How do markets arrive at prices? There is perhaps no question more central to economics. This paper focuses on understanding the behavior of prices in financial markets, where the following question looms especially large: How, if at all, is news about macroeconomic fundamentals incorporated into stock prices, bond prices and foreign exchange rates?
The process of price discovery in financial markets remains poorly understood. Traditional “efficient markets” thinking suggests that asset prices should completely and instantaneously reflect movements in underlying fundamentals. Conversely, several influential authors have recently gone as far as to assert that asset prices and fundamentals may be largely and routinely disconnected. Experiences such as the late 1990s U.S. technology-driven market bubble would seem to support that view, yet simultaneously it seems clear that financial market participants pay a great deal of attention to data on underlying economic fundamentals. The notable difficulty of empirically mapping the links between economic fundamentals and asset prices is indeed striking.
We seek to better understand the links between asset prices and fundamentals by simultaneously combining: high-quality and ultra-high frequency asset price data across markets and countries, which allows us to study price movements in (near) continuous time; synchronized survey data on market participants’ expectations, which allow us to infer “surprises” or “innovations” when news is announced; and advances in statistical theory of volatility modeling, which facilitate efficient inference. This in turn allows us to probe of the workings of the marketplace in powerful ways, focusing on episodes where the source of price revisions is well identified, leading to a high signal-to-noise ratio.
The central question posed above how do financial asset prices respond to news about underlying fundamental economic conditions has many dimensions and nuances, which include, but are not limited to, the following. How quickly, and with what patterns, do adjustments to news occur? Does announcement timing matter? Are the magnitudes of effects similar for good news and bad news, or, for example, do markets react more vigorously to bad news than to good news? Quite apart from the direct effect of news on assets prices, what is its effect on financial market volatility? Do the effects of news on prices and volatility vary across assets and countries, and what are the links? Are there readily identifiable herd behavior and/or contagion effects? Do news effects vary over the business cycle?
Just as the central question of price discovery has many dimensions, nuances, and sub-questions, so too does a full answer. In this paper we progress by characterizing the simultaneous response of foreign exchange markets, and domestic and foreign stock and bond markets, to real-time U.S. macroeconomic news. Such a joint, multimarket analysis enables examination of both the robustness of earlier results and the study of cross-market movements and interactions.
We proceed as follows. In Section 2 we provide background by situating our paper in the existing literature. In Section 3 we sketch a stylized multi country monetary model that provides a simple theoretical benchmark and useful guidance for interpreting our empirical results. In Section 4 we describe our data, and in Section 5 we present our new empirical findings. We conclude in section 6.
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