges, which is presented in Figure 14.5.
From 2004 on, the RBA Index and the AUD-CNY movements
are closely linked—an 11-year stretch of correlation that is yet
another indicator that a strong relationship exists between the out-
look of the RBA and Chinese economy.

* * *

Beyond further bolstering this thesis, the accuracy provided by

the less smoothed average highlights an advantage of the data we’ve
created through a systematic analysis of central banking commu-
nications: its versatility. Through a historical analysis of market
and central bank communication trends, the transformation of the
sentiment data that seems most suited to the specific market under
scrutiny can be found. This is not a case of ad hoc alignment, but
instead an examination of how central banking moods proliferate
into the diverse financial mechanisms that drive economy. Some
markets, by the nature of the financial instruments they concern,
will inherently be more responsive to the day-to-day attitude of a
central banking. The FOREX market is a perfect example of this
 RBA SENTIMENT 157

kind of sensitivity, as economic trends are quickly digested and

acted upon through the agile trading strategies that drive currency
exchange. The markets that seem to better align with general index
trends, like commodities markets, are likely those markets whose
movements are more generated by the slower hand of monetary
policy and broad communication themes.

* * *

Australia is certainly home to a major economy in its own right,

and that importance is only magnified when its ties to the Chinese
market are explored. The compelling patterns that our data has iden-
tified suggest that a deeper investigation of these connections—par-
ticularly leveraging RBA texts—could help lift the veil of opacity that
surrounds the second largest (possibly the largest) economy in the
world. Embedded with multitiered significance, RBA communica-
tions represent a truly rich macroeconomic indicator, capturing the
complex interplay at work among the RBA, the Australian, and the
Chinese economies. For financial professionals looking to understand
the RBA, either of these economies, or all of the above, the RBA Index
could serve as an innovative and important part of that process.
This additional insight could be particularly helpful given the
slowdown in growth that China has been experiencing in recent
years:

Structurally, China’s economy faces headwinds. In the long run, growth is

a function of changes in labour, capital and productivity. When all three
increase, as they did in China for many years, growth rates are superla-
tive. But they are all slowing now. China’s working-age population peaked
in 2012. Investment also looks to have topped out (at 49% of GDP, a level
few countries have ever seen). Finally, China’s technological gap with rich
countries is narrower than in the past, implying that productivity growth
will be lower, too. (The Economist 2015)

As China grapples with uncertain economic conditions while it

continues to preserve secrecy within its central bank, it will become
increasingly important for market players to leverage what data
streams they have at their disposal to make informed decisions in
a difficult environment. From what our data demonstrates, RBA
communications appear to be a vital resource toward that end.
 15

Global Sentiment:
International Central
Bank Transparency

T he Federal Reserve. The European Central Bank. The Bank of

England. The Bank of Japan. The Reserve Bank of Australia.
The People’s Bank of China. Exploring their history, politics, and
processes, this book has tackled this influential group to assess the
development of transparency within central banking’s most signif-
icant institutions. This is not to diminish the power of other cen-
tral banks. All central banks have tremendous economic sway—if
not globally, domestically—and consequently merit the attention
of those who wish to have a grasp on the financial world. In light
of this necessity, this chapter picks up where the last four left off,
concisely cataloguing the background and current strategies of a
host of additional institutions. This chapter does not cover every
central bank in the world; there are over a hundred. Instead, we
review a selection of institutions that represent the three general
categories that central banks fall into globally: banks in developed
countries that are transparent, banks in developed countries that
have yet to firmly embrace transparency, and, banks, regardless
of transparency, of emerging national economies. An integral
element of this account will be our sentiment data and the bear-
ing it has on each of the economies these banks preside over. By
taking this approach, this chapter aims to afford both a better
understanding of central banking operations worldwide and the
broad applications of our methodology, expanding on the global
160 HOW THE FED MOVES MARKETS

perspective that was afforded by the earlier chapter on central

banks and currency trading.

* * *

Transparent Banks of Developed Economies

Bank of Canada

The Bank of Canada (BOC) is one of the most transparent

banks in the world. The BOC was founded as a privately owned
institution in March 1935 as a reaction to the Great Depression
and the resulting worldwide economic plunge. In 1938, the bank,
headquartered in Ottawa, was nationalized under a mandate “to
regulate currency in the best interests of the economic life of
the nation” (Bank of Canada 2015b). Today, the mission of the
bank remains “to promote the economic and financial welfare
of Canada” with four core functions: establishing the monetary
policy, maintaining the financial system, issuing currency, and
overseeing funds management (Bank of Canada 2015a). The
goal of the current monetary policy is to preserve the value of
the Canadian dollar by keeping inflation predictable, low, and
stable.
In order to accomplish this objective, the BOC has set an infla-
tion-control target of 2 percent, the midpoint of its 1- to 3-percent
acceptable range. The target was set in 1991 and is reviewed every
five years. Additionally, Canada’s flexible exchange rate allows the
bank to adopt an independent monetary policy that is the most
beneficial in Canada’s economic climate and most useful for attain-
ing the inflation target. The bank has also recently made efforts to
increase transparency, including launching the operating band for
the overnight interest rate, publicizing forecasts about the economy
in the semi-annual Monetary Policy Report, setting eight fixed
announcement dates throughout the year to note the inflation-
control target rate setting, and issuing press releases to explain the
rationale behind policy changes.
The BOC offers Maple Bonds, which are “Canadian-dollar-
denominated bonds issued by foreign borrowers in the domestic
Canadian fixed-income market,” domestic Government of Canada
bonds, and saving bonds (Hately 2012).
 GLOBAL SENTIMENT 161

4.0 0.2

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BOC Index Maple Bond Yield TSX 60

Figure 15.1 BOC Index and TSX 60.

An analysis of Figure 15.1 suggests that our data serves as a use-

ful indicator for the Canadian Security Exchange’s TSX 60.
Figure 15.1 presents the TSX 60’s index along with the Band of
Canada Index (BOC Index). The TSX 60 is represented by the bro-
ken and dotted line, while the BOC Index is represented by the solid
black line. The BOC Index’s general trend from very dovish to neu-
tral, along with variance in the data, anticipates, mirrors, then antici-
pates the variance in the increase in equities prices. From early 2009
to early 2011, the BOC Index leads the TSX 60 with its fluctuations,
trending toward positive gains. This two-year stretch is followed by
three years—spring 2011 through spring 2014—of back and forth
leading and following. Finally, from early 2014 on, the BOC Index
regains its lead on the market: the valley, followed by a peak and an
ensuing valley are all ahead of the index movements. This suggests
that the BOC Index is useful as both a leading indicator for equity
market developments and as a market barometer.

Bank of Sweden (Riksbank)

The Bank of Sweden, or the Riksbank, is not only considered the

world’s oldest bank, it’s also believed to be the most transparent
162 HOW THE FED MOVES MARKETS

(Holmes 2013). Although it has been around since 1667, the

Riksbank did not become the official central bank of Sweden until
the 1897 Riksbank Act. Located in Stockholm, the Riksbank oper-
ates under the Swedish parliament. Today, the Riksbank’s main
objective is to “maintain price stability” by sustaining a low, secure
rate of inflation (Sveriges Riksbank 2015b). The 2 percent infla-
tion target was applied in 1995 and has remained at that point ever
since.
The Riksbank is led by an Executive Board of six members,
made up of a governor and five deputy governors. Members of
the Executive Board are appointed for a period of five or six years
by the bank’s General Council, which in turn is appointed by the
Swedish parliament. General Council members do not have the
right to vote on or propose policies to the Executive Board. The
governor is selected from the members of the board, also by the
General Council. The Executive Board holds six meetings a year to
discuss its monetary policy and changes to the bank rate. In order
to promote greater transparency, the Riksbank publishes press
releases after each meeting as well as a Monetary Policy Report that
contains forecasts for inflation and economic changes (Sveriges
Riksbank 2015a).
The Riksbank offers government bonds through the Swedish
National Debt Office. Their maturation timelines range from two
to ten years. Swedish equities are traded on the Stockholm Stock
Exchange, known as OMX. Its major indexes include OMX S30
and the OMX Nordic 40, which represent baskets of top equities.
Figures 15.2 and 15.3 set our data alongside the benchmark data
for the Swedish equities (OMX 30) and fixed income markets (ten-
year government bond), demonstrating its use as an indicator for
both markets. Figure 15.2 presents the Bank of Sweden Index (SWE
Index) alongside the OMX 30 index.
The broken line represents the OMX 30, and the solid black line
represents the SWE Index. The general trends in the index and the
central bank’s mood appear to be inversely related. As the senti-
ment indicator drops from very hawkish (1.6) to moderately hawk-
ish (0.8) from January of 2009 to January of 2012, the equities index
sees a general ascent. This trend continues as the sentiment indi-
cator drops to almost neutral. As general movements in the SWE
 1400 1.2

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SWE Index OMX 30

Figure 15.2 SWE Index and OMX 30.

3.5 1.2

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Figure 15.3 SWE Index and Swedish government ten-year bond yield.
164 HOW THE FED MOVES MARKETS

Index seem connected to market gains and losses (often anticipat-

ing them), this inverse relationship could be used by financial pro-
fessionals to understand (and predict) market conditions.
Figure 15.3 presents the sentiment indicator alongside the
Swedish government’s ten-year bond yield.
The solid black line represents the sentiment indicator, while the
broken line represents the ten-year bond yield. Movements in the
sentiment indicator are exaggerated in the bond yield, and, as it was
with the equities, the SWE Index is split between reflecting and
anticipating the bond yield. From 20010 to late 2012, the sentiment
indicator leads the ten-year bond yield by a period of five to seven
months. In the winter of 2012, this leading becomes tracking, as the
both the SWE Index and the bond yield rise and fall in unison.

Reserve Bank of New Zealand

The Reserve Bank of New Zealand (RBNZ) was founded in 1934

in Wellington. Although the government was initially reluctant, the
Great Depression and pressing foreign economic issues made the
need for a central bank clear, and over the last 80 years the RBNZ
has become one of the most transparent banks on earth. Upon
its creation, the reserve bank’s policies were aimed at enhancing
growth, reducing unemployment, and keeping prices stable. Today,
the reserve bank’s uses monetary policy to contain inflation by
keeping it within a targeted range. In 1989, Government of New
Zealand gave the reserve bank the statutory authority to control
inflation. It does this by updating its Policy Targets Agreement
(PTA) between the governor of the reserve bank and the Minister
of Finance to agree to keep inflation between 1 and 3 percent a year
on average. Additionally, since March 1999, the reserve bank has
implemented the Official Cash Rate (OCR), an interest rate set by
the bank to meet the inflation band previously specified. The OCR
is reviewed eight times a year. Over the last several decades, the
RBNZ has made a concerted effort to build upon its tradition of
open communication by embracing increasing transparency mea-
sures (Reserve Bank of New Zealand 2015).
 GLOBAL SENTIMENT 165

The utility of Prattle’s data for New Zealand assets is exemplified

in its application to interpreting currency fluctuations. Figure 15.4
sets the RNZ Index (thin black line) beside the New Zealand dollar-
basket of currencies pair (thick black line).
As Figure 15.4 illustrates, there is a strong correlation between
the RNZ Index and the currency movements. Throughout the
timeframe captured, the RNZ Index shifts between correlating
with the currency fluctuation and correlating and anticipating
the movements. From January of 2005 until the same month in
2009, the RNZ clearly anticipates every major currency fluctua-
tion, powerfully dipping and driving eight to six months before
the market reflects these trends. From early 2009 to mid-2010,
the dynamic reverses—with the RNZ Index trailing the currency
movements. Then the RNZ Index retains its trend-leading status,
anticipating the market dip of mid-2010–early 2011 with its own
rapid downward trend. From 2011 to 2014, the RNZ Index’s fluc-
tuations become noticeably more reserved than the currency’s, but
the central banks mood still shows predictive stretches—the late
2012/early 2013 RNZ Index dip serves as a leading indicator for
mid-2013’s currency drop. With this comparison in mind, it seems
2.0
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1999 2001 2003 2005 2007 2009 2011 2013

Figure 15.4 RNZ Index and exchange rates.

166 HOW THE FED MOVES MARKETS

clear that the RNZ Index shares an identifiable relationship with

the currency market.

* * *

(Slightly) Less Transparent Banks of Developed Economies

Swiss National Bank

The Schweizerische Nationalbank, also known as the Swiss

National Bank (SNB), was founded by Federal Act in 1907 to insure
price stability and provide informed management of Swiss eco-
nomic developments. Established as a special statute joint-stock
company, it is administered under the supervision of the Swiss
Confederation, which—unlike most national banks—does not
own a single share of the bank. Instead, the bank’s 25-million-franc
capital is split roughly 55–45 among public shareholders, the Swiss
cantons, and cantonal banks and private investors. The reason for
the central bank’s distributed ownership, specifically among the
cantonal banks, is the federated nature of the Swiss government.
The bank is governed by general meetings of shareholders, which
occur once per year. In the interim, bank operations are man-
aged by the Governing Board, Enlarged Governing Board, and
the eleven-member Bank Council; five of whom are elected by the
Shareholders’ Meeting and six of whom are elected by the Federal
Government (Swiss National Bank 2015).
The SNB defines price stability as less than 2 percent inflation
per year—but, unlike other central banks, this mark represents an
upper bound instead of a target. Given the power to set interest
rates on its deposit accounts and control the cash supply, the SNB
implements its monetary policy by manipulating the levers it has
been given. The SNB executes its policy from its two head offices,
located in Zurich and Bern, along with six representative offices
peppered throughout the country, and fourteen agencies operated
by cantonal banks. Perhaps the bank’s most significant achieve-
ment is its maintenance of the franc: since the SNB’s founding in
1907, the Swiss franc has well outperformed all other currencies,
losing only 87 percent of its value vis-à-vis gold over the past cen-
tury while most other currencies have lost roughly 99 percent. Since
 GLOBAL SENTIMENT 167

the onset of the financial crisis, the SNB has battled Switzerland’s
low inflation rate by experimenting with pegging and de-pegging
from the euro (Swiss National Bank 2015).
Figure 15.5 presents the Swiss National Bank Index (SNB Index),
represented by the broken black line, alongside the Swiss Market
Index (SMI), which is represented by the solid black line. Since
2009, the SNB’s communications have been generally dovish with a
trend toward hawkishness, with the exception of a hawkish spike in
mid-2011. This suggests that the SNB’s policy has been to encourage
inflation even as disinflation concerns slowly eased; indeed, as the
discussion above highlights, the SNB has adamantly fought against
Switzerland’s low inflation rate, only recently curbing its measures.
Similarly, the hawkish spike in mid-2011 is not out of the ordinary
when considering the context: Switzerland faced major doubts
about its financial strength after its foreign exchange reserves were
depleted—a consequence of the recession (Jordan 2011). The SNB
had to react to decreasing confidence in the equities market with
hawkish policy—which ultimately resulted in the bank abandon-
ing its peg to the euro. Their actions and the market’s subsequent

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Figure 15.5 SNB Index and Swiss Market Index (SMI).

168 HOW THE FED MOVES MARKETS

adjustment are echoed in the figure. One can see how the story
told by the data is corroborated once the events that took place are
considered.
When compared with the SMI, the SNB Index serves as a lead-
ing indicator. A general peak and subsequent denouement in mid-
2009 to mid-2011 serve as precursors to similar movements in the
equities index. After the hawkish spike, which was in reaction to
concerns about the strength of the franc, we see that the SMI ral-
lies—in other words, the corrective actions (such as pegging to the
euro) taken by the SNB boosted confidence in the market. Several
Index fluctuations in the dovish direction along the way, like those
in early 2012 and mid-2014, lead small market adjustments roughly
four to six months following. In light of the correlated trends and
the strong mechanistic connection the contextual analysis suggests,
the data could prove useful to those interested in examining the
relationship between the Swedish equities market and the Swedish
National Bank’s sentiment. Our data could also benefit FOREX
market players, as the Swiss franc is one of the most heavily traded
currencies in the world—and thus demonstrating the value of any
additional insight into the actions and attitude of the SNB.

Bank of Korea

The Bank of Korea (BOK) was founded on June 12, 1950 through
the Bank of Korea Act. The bank is located in Seoul. It was founded
to insure price stability and to maintain inflation at certain rates to
maximize economic output and employment (Bank of Korea 2015).
Like other central banks, the BOK’s other functions include issuing
banknotes and coins, supervising financial institutions, and man-
aging South Korea’s foreign reserves.
The traditional policy of the bank has followed closely what its
Western counterparts have done. Manipulation of interest rates
has been stable and predictable, and the bank has largely main-
tained independence from government pressure. In the wake of
the 2008 financial crisis, the bank has become more responsive
to government demands and has cut interest rates to historic lows
(1.75 percent) (Kim and Yoo 2014) and has missed its target rate
of inflation (Mundy and Jung-a 2015). The BOK engages in open
 GLOBAL SENTIMENT 169

market operations in order to control inflation and preserve the

purchasing power of the won.
The BOK is transparent with regards to the frequency of its com-
munications, but is less so when comes to the quality of the infor-
mation they release. As of 2015, rate-setting meetings occur every
month, and the bank publishes minutes following these meetings.
There are proposals being considered to move toward less frequent
meetings that yield more substantive communications.
As with a number of other central banks, the utility of our data
is evidenced by its predictive relationship to the Korean Stock
Exchange 100 (KRX 100). Figure 15.6 presents the KRX 100 index
along with the Bank of Korea Index (BOK Index).
The KRX 100 index is represented by the broken line, while the
BOK Index is represented by the solid black line. Clearly, the KRX
100 is a very volatile index, with several peaks and troughs coupled
with cyclic, pronounced variance. Yet, remarkably, the BOK Index’s
tune is on key: peaks and troughs in the BOK Index lead peaks and
troughs in the KRX 100 by two to four months. This suggests that the
BOK Index is a strong leading indicator for Korean equity activity.

0.4

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BOK Index KRX 100

Figure 15.6 BOK Index and KRX 100.

170 HOW THE FED MOVES MARKETS

Bank of Israel

The Bank of Israel (BOI) was established on August 24, 1954

through the Bank of Israel Act. The bank’s mandate is to maintain
price stability, preserve the purchasing power of the shekel, support
government economic policy, and to maintain the stability of the
Israeli financial system (Bank of Israel 2015).
The traditional policy of the bank has been fairly conservative.
Israeli development occurred rapidly after statehood, benefiting
from large capital inflows. This meant that the bank had to do little
to spur economic development and growth—but had to double-
down on inflationary pressure. Policy is aimed at maintaining
the competitiveness of the shekel so Israeli goods are attractive on
export markets, and, to this end, the bank has set the target infla-
tion rate in a range from 1 to 3 percent. The low or negative infla-
tion in post-financial-crisis years has, however, resulted in interest
rates near 0.0 percent.
Although fairly transparent, the BOI is less transparent than
several of its counterparts in other developed countries; the BOI
publishes information and reports less frequently, their reporting
is of a lower quality and contain less information, and the bank’s
policy is mandated to support government policy, reducing the
bank’s independence relative to Western central banks (Nissan
2015). The bank’s five-member monetary policy panel makes deci-
sions regarding monetary policy. This concentration of decision-
making power in a smaller group further contributes to reduced
transparency.
The predictive capacity of our data on the Israeli central bank is
demonstrated below in a comparison to the government’s ten-year
bond yield. Figure 15.7 presents the BOI Index vis-à-vis the Israeli
government ten-year bond yield.
The ten-year bond is represented by the broken line, while the
BOI Index is represented by the solid black line. The BOI Index’s
peaks and troughs consistently predate changes in the bond yield
by roughly six months, suggesting that the BOI Index is a leading
indicator of bond movements. The decline seen in the bond yield
from mid-2009 to late 2010 is prefigured in the BOI Index trends,
as is late 2010 and early 2011’s yield surge. The sentiment indica-
tor once again leads the strong, general declines seen from then on
with its own intense descent, predicting a slight upward trend with
 GLOBAL SENTIMENT 171

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10yr Yield

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BOI Index 10yr Yield

Figure 15.7 BOI Index and Israeli government ten-year bond yield.

an exaggerated flourish. In short, the BOI Index proves to be a use-

ful leading indicator of this benchmark fixed income rate.

Bank of Mexico

The Bank of Mexico (BOM) was founded on September 1, 1925,

after revolution fractured the ability of the retail banks to issue
reliable and trustworthy bank notes. In July 1931, the Monetary
Law was passed, establishing the peso as the official currency, as
a demonetization of gold, and formalizing the bank’s power. Its
duties since have been to print currency, preserve the purchasing
power of the peso, and make sure inflation creates conditions ripe
for sustained growth and job creation. The bank is located in the
Federal District of Mexico City (Bank of Mexico 2015a).
In the spirit of an open market of retail bank competition, the
BOM was established by government funds as an autonomous insti-
tution. The bank buys and sells reserves and securities on the open
market. The bank is managed by a board of governors made up
of five officials—a governor and four deputies—appointed by the
president and confirmed by the senate. The governor is appointed
172 HOW THE FED MOVES MARKETS

for a six-year term, while the deputy governors are appointed for
eight-year terms. The current governor is Agustín Carstens (Bank
of Mexico 2015b).
The BOM takes government reporting and oversight seriously
and, consequently, has begun to take meaningful steps toward
transparency. In fact, board members and central bank staff are
subject to the Federal Civil Servants Liability Law, which allows for
their impeachment if they are not meeting the standards set by the
bank. The bank reports its policies and activities to Congress and
their publishing schedule is public knowledge. Reports are pub-
lished frequently.
Since 1996, the bank has set annual inflation targets. As of 2015,
the target is set at 3 percent per year. Similarly, the bank rate, like
the federal funds rate, is set at 3 percent per year. The Government
of Mexico offers bonds ranging in maturity from overnight to
30 years. Equities are traded on the Mexican Stock Exchange,
located in Mexico City’s financial district. The exchanges primary
index is the Indice de Precios y Cotizaciones (IPC).
Comparing our data on the to the Mexican Stock Exchange’s
IPC, Figure 15.8 presents the IPC’s index along with the Bank of
Mexico Index (BOM Index).
The broken line represents the IPC, while the solid black line
represents the BOM Index. The BOM Index’s undulating move-
ment from neutral dovish to moderately hawkish during the 2009–
2012 time period accurately predates symmetrical movements by
the IPC by about six months. The BOM Index’s fluctuations are,
however, far more extreme than their equity counterparts, and this
exaggerated dynamic is seen most clearly from the end of the 2013
to the beginning of 2014, where a relatively minor market dip is
prefigured by an enormous sentiment indicator plunge. This fluc-
tuation indicates that the BOM is extremely sensitive to market
conditions and likely a very reliable indicator of even minor market
changes.

* * *

Banks of Emerging Economies

The terms BRICS has become common among those involved in

international finance. While originally referencing Brazil, Russia,
 GLOBAL SENTIMENT 173

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Figure 15.8 BOM Index and Mexican IPC.

India, China, and South Africa, the acronym has now become syn-
onymous with systemically important, rapidly growing developing
economies. Because of data limitations we’ve already discussed, the
PBoC was already touched on in an earlier chapter. This section
will focus on Brazil, Russia, India, and South Africa.

Central Bank of Brazil

The Central Bank of Brazil (BCB) as we know it today arose

from the centuries-separated marriage of the Brazilian Mint (estab-
lished in 1694), the Bank of Brazil (established in 1808 by John VI
of Portugal), and the Superintendency for the Currency and Credit
(SUMOC) (established by decree of President Vargas in 1945).
The central bank—formally opened in December of 1964—came
into being 270 years after its metaphorical cornerstone had been
laid. The bank’s operation, however, did not begin peacefully: the
Central Bank of Brazil began negotiating its status as Brazil’s single
monetary authority in the aftermath of the 1964 Brazilian coup
d’état, which established Brazil’s military government. When con-
sidering the bank’s precarious birth, the levels of accountability and
174 HOW THE FED MOVES MARKETS

monetary efficacy it has achieved are remarkable (Central Bank of

Brazil 2015a).
Today, the bank is headquartered in Brasília. The CBB’s com-
plex policymaking structure is overseen by a board of governors.
This board is comprised of a governor and the deputy governors
for each of the bank’s secretariats. The bank’s monetary policy,
though, is determined by the bank’s Monetary Policy Committee,
also referred to as COPOM. With the power to set monetary policy
and the short-term interest rate, known as the SELIC rate, COPOM
is responsible for the protection of the Brazilian real. COPOM is
composed of the members of the board of governors, including the
governor and the several deputy governors for Monetary Policy,
Economic Policy, International Affairs and Risk Management,
Financial Regulation, Financial System Organization, Control of
Farm Credit, Supervision, Administration, Institutional Relations
and Citizenship (Central Bank of Brazil 2015b).
The SELIC rate, as of 2015, is set at 13.25 percent, the highest it
has been since January of 2009, a 6 percent increase from the 2013’s
low of 7.25 percent. This high bank rate is a side effect of lowered
growth expectations for the country’s slowing economy, which
place estimates for 2015 growth around 1.8 percent, and raise infla-
tion expectations, which are estimated to be around 6 percent in
2015. Brazilian equities are traded on the BM&F BOVESPA stock
exchange.
To illustrate how our data measures up as a tool for understand-
ing the Brazilian market, Figure 15.9 places the Brazilian Central
Bank Index (BCB Index) beside the BOVESPA.
The BCB Index is represented by the solid black line and the bro-
ken line represents the BOVESPA Index. While exaggerated, the
movements in the BCB Index consistently prefigure equity move-
ments. In mid-2013, while the market is still generally trending
downward, the BCB Index is making gains, climbing until autumn
before falling until the end of the year. An analogous trend is seen
in a few months later in equities. From spring 2014 until summer
2014, equities again leap up—an upward trend that is anticipated
in the Index movements of that year. The BCB Index then rap-
idly dives—mid-2014 through late 2014—and the market follows
suit—late summer through the very end of the year. The BCB Index
 GLOBAL SENTIMENT 175

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BCB Index BOVESPA

Figure 15.9 BCB Index and the BM&F BOVESPA Index.

continues to anticipate or reflect changes in the equity market for

the rest of the timeline. Given the correspondence between the
two data streams, a relationship between the Brazilian Central
Bank’s communications and the Brazilian equities market seems
apparent.

Bank of Russia

Like most central banks, The Bank of Russia’s mission is to

insure the stability of Russia’s national currency, the ruble, through
monetary policy. Unlike most central banks, however, the Bank of
Russia—or, as it is formally named, the Central Bank of the Russian
Federation—was founded a mere 25 years ago on July 13, 1990, as
one of the last wishes of the dying USSR. Its recent founding makes
it one of youngest central banks in the world. Accountable to the
Supreme Soviet of the RSFSR, it was originally called the State Bank
of the RSFSR. The bank’s mission is to protect the nation’s currency
through the levers of monetary policy persists today. Further, the
176 HOW THE FED MOVES MARKETS

bank notes that though “it is not a body of state power, [ . . . ] its
powers are, in effect, the functions of a body of state power, because
their implementation implies the use of state compulsion” (Bank
of Russia 2015c). In this sense, the bank carries the power of the
Russian government with it—and thus, so do its communications.
Though it is independently managed on a day-to-day basis,
the Bank of Russia is wholly owned by the Russian government,
answerable to the State Duma of the Federal Assembly. The bank
is governed by a board of governors. The State Duma appoints
and dismisses the board’s governor when prompted to do so by
the president of the Russian Federation. The appointed governor,
in turn, nominates the appointment and dismissal of members for
the board, which are officially appointed or dismissed by the State
Duma in agreement with the president of the Russian Federation
(Bank of Russia 2015b).
As Russia’s 2014–2015 gross domestic product (GDP) growth
forecast hovered at 3.3 percent, the Bank of Russia decided to alter
their planned 4 percent inflation target, instead raising it to 5 per-
cent. As of May 2015, the key rate—much like the federal funds
rate—was set at 12.5 percent (Bank of Russia 2015a).
How does our data stack up to the Russian equity markets?
Figure 15.10 allows for an easy comparison between the Central
Bank of Russia Index (CBR Index) and the MICEX.
Late 2012 through mid-20l4, the CBR Index, the solid black line,
and the MICEX, the broken line, share common fluctuations. The
CBR Index’s peaks and valleys generally prefigure several market
movements. This connection only intensifies after the summer
of 2014: the ensuing dive and rapid climb seen in the CBR Index
reflect market conditions. This suggests that correlation between
the central banks communicative arm and the economy is only on
the rise. The data gives Russian central bank watchers cause for
optimism, as it appears that CBR communication will continue
to be a significant force in the market—and therefore represents a
dependable financial data resource.

Reserve Bank of India

The Reserve Bank of India (RBI) was founded on April 1, 1935

by virtue of the Reserve Bank of India Act. The Bank of India was
 GLOBAL SENTIMENT 177

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Figure 15.10 CBR Index and the MICEX Index.

established to “regulate the issue of Bank Notes,” insure “monetary

stability in India,” and generally to “operate the currency and credit
system of the country to its advantage” (Reserve Bank of India
2015b). Though originally privately owned, the bank was national-
ized in 1949 and is now fully owned by the Government of India.
The bank is currently headquartered in Mumbai.
Like most central banks, the RBI is governed by a central board
of directors. The board consists of a governor, four deputy gover-
nors, and fourteen directors. All officers are appointed for terms of
four years by the Government of India; four of the directors must
come from local bank boards in Mumbai, Calcutta, Chennai, and
New Delhi, and one director must be a government official (Reserve
Bank of India 2015a).
The inflation rate in India has varied between 12.0 and 6.4 per-
cent per year since 2010. In 2015, the RBI set an inflation target of
below 6 percent per year by January 2016 and a 4 percent per year
target following that. Since 2015, the RBI’s bank rate—similar to
the federal funds rate—rests at 8.75 percent per year (Reserve Bank
of India 2015b).
178 HOW THE FED MOVES MARKETS

Indian equities are traded on the Bombay Stock Exchange (BSE).

The S&P BSE SENSEX index (S&P Bombay Stock Exchange Sensitive
Index) tracks 30 of the largest and most actively traded stocks on
the exchange. With a projected GDP growth rate of 7.5 percent
in 2015–2016 (The World Bank 2015), the Indian economy could
overtake China as the world’s fastest-growing economy.
Interestingly, the RBI issues more communications than any
other central bank we analyze—on average, more than four times
as many as the Fed. This makes them very communicative, but it
also makes it difficult to discern the credible signals from chat-
ter. Compounding matters, while lower rates usual correlate with a
weaker currency, in India lower interest rates often cause the rupee
to rise. Taken together, these idiosyncrasies make RBI communica-
tions challenging to decode—but could provide the clearest picture
in a cloudy FOREX atmosphere.
To test this assertion, the Reserve Bank of India Index (RBI
Index; the solid black line) is set beside two currency pairs in the
graph below—the rupee-USD (the broken and dotted line) and the
rupee-yuan (the broken line) (Figure 15.11).
The similarities among these data streams are numerous and
remarkable. The RBI Index exhibits 10 major and minor peaks

0.15 0.022

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INR-CNY

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Figure 15.11 RBI Index and exchange rates.

 GLOBAL SENTIMENT 179

from the beginning of 2009 to the end of 2014, and every one of
these peaks finds its analogue in the movements of the currency
pairs. From early 2009 to late 2010, for instance, the RBI Index sees
three major peaks and both currency pairs manifest these trends.
General similarity aside, the first two RBI Index peaks in that
stretch—summer 2009 and spring 2010—also anticipate the cur-
rency market movements seen in both pairs within a few months.
This correlative—and anticipatory—relationship is present
throughout the graph, strongly suggesting that the RBI Index could
indeed help decode India’s convoluted currency fluctuations.

South African Reserve Bank

The South African Reserve Bank (SARB) opened its doors on June
30, 1921 as the result of the South African Parliament’s Currency
and Banking Act of 1920. The bank’s original purpose was to cen-
tralize the South African currency and prevent financial loss due
to British arbitrage. Before the central bank was established, South
African banks issued their own reserve notes and were required to
convert those notes to gold on demand. When the price of gold in
United Kingdom rose above the price of gold in South Africa, UK
traders made a profit by buying gold in South Africa and reselling
it in the United Kingdom. The gold had to be repurchased by South
African commercial banks at a loss to back their currencies. By cen-
tralizing the currency and shifting gold reserves to the reserve bank,
the South African Parliament was able to stop losses due to British
arbitrage (South African Reserve Bank 2015a).
Headquartered in Pretoria, SARB is a joint-stock company with
2 million shares of capital stock, all of which are privately owned
by about 650 individuals. The stock is traded on a over-the-counter
facility that is publicly accessible, but which is separate from the
Johannesburg Stock Exchange. SARB is governed by a governor,
three deputy governors, and eleven directors, all of whom make up
the board of directors. Seven of the directors are appointed by the
bank’s shareholders for three-year terms, while the governor and
deputy governors are appointed for five-year terms by the presi-
dent of the South African Republic. The remaining four directors
are appointed by the president for three-year terms (South African
Reserve Bank 2015c).
180 HOW THE FED MOVES MARKETS

Since its founding, the central bank’s powers have expanded.

The bank is now responsible for setting interest rates and con-
trolling the liquidity of the money supply to insure price stability,
which it defines as inflation from 3 to 6 percent per year. The bank’s
Monetary Policy Committee, which manipulates policy to fulfill the
bank’s goals, meets six times per year, or every two months. SARB
has made a “commitment to transparent monetary policy” that “has
resulted in several initiatives to improve the communication of its
policies to the public” (South African Reserve Bank 2015b).

At the conclusion of every MPC meeting, an MPC statement is issued

through a press conference by the Governor of the Bank explaining the
reasons for the MPC’s policy stance. This press conference is broadcast live
on national television and at the same time the MPC statement is released
on the Bank’s website. (South African Reserve Bank 2015b)

With live, nationally televised broadcasts created to convey mon-

etary policy decisions, the Reserve Bank of South Africa has clearly
dedicated itself to open communication with the public.
To assess the relationship between SARB communications and
the South African economy, Figure 15.12 places the South African

50000 0.6

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Figure 15.12 SARB Index and FTSE/JSE 40.

 GLOBAL SENTIMENT 181

Reserve Bank Index (SARB Index) beside the performance of the

benchmark equity index (and of, in fact, the entire South African
economy): the FTSE/JSE 40.
The SARB Index is represented in Figure 15.12 by the solid black
line, and the FTSE-JSE 40 is represented by the broken line. From the
end of 2011 to late 2014, the general upward trend in the sentiment
indicator matches the market’s climb; powerful fluctuations in the
Index, however, result in minor movements in the market index.
After the SARB Index peaks in the summer of 2012, it descends
gratuitously into mild dovish territory before climbing hawkishly
again. The equities index mirrors this trend, though at a three- to
five-month lag. This analysis mounts a healthy amount of evidence
to suggest that there is a strong predictive correlation between the
SARB Index and the South African equities market.

* * *

As central banks around the world work to oversee their respec-

tive economies, it is clear that open communication has become an
integral part of that effort. Often, these dispatches not only relay
the sentiments of the central bank from which they come, but they
also shape the market that bank oversees—a recent development
that makes the impact of these communications consequential
for any market actor. Through its unbiased, comprehensive, and
quantitative evaluations of these tests, our methodology is able to
shed light on the attitudes and influence of central banks world-
wide—an influence that spans the equity, the fixed-income, and
(especially) the currency markets. Our data also provides students
of these institutions and markets a valuable data stream with which
to decode international economic developments.
 Conclusion

N o longer financial black boxes, modern central banks are talk-

ative, even verbose. Of course, this trend is not unilateral—
China stands as a marked exception—but the vast majority of these
institutions are actively integrating this strategy, and, given recent
evidence, it seems likely that the role of open communication in
central banking will only continue to expand. For those who study
central banks—especially the history of the Fed—this trend is only
the latest, logical step in the development of these institutions.
It is this sentiment—along with the potential of our analytical
methods—that it has been the aim of this book to convey.
By tracing the progress of the Fed from its first days to the finan-
cial crisis and beyond, we have attempted to unpack the rationale
and circumstances that have brought about the central bank’s rise
to power and explain that the subsequent adoption of transparency
is yet another manifestation of that authority. Along with this nar-
rative, we have presented the Fed’s evolution as one story in a grow-
ing anthology of analogous developments seen in central banks
around the world. By investigating the domestic scene as well as
the global picture, we have constructed a comprehensive account
of institutional trends and, simultaneously, a formidable founda-
tion for assessment. Through our research we were not only able
to identify the rise of transparency as a nearly ubiquitous phenom-
enon but, also, conclude that our text-based analytical methods are
well suited to this development.

* * *

Examining the influence and foresight of central banks through

an objective and comprehensive interpretive process that presents
its conclusions in quantitative terms, our methodology represents
184 CONCLUSION

the next, necessary step in the evolution of central bank watching.

As we have explored throughout this book, our data is extremely
versatile: it can be used to understand fluctuations in the fixed
income, equities, and FOREX markets; it can be broken down by
correlation to industrial sector or individual equity to shed light on
the power central banks have on different assets; it can manage a
diverse array of portfolios and achieve significant, market-beating
returns. These examples represent only the initial wave of applica-
tions for our data, and, as we (and others) continue to study central
banks and the markets they move through this method, we can
only expect the pool of innovative applications to grow.
Looking forward, we’ve identified several promising areas of
research. Of these, perhaps the most apparent would be an inves-
tigation of the market-moving hierarchy of central banks inter-
nationally—and the comparative role each bank plays in each
market. The communications of key central banks, like the Federal
Reserve or the European Central Bank, have significant weight not
only in their own economies—but in the global market as well.
Understanding the precise level of global influence each central
bank commands through communication could significantly con-
tribute to the study of international market trends.
Naturally, this path of research could also lead to better under-
standing of the fluctuations in individual economies. Because of
the domestic and international pull central bank communications
have—especially the heavyweight central banks—a comprehensive
(and more accurate) understanding of the part these dispatches play
in each economy is more complex than an examination of the offi-
cial central bank of a given nation. Turkey’s economic activity, for
example, is far more influenced by the ECB than its native central
bank, and, consequently, any analysis of the role central banking
communications play in this market is manifestly incomplete with-
out taking into account a diversity of institutional voices. Because
quantifying the impact of central bank communications is still a
young area of study, such multilayered research would represent
the frontier of this field.
Another potential direction for continued study would be a
deeper investigation of the market expectations that surround these
communications. Since central bank watchers project the direction
of future communications, market actors that are attentive to these
 CONCLUSION 185

forecasts may adjust their strategies accordingly. Once the actual

communication is released, it is quite possible that a gap between
the expected central bank sentiment and the actual sentiment could
exist. Using our methods, it would be possible to evaluate the score
of both the anticipated mood and the actual mood; the difference,
should one exist, represents the likelihood of surprise. Advanced
knowledge of potential incoming market adjustments would repre-
sent an obvious advantage to financial professionals.
This also could lead to an exploration of how the interpretations
of central banking communication effect economic change. The
market, after all, is influenced not only by central bank texts them-
selves, but by the analyses of those communications. In its current
form, our process produces a score that captures these together: a
reaction to a central bank text alone and a reaction to an analysis of
a central banking text all fall under the umbrella of the total market
reaction. If it were possible to score these separately, it could help
identify the accuracy of current analytical methods, help unpack
how market actors digest central bank dispatches, and also work
toward a deeper understanding of how central banks exert their
influence over the economy. This would entail an immensely
involved research process—including a specialized implemen-
tation of our methodology—but the results could certainly yield
worthwhile insight into how monetary policy becomes market
movement.
While central banks certainly make waves, economic trends are,
of course, the result of many factors. Currently built to evaluate
central banking texts, our algorithm could be retooled to assess
market-moving data of all stripes. Regulatory bodies, like the
Securities and Exchange Commission (SEC), Financial Industry
Regulatory Authority (FINRA), and the Commodities Futures
Trading Commission (CFTC), also exert influence through their
communications, and, utilizing similar processes to that which we
developed to examine central banking sentiment, a program cus-
tomized to these data streams could also be designed and built.
Using our methodology, expansive pieces of regulatory legisla-
tion, like Dodd Frank, no longer represent such an interpretive bur-
den. Even seemingly simple legislative directives, like the Volcker
Rule, have spawned hundreds or thousands of pages of regulatory
rules, and our methods can help shortcut analysis of such complex
186 CONCLUSION

policy implementation. So, while it may take years and tens of thou-
sands of pages to produce the regulatory rules associated with com-
plex financial legislation, given proper scaling it takes only seconds
to analyze that text and clarify complex policy directives.
This potential extends to other forms of regulation and their
communication applications. The legal actions of the Food and
Drug Administration (FDA) and Environment Protection Agency
(EPA), for example, have a substantial impact on food, drug, and
energy businesses. To unpack the consequences of regulatory legis-
lation on businesses, lawyers spend countless hours keeping track
of the prolific bureaucratic rule-making processes. Leveraging our
methodology, we can dramatically reduce such legal efforts. In this
arena our data may not be a perfect (or near perfect) substitute for
close reading, but it can serve as a reliable and unbiased highlighter,
identifying the areas requiring more careful qualitative examina-
tion. This simple act could reduce legal costs, speed along regula-
tory review processes, and democratize the ability to understand
and comment on complex government regulations.
The application of this process, however, extends beyond gov-
ernment regulatory and monetary policy bodies—similar varia-
tions of our algorithm could be built to assess the communications
of private companies as well. By collecting and evaluating share-
holder newsletters, press conference texts, meeting transcripts
and media reactions to company developments against a lexicon
of company specific, reaction-scored words, the effect that current
company communications will have on their stock’s performance
can be better understood—and anticipated. Although the market
is already flooded with analysts examining individual equities, our
text analysis methods could yield quantitative results that provide
ordinal rankings of sentiment toward a stock based on official cor-
porate and regulatory documents. Such data is undeniably more
valuable than a simple buy/sell/hold rating. As this and the para-
graphs above suggest, the possible applications of this methodology
are virtually limitless.

* * *

With so many central banks conversing more than ever before,

traditional interpretative techniques, whose detail-centric analysis
 CONCLUSION 187

already limits credibility, will only seem all the more conspicuously
restricted. In other words, the assessments (and forecasts) derived
from a small sampling of specific words and phrases—orthodox
central bank watching—necessarily become less representative of
central banking sentiment as the data set from which they were
pulled grows in size. To maintain its relevance, central bank watch-
ing needs an inclusive interpretive methodology, and this book has
presented a novel method of central banking analysis built from
the ground up to be inclusive.
This inclusivity leverages the comprehensive approach that has
marked the recent wave of “Big Data” applications, while, at the
same time, being grounded in domain expertise. The financial
technology world is flooded with firms using simplified text analy-
sis techniques to glean the sentiment out of social networks, blogs,
news, and almost any other form of text. The trouble is that most
of these firms rely on set dictionaries of terms, some are dubbed
positive, some negative, and the sentiment is calculated by add-
ing positive buzzwords together then subtracting out the negative
buzzwords. There are many variations of this simple method, but
all rely on building (often complex) dictionaries of terms or phrases
and presuming that language does not evolve faster than the estab-
lished word bank. Unfortunately for the computer scientists reliant
on this methodology, complex market dynamics and correspond-
ing policy issues tend to evolve quickly—and often with their own
lexicon.
What are less common—and more vital—are applications that
harness domain expertise to help unlock the potential of the wealth
of data now available. Domain experts can not only train a system
to evolve with changing linguistic cues, but their analysis relies on
a logical combination of individual words and the content in which
those words are communicated. When this type of domain exper-
tise is added to text analytics methods utilizing impartial scaling
and coupled with a sufficiently large amount of data (text), the end
result is valuable, comprehensive, unbiased, quantitative data.
Essentially, data science alone cannot develop valuable data
on complex subjects like central banking or regulation without
domain experts providing viable parameters to reduce the nearly
infinite number of dimensions upon which language can be
scaled. Thus, it is necessary to have a combination of deep domain
188 CONCLUSION

expertise and valuable methodological skills to accurately analyze

central bank (and all other complex) communications. That is why
our firm understanding of the history of central banking institu-
tions, the markets in which they operate, and our grasp of econom-
ics, statistics, and computer science methodology has given us the
foundation necessary to build intelligent and informed interpretive
programs. These are programs that not only point out interesting
patterns in colossal data sets, but sort through the noise and clutter
of central bank communications to provide efficient, expert assess-
ments as well.
As was briefly mentioned above, this approach has broad appli-
cations within, and beyond, financial data. Human beings, and
especially their institutions, are never at a loss for words, and these
words are data. Our methodology not only treats words as data, but
whole communications as data sets requiring expertise to properly
scale, score, and examine. There are numerous institutions, pri-
vate and public, whose voices impact market developments and,
therefore, could be understood more thoroughly through a special-
ized application of our methodology. We chose central banks first
because of our specific expertise and because of the influence cen-
tral banks wield, but we look forward to what further research will
reveal about the remaining of gears of the financial machine.
Ultimately, this book isn’t only about offering a different way
of understanding the influence of central banks; it’s about a dif-
ferent way of understanding the entire market. Vast sets of data sit
relatively unused, and our work serves as an initial effort toward
unlocking the potential buried in the strong, rapid current of com-
munication that drives market dynamics. We believe that the fore-
front of financial data is a marriage between domain expertise and
data processing technology. We believe that the future of finance
lies hidden in plain sight—a puzzle in the prattle.
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 Index

1951 Accord, 25–30 Dodd Frank, 185

domain expertise, 61, 63, 187–8
Aldrich Plan, 10–11, 23 Douglas, Paul, 22–3, 25–6
algorithm Draghi, Mario, 118, 121
Prattle, 62, 185–6
Wall Street, 65–6 Eccles, Marriner, 21, 23–4
Axilrod, Stephen, 32, 41, 43–6 Eisenhower, Dwight D., 28–9
Environment Protection Agency
backtest (EPA), 186
equity markets, 88 European Commission, 116–17
fixed-income markets, 69, 71–5 European Union (EU), 116–18, 120–2
forecast, 93–4, 97 exchange rate, 56, 99–102, 111, 167
Beige Book, 47 exchange-traded fund (ETF), 71
Bernanke, Ben, 55, 58
Binder, Sarah, 12–13 Fed watching, 2–3, 54, 57, 59, 60,
Blue Book, 38 63–5, 92
Bretton Woods, 20, 40, 128 Federal Deposit Insurance
Brill, Daniel, 35, 37 Corporation (FDIC), 18
Burns, Arthur, 39–41, 44, 52, 54 federal funds rate (FFR), 69, 75–6
buzzwords, 62–3, 187 Federal Reserve Reform Act
of 1977, 43
Carter, Jimmy, 44 financial crisis, 57, 74, 75, 82, 84,
centralization, of the Fed, 4, 9, 15–16, 98, 120
31, 38 Financial Industry Regulatory
close reading Authority (FINRA), 185
legal, 186 Food and Drug Administration
literary, 56, 59 (FDA), 186
Committee on Interests and Fratzscher, Marcel, 79, 81–2, 99,
Dividends (CID), 40 101–2
commodities Freedom of Information Act, 36, 41
Australian, 150, 152
Commodities Futures Trading Great Depression, 16–17, 51, 160, 164
Commission (CFTC), 185 Green Book, 38
markets, 157 Greenspan, Alan, 2, 4, 48, 52–5
198 INDEX

innovation position
approach, 157, 184 long, 71–2, 87, 97–8, 136
policy, 44–5, 53 short, 71–2, 136
investment models, 66–7, 74–7 Proxmire, William, 34–5

Knipe, James, 32–3 qualitative evaluations, 3, 59, 64–7

Korean War, 23, 25, 28 quantitative
easing, 120, 131–2, 140
long-term refinancing operation evaluations, 3, 61–2, 64–5, 125
(LTRO), 119
rational expectations philosophy, 54
M2, 40 regional banks, 32, 36–8, 47–8
main refinancing operation (MRO), Reserve Bank Operating Committee
119–20 (RBOC), 11–14
market
currency, 99–111, 144–5, 156–7, Securities and Exchange Commission
165–6, 178–9 (SEC), 18, 185
equity, 77, 79–89, 110–11, 124–5, selection bias, 62–3
133–5, 141–4, 151–4, 161–2, sentiment analysis
167–9, 172, 174–6, 178, 181, 184 Prattle, 62–3, 116, 125
fixed income, 77, 79, 80, 83–4, 97, traditional, 62–3
111, 122–3, 143–5, 152–4, 160, Snyder, John, 23–4
162–4, 170–1, 181 Spindel, Mark, 12–13
Martin, William McChesney, 26–8, Sproul, Alan, 23
31–3, 39, 45, 51
track changes, 57
New Deal, 17–18 Treasury, the United States, 10,
Nixon, Richard, 31, 39–40 16–29, 47
Truman, Harry S., 19–21, 24,
paper trading, full, 71–2 26–8
Patman, Wright, 34–5
portfolio Volcker, Paul, 4, 44–7, 51–2
control, 74, 135–6 Volcker Rule, 185
Fed Index, 69, 74–5, 77, 87–8, 97–8,
135–6, 184 Yellen, Janet, 4, 55, 58