The Impact of US Normalization of Monetary Policy on Stock Market Performance of Emerging Markets: Evidence from Capital Flows and Commodity Price Channels

Abstract

2013 marked a turning point in the US Federal Reserve’s conduction of monetary policy, shifting from an age of unorthodox zero-bound interest rates and quantitative easing, and returning to the normalization of monetary policy. This paper investigates the impacts of the Fed’s normalization of monetary policy on the stock market performance of emerging markets. I focus specifically on the change in US interest rates and its effect on the stock price indices of South Korea, Turkey, Chile, Brazil, Indonesia, Botswana, and Nigeria. I hypothesis that there is a negative relationship between the federal funds rate and stock market performance. The contagion effect is observed through two main mechanisms, the capital channel and the commodities channel. Theoretically, US interest rate hikes leads to capital outflows from emerging markets. It also lowers commodity prices. Since, emerging market countries are highly reliant on the commodity sector, their response to changes in the price of commodities depends on if the good is primarily an export or import. We hypothesis that a change in the price of commodities overall positively impacts these stock market indices. Bayesian VAR is used to investigate research questions. It largely finds a negative relationship between the federal funds rate and the stock price indices of emerging markets. For some countries this relationship is not statistically significant, likely due to changes in domestic monetary policy. There is a significant negative relationship between the funds rate and liabilities, the capital outflow of these countries. I find a statistically significant positive relationship between all commodity prices implemented and stock price indices.