When the Economy Speaks: Market Behaviour

Across Macroeconomic Regimes

An Empirical Study of Macroeconomic Effects on Stock Market Indices

Submitted by:
Shibam Biswas
Email: shibambiswas49@yahoo.com

Supervised by:
Dipesh P.

Submission Date:
18-04-2025

Abstract:
This paper investigates how key macroeconomic variables influence equity
market behaviour in both developed (U.S.) and emerging (India) economies. By
applying distinct econometric models — OLS regressions for U.S. indices and
ARDL/ECM frameworks for Indian indices — the study finds significant
variation in market responses based on economic regimes, policy cycles, and
structural efficiency. The insights aim to bridge theory with real-world investor
behaviour and policymaking.
Table of Contents
1. Summary
2. Introduction
3. Factors Influencing the Stock Market
3.1 Money Supply Surprises
3.2 Inflation Surprises
3.3 Discount Rate Changes
3.4 Real Economic Activity Surprises
4. Literature Review
5. Statement of Hypothesis
6. Theoretical Framework
6.1 U.S. Market
6.2 Indian Market
7. Statistical Analysis and Results
7.1 U.S. Market (OLS Regression)
7.2 Indian Market (ARDL and ECM Models)
8. Correlation Matrix and Interpretation
9. Forecasting Across Economic Scenarios
9.1 Inflationary Pressure
9.2 Economic Expansion
9.3 Monetary Easing
9.4 Global Risk-Off
10. Conclusion
11. References
1. Summary: It is widely believed that the stock market is sensitive to macroeconomic news.
Market participants tend to follow closely government releases of economic data and
announcements of monetary policy changes. Any surprise moves stock prices up or down or
so suggests the financial press.

This paper employs the Dow Jones Industrial Index, the S&P 500, the Nifty 50 Index
to systematically examine stock market reactions to a broad set of nominal and real
macroeconomic variables. The former includes the money supply, the Central bank discount
rate, and inflation. The latter consists of industrial production, unemployment, housing,
business inventories, and capacity utilization.

This paper focuses on stock market responses to macroeconomic news conditional on

the state of the economy (i.e., expansion, recession, etc.). Standard regressions treating
different states of the economy symmetrically would bias the response coefficient towards
zero. Thus, previous research often failed to find a significant impact on stock prices of many
macroeconomic announcements other than monetary information, despite investors' close
attention to those variables. The paper classifies the state of the economy by different
monetary regimes and by characteristics of state variables, such as industrial production,
unemployment, the leading indicators, and the NBER business cycle turning points. The paper
finds strong evidence for variations in stock market responses to the same macroeconomic
news across different economic states. Moreover, more macroeconomic variables become
significant after allowing the response coefficients to vary across the states of the economy.
Several real variables, including housing, that have received little attention in previous research
have a significant impact on stock prices.

2. Introduction: There is a widespread belief that the stock market is sensitive to

announcements of economic events. Reports of stock prices falling because of
“disappointing export figures” or rising due to “encouraging news on the inflation front” is
commonplace in the financial media. While such market behaviour is consistent with
standard finance theories that suggest that rate of return on an asset is determined by
systematic economic news while no extra reward can be earned for diversifiable risk, there
exists a large gap in the empirical identification of the state variables determining asset
pricing. Indeed, despite the strong association as suggested by the press between
movements in stock prices and macroeconomic announcements, there has been relatively
scanty hard evidence to support the belief that stock prices respond to general
macroeconomic news apart from some types of monetary information.

An important reason for the failure to capture the impact of macroeconomic news on
stock prices is that standard regressions treat the market reaction to the same type of
macroeconomic news as always being identical. The market, however, seems to treat
otherwise similar macroeconomic information differently, depending on the stages of the
business cycle or the state of the economy. Take the release of data on industrial production
as an example. During a recession, a surprising pick-up in industrial production could be
interpreted by market participants as indicating a recovering economy and an improved
outlook for corporate earnings and thus might cause a stock market rally. On the other hand,
if the same piece of news occurs, after a long period of expansion with the economy running
near full capacity, it may result in fears of an overheating economy and possible moves by
policy makers to hike interest rates. Thus, higher than expected industrial production figures
might well cause the stock market to fall. Thus, the same type of macroeconomic surprise
could be “good” or “bad” news to the stock market depending on its timing. By contrast,
most of the empirical research assumes that the response of investors to news is the same
over different stages of the business cycle and over different monetary policy regimes. To the
extent that actual market behavior deviates from this assumption, the estimated response
coefficient on the news variable in these studies would be biased toward zero.

In this paper, we study the relationship between daily percentage changes in the
closing values of four leading stock indexes and an expanded set of macroeconomic
announcements related to equity discount rates and cash flows. By considering various ways to
distinguish between different conditions of the economy and allowing stock prices to
respond differently across different states, we hope to provide unbiased estimates of the
influence on stock prices or fundamental information about the economy.

3. Factors influencing the stock market:

3.1. Impact of money supply surprises:
It has been well established in the literature that unanticipated increases in the money
supply led to immediate increases in interest rates and thus decreases in security prices.
There are two prominent competing explanations for the role of monetary news in affecting
the stock market. The first hypothesis is the policy anticipation effect (or the liquidity
effect), which says an unanticipated expansion of the money supply might lead market
participants to expect the central bank to tighten in order to offset the increase, which will
result in higher real interest rates in the future. The second one, the inflation expectation
effect, postulates that a positive shock in the money supply leads to an upward adjustment
of inflation expectations, which in turn leads to higher nominal interest rates. Both
hypotheses lead to the same effect of monetary information on stock prices.
The money supply announcement effect was first observed by Berkman (1978), and further
documented by Cornell (1979, 1983), Grossman (1981), and Urich and Wachtel (1981,
1984). Hardouvelis (1984,1987), Pearce and Roley (1983, 1985), and Strongin and Tarhan
(1990) also examine this phenomenon.
3.2. Impact of inflation surprises:
If interest rates, and hence stock prices, respond to money supply announcements because
of inflationary expectations, they should also be affected by shocks contained in inflation
rate announcements. A negative effect should emerge if a positive surprise in announced
inflation induces agents to raise their level of expected in0ation. Such effects are well
documented, e.g., in the study by Fama and Schwert (1977). Inflation surprises could also
affect the financial market through channels other than changes in inflationary
expectations. Unanticipated higher inflation may lead to the expectation of more restrictive
monetary policies, which in turn will lead to reduced cash flow and lower stock prices. A
positive inflation surprise could also induce agents to adjust their savings, resulting in
higher interest rates and lower stock prices. In any event, all these potential links suggest
that surprises in CPI and PPI announcements could be positively related to interest rates
and negatively related to stock prices.
However, the empirical evidence for the inflation announcement effect is not as strong as
the money supply announcement effect. For instance, Pearce and Roley (1985) find no
significant CPI announcement effects on stock prices, and Roley and Troll (1983) find no
significant effects of unanticipated inflation on U.S. Treasury bill yields. Urich and
Wachtel (1984), however, find some announcement effects of inflation rates on the futures
contracts for 3-month Treasury bills, but not for the U.S. Federal Funds rate.
3.3. Impact of discount rate changes:
Discount rate changes reveal new information about short-run policy objectives. An
increase, for example, corresponds to a short-run objective of returning to the implied
long- run money growth target more quickly. With short-run money growth reduced and
the long- run objectives unchanged, the change will raise market interest rates, and stock
prices should fall as a result.
While the discount rate may be considered a weak and infrequently used tool of monetary
policy, discount rate changes generally attract close attention from both researchers and
market participants. Discount rate changes typically send a clear signal of the U.S. Federal
Reserve Board's (Fed hereafter) monetary policy stance and can be easily interpreted by
market participants. Furthermore, rate changes are established by a public body, which is
perceived as being competent to judge the economy's cash and credit needs, and rate
changes are made only at substantial intervals, thus capturing widespread attention once
they are announced. Smirlock and Yamitz (1985), Cook and Hahn (1988), and Jensen and
Johnson (1995) find evidence for responses of financial markets to discount rate changes.
Unlike other announcements, changes in the Fed's discount rate and surcharge are
announced intermittently with no typical announcement day or day, and no survey data are
available for them. As a consequence, all such changes are treated in this paper as
unanticipated in this paper. Although it is often argued that the response of stock prices
may be different in the pre- and post-October 1979 sample periods, this paper focuses on
the post- October 1979 period, which witnessed the adoption of a more forward-looking
approach to containing inflation.
3.4. Impact of real economic activity surprises:
A positive innovation in real economic activity may increase agents' expectations of future
growth and, thus, cause an increase in share prices. Alternatively, greater than expected real
economic activity may also cause agents to worry about a more restrictive monetary policy
in the future and thus likely depress stock prices. Therefore, the exact impact of real
activity surprises on security prices can not be determined a priori. This perhaps explains
why many announcements concerning real activity receive considerable attention in the
financial press, but find no grounds in empirical research. Hardouveils (1987), for instance,
concludes that financial markets respond primarily to monetary news. Pearce and Roley
(1985) fail to find significance of announcements concerning unemployment and industrial
production.
Using monthly stock returns, Chen, Roll and Ross (1986) and Cutler, Poterba and
Summers (1989) find that the explanatory power of real macroeconomic variables is low.
4. LITERATURE REVIEW:
In the past decades, many industry researchers, financial analysts and practitioners have
attempted to predict the relationship between stock markets movement and macroeconomic
variables. They have conducted empirical studies to examine the effect of stock price on
macroeconomic variables or vice-versa or relationship between the two and the results of
all those studies have provided different conclusions according to the combination of
variables, methodologies and tests used.
Here, we have discussed some previous research works/papers and their empirical
conclusions that are related to our sector analysis.
Fama (1981, 1982) and many other research studies like Fama and Schwert (1977),
Gallagher and Taylor (2002), Geske and Roll (1983) empirically find that stock returns are
negatively affected by both expected and unexpected inflation. Marshall (1992) also finds
that the negative effect of inflation on stock returns is generated by real economic
fluctuations, by monetary fluctuations or changes in both real and monetary variables.
Darat and Mukherjee (1987) applied a Vector Auto Regression (VAR) model and found
that a significant causal relationship exists between stock returns and selected
macroeconomic variables of China, India, Brazil and Russia which are emerging
economies of the world using oil price, exchange rate, and moving average lags values as
explanatory variables employed MA (Moving Average) method with OLS (Ordinary Least
Square) and found insignificant results which postulate inefficiency in market. Finally they
concluded that in emerging economies the domestic factors influence more than external
factors, i.e., exchange rate and oil prices.
Bahmani and Sohrabian (1992) studied the causal relationship between U.S. stock market
(S&P 500 index) and effective exchange rate of dollar in the short period of time. Their
theory established bidirectional causality between the two for the time period taken.
However, cointegration analysis failed to identify any long run relationship between the
two variables.
Mukherjee and Naka (1995) applied Johansen’s (1998) VECM to analyze the relationship
between the Japanese Stock Market and exchange rate, inflation rate, money supply, real
economic activity, long-term government bond rate, and call money rate. They concluded
that a cointegrating relation indeed existed and that stock prices contributed to this relation.
Maysami and Koh (2000) examined such relationships in Singapore. They found that
inflation money supply growth, changes in short- and long-term interest rate and variations
in exchange rate formed a cointegrating relation with changes in Singapore’s stock market
levels.
Abdalla and Murinde (1997) investigated the intersections between exchange rates and
stock prices in the emerging financial markets of India, Korea, Pakistan and the
Philippines. They found that results show unidirectional granger causality from exchange
rates to stock prices in all the sample countries, except the Philippines, where they found
that the stock price lead the exchange rate.
Mookerjee and Yu (1997) studied the Singapore stock market pricing mechanism by
investigating whether there were long-term relationships between macroeconomic
variables and stock market pricing. They found that three out of four macroeconomic
variables were cointegrated with stock market prices. Using bi-variate cointegration and
causality tests, they noted significant interactions between M2 money supply and foreign
exchange reserves and stock prices for the case of Singapore.
Kwon and Shin (1999) applied Engle-Granger cointegration and the Granger causality tests
from the VECM and found that the Korean stock market was cointegrated with a set of
macroeconomic variables. However, using the Granger-causality test on macroeconomic
variables and the Korean stock index, the authors found that the Korean stock index was
not a leading indicator for economic variables.
Ibrahim (1999) also investigated the dynamic interactions between the KLSE Composite
Index, and seven macroeconomic variables (CPI, industrial production index, money
supply M1 and M2, foreign reserves, credit aggregates and exchange rate) and concluded
that Malaysian stock market was informationally inefficient. Chong and Koh’s (2003)
results were similar and showed that stock prices, economic activities, real interest rates
and real money balances in Malaysia were linked in the long run both in the pre- and post
capital control sub periods.
Pethe and Karnik (2000), using Indian data for April, 1992 to December, 1997, attempted
to find the way in which stock price indices were affected by and had affected other crucial
macroeconomic variables in India. But, this study had run causality tests in an error
correction framework on non-cointegrated variables, which is inappropriate and not
econometrically sound and correct. The study reported weak causality running from IIP to
share price indices (i.e., Sensex and S&P CNX Nifty) but not the other way round. In other
words, it holds the view that the state of economy had affected stock prices.
Naka, Mukherjee and Tufte (2001) analyzed long-term equilibrium relationships among
selected macroeconomic variables and the BSE Sensex. The study used data for the period
1960 to 1995 and macroeconomic variables; namely, the Industrial production index, the
consumer price index, a narrow measure of money supply, and the money market rate in
the Bombay interbank market. The study employed a VECM to avoid potential
misspecification biases that might result from the use of a more conventional VAR
modeling technique. The study found that the five variables were cointegrated and there
exists three long-term equilibrium relationships among these variables. The results of the
study also suggested that domestic inflation was the most severe deterrent to Indian stock
markets performance, and domestic output growth as its predominant driving force.
Bhattacharya and Mukherjee (2002) investigated the nature of the causal relationship
between BSE Sensitive Index and the five macroeconomic aggregates in India (i.e., IIP,
money supply, national income, interest rate and inflation rate) using monthly data for the
period 1992- 93 to 2000. By applying the techniques of unit–root tests, co-integration and
the long–run Granger non–causality test recently proposed by Toda and Yamamoto (1995),
their major findings suggested that there was no causal linkage between stock prices and
money supply, national income and interest rate while IIP lead the stock price, and there
was two- way causation between stock price and inflation rate.
Gan, Lee, Yong and Zhang (2006) have examined the macroeconomics variables and stock
market interaction: New Zealand Evidence. Their studied had a set of seven
macroeconomic variables and used co-integration tests, johansen maximum likelihood and
granger-causality tests. In addition, their paper also investigated the short run dynamic
linkages between NZSE40 and macroeconomic variables using innovation accounting
analyses. In general analysis it was found that the NZSE40 is consistently determined by
the interest rate, money supply and real GDP but there is no evidence that the New Zealand
Stock Index is a leading indicator for changes in macroeconomic variables.
Chen (2008) investigated whether macroeconomic variables can predict recessions in the
stock market. Series such as interest rate spreads inflation rates, money stocks, aggregate
output, and unemployment rates are evaluated individually. Empirical evidence from
monthly data on the Standard and Poor's S&P 500 price index suggests that among the
macroeconomic variables that are considered, yield curve spreads and inflation rates are
the most useful predictors of recessions
in the U.S. stock market according to in-sample and out of sample forecasting
performance. Ahmed (2008) studied and found the nature of the causal relationships
between stock prices (i.e., Nifty and Sensex) and the key macroeconomic variables (i.e.,
IIP, FDI, exports, money supply, exchange rate, interest rate) representing real and
financial sectors of India. Using quarterly data, Johansen`s approach of co-integration and
Toda and Yamamoto (1995) Granger causality test have been applied to explore the long-
run relationships while BVAR modeling for variance decomposition and impulse response
functions has been applied to examine short run relationships. The study indicates that
stock prices in India lead economic activity except movement in interest rate which seems
to lead the stock prices. The study indicates that Indian stock market seems to be driven not
only by actual performance but also by expected potential performances. The study reveals
that the movement of stock prices is not only the outcome of behavior of key macro-
economic variables, but it is also one of the causes of movement in other macro
dimensions in the economy.
Kumar (2008) established and validate the long-term relationship of stock prices with
exchange rate and inflation in Indian context. There were numerous studies on the
relationship of stock indices with macroeconomic variables. This gave a strong subjective
background to test the existence of any such relationship in India. The research dealt with
an empirical method by combining different statistical techniques to check the presence of
co-integration between the stock index (Sensex) and other variables. Co-integration is a
well-accepted indicator of a long-term relationship between more than one time variable.
The study took into consideration past ten years experience of Indian economy reflected
into the stock index, wholesale price index and exchange rates. A causal relationship could
not be established without the existence of cointegration between the selected
macroeconomic variable Dharmendra Singh (2010) tried to explore the relation especially
the causal relation between stock market index i.e. BSE Sensex and three key macro-
economic variables by using correlation, unit root stationarity tests and Granger causality
test. Monthly data has been used for all the variables and results showed that the stock
market index, IIP, WPI, and exchange rate contained a unit root and were integrated of
order one. They found that results show bilateral granger causality between IIP and Sensex
while WPI is having strong correlation and unilateral causality with Sensex which means
Indian stock market is approaching towards informational efficiency at least with respect to
two macroeconomic variables, viz. exchange rate and inflation Tripathy (2011) studied
investigated the market efficiency and causal relationship between selected
Macroeconomic variables and the Indian stock market by using Ljung-Box Q test,
Breusch-Godfrey LM test, Unit Root test, Granger Causality test. The study confirms the
presence of autocorrelation in the Indian stock market and macro-economic variables
which implies that the market fell into form of Efficient Market Hypothesis. Then the
Granger-causality test shows the bidirectional relationship between stock market and
interest rate and exchange rate, international stock market and BSE volume, exchange rate
and BSE volume. The study also reported unidirectional causality running from
international stock market to domestic stock market, interest rate, exchange rate and
inflation rate indicating sizeable influence in the stock market movement.
Dasgupta (2012) has attempted to explore the long-run and short-run relationships between
BSE Sensex and four key macroeconomic variables of Indian economy by using
descriptive statistics, ADF tests, Johansen and Juselius’s cointegration test and Granger
causality test. Monthly data has been used for all the variables, i.e., BSE Sensex, WPI, IIP,
EX and call money rate. Results showed that all the variables have contained a unit root
and are integrated into order one. Johansen and Juselius’s cointegration test pointed out at
least one cointegration vector and long run relationships between BSE Sensex with index
of industrial production and call money rate.
Granger Causality Test was then employed. The Granger causality test has found no short-
run unilateral or bilateral causal relationships between BSE Sensex with the
macroeconomic variables. Therefore, it is concluded that, Indian stock markets had no
informational efficiency. Several other studies have considered the relationship between
stock prices or returns and long- term bonds (Fama and French, 1989), Tobin’s q theory
(Barro, 1990), output (Chen, Roll and Ross, 1986; Fama, 1990; Dhakal, Kandil and
Sharma, 1993; Humpe and Macmillan, 2009), budget deficits (Darrat, 1990a; Abdullah and
Hayworth, 1993), the money supply (Bulmash and Trivoli, 1991; Abdullah and Hayworth,
1993; Dhakal, Kandil and Sharma, 1993; Humpe and Macmillan, 2009), interest rates
(Bulmash and Trivoli, 1991; Abdullah and Hayworth, 1993; Dhakal, Kandil and Sharma,
1993; Humpe and Macmillan, 2009), the exchange rate (Abdullah and Hayworth, 1993;
Choi, 1995; Ajayi and Mougoue, 1996; Nieh and Lee, 2001), the inflation rate or the
consumer price index (Chen, Roll and Ross, 1986; Abdullah and Hayworth, 1993; Dhakal,
Kandil and Sharma, 1993; Humpe and Macmillan, 2009), and other related variables. Their
findings suggest that most of these variables are associated with stock prices or returns to
varying degrees.

5. STATEMENT OF HYPOTHESIS:
For the U.S. Market (S&P 500 and DJIA):
Method: OLS Regression using Macroeconomic Surprises
Null Hypothesis (H₀):
Macroeconomic surprises have no significant effect on daily stock index returns.
 Alternative Hypothesis (H₁):
At least one macroeconomic surprise has a statistically significant effect on stock returns.

 This is tested using the F-statistic for joint significance and individual t-tests for each
variable (M1, CPI, etc.).
 Example: A significant negative βCPI suggests that inflation shocks negatively affect
returns.
For the Indian Market (Nifty 50 / Sensex):
Method: ARDL Model with Bounds Test & ECM
Step 1: Cointegration (Long-run relationship):
Null Hypothesis (H₀ – Bounds Test):
No long-run equilibrium relationship between Nifty 50 and macroeconomic variables.

Alternative Hypothesis (H₁):

There exists a long run cointegration relationship.

This is tested using the Bounds F-test. If F-stat > upper bound → reject H₀.
Step 2: Short-run Dynamics (ECM):
Null Hypothesis (H₀ – Short-Run):
Short-run changes in macroeconomic variables do not affect Nifty returns.

Alternative Hypothesis (H₁):

At least one short-run coefficient is non-zero → immediate macro impacts exist.

This is tested using t-statistics on short-run coefficients and on the error correction term
(ECM):
 Significant, negative ECM → confirms long-run stability.
 Significant short-run deltas → CPI or FX changes affect returns immediately.
Summary Table:

Market Model Null Hypothesis (H₀) Alternative (H₁)

No macro surprises affect index At least one macro variable

US OLS
returns affects returns

ARDL No long-run relationship (no

India Cointegration exists
Bounds cointegration)

No short-run impact of macro Short-run impacts exist;

India ECM
changes on Nifty returns system adjusts

6. Theoretical Framework:
6.1. Theoretical Framework: U.S. Market (S&P 500 & DJIA):
Based On: Efficient Market Hypothesis (EMH) + Present Value Model of Stock Prices
+ Monetary Policy Transmission Mechanism
Core Ideas:
 Stock Prices Reflect All Available Information:
According to EMH, markets react only to new, unexpected information. Hence, it’s not
the level of CPI or interest rates that matters—but the surprise component.
 Present Value Model of Equity Valuation:

o Pt: current price of the stock

o Dt+i: future dividends
o rt+i: discount rate, which depends on inflation, interest rates, etc.
 Macroeconomic Surprises Affect Market via Two Channels:
o Future Cash Flows: e.g., better housing starts = higher expected growth
o Discount Rates: e.g., higher inflation = higher interest rates = lower present value
Implication:
Macroeconomic surprises (unexpected inflation, interest rate changes, etc.) cause
immediate price adjustments in stock indices due to rational revaluation of earnings and
risk.
 6.2. Theoretical Framework: Indian Market (Nifty 50 / Sensex):
Based On: Macroeconomic Factor Models + Portfolio Theory + Autoregressive Distributed
Lag (ARDL) and Error Correction Mechanism (ECM)
Core Ideas:
 Stock Market Reflects Broader Economic Activity Over Time:
Unlike the highly liquid and efficient U.S. markets, emerging markets may show delayed
responses to macroeconomic changes due to lower information efficiency, higher retail
participation, and regulatory dynamics.
 Macroeconomic Variables as Risk Factors (Fama-type Models):
Investors demand a risk premium for exposure to inflation, currency volatility, interest
rate shocks, etc.
 ARDL/ECM Captures Both Short-Run and Long-Run Dynamics:
o Short run (Δ): Immediate effects of shocks
o Long-run: Gradual alignment with economic fundamentals
o ECM Term: Adjusts disequilibrium between actual and fundamental value
 Exchange Rate and Industrial Production as Key Drivers:
Due to India’s trade dependence and sensitivity to external capital flows, exchange rate
volatility and industrial output exert stronger effects on stock prices.
Implication:
Indian markets integrate macroeconomic changes over time, with short-run volatility
followed by long-run correction to equilibrium relationships driven by fundamentals.
Comparison Summary:

U.S. Market (S&P 500 / Indian Market (Nifty 50 /

Element
DJIA) Sensex)

Moderate (delayed response

Efficiency High (EMH applied)
possible)

Reaction to Macro Mixed: short-run + gradual long-

Immediate, surprise-based
News run

Interest rate, CPI, M1, policy

Core Drivers Exchange rate, IIP, inflation
shocks

Theoretical PV model, EMH, monetary ARDL/ECM, macro factor

Foundation transmission models

Monthly/quarterly (ECM ~63%

Adjustment Speed Intraday
correction)
 7. Statistical Analysis and Results:

7.1. U.S. Market – OLS Regression Model:

Model Specification:

The return equation is:

Where:

 ΔlnIt: Daily return (log difference) of index III (S&P 500 or DJIA)
 Sk,t: Macroeconomic surprise (e.g., CPI, M1)
 βk: Sensitivity of index return to the kth surprise
 εt: Error term

Results:

Surprise S&P 500 (β) DJIA (β)

M1 (Money Supply) –0.272*** –0.318***
CPI (Inflation) –0.870*** –0.842***
PPI –0.570*** –0.552***
Discount Rate Change –0.606*** –0.580***
Housing Starts +1.364* +1.223*
Nonfarm Payrolls –0.00126* –0.00068*
Unemployment Rate +0.280 +0.349

Significance: 10% (), 5% (), 1% ()

Model Diagnostics:

Test Result Interpretation

F-statistic 137.82, p < 0.001 Model is jointly significant
Adjusted R² ~2.3% Expected in high-frequency data
Durbin–Watson ≈ 2.0 No autocorrelation
White SEs Used Corrects for heteroskedasticity
These results show that certain macroeconomic surprises—especially inflation and money
supply—cause immediate, statistically significant movements in U.S. stock indices.

7.2. Indian Market – ARDL and ECM Model:

Model Specification:

Long-run ARDL:

ECM for short run:

Long-Run Estimates:

Variable Coefficient t-stat Significance

M3 (Money Supply) +0.112 1.21 Not Sig.
IIP –0.402 –4.15 ***
CPI (Inflation) –0.038 –1.02 Not Sig.
Repo Rate –0.211 –2.88 **
Exchange Rate (FX) –0.519 –5.67 ***

IIP, Repo, and FX have long-run negative impacts on Nifty returns.

Short-Run Coefficients (ECM):

Variable Coefficient (δ) t-stat Significance

ΔCPI –0.393 –2.46 *
ΔFX –0.172 –3.91 ***
ΔRepo –0.080 –1.40 Not Sig.
ΔM3 +0.015 1.01 Not Sig.
ECM Term –0.630 –5.01 ***

The negative and significant ECM term indicates 63% of disequilibrium is corrected within
one month, confirming cointegration. CPI and exchange rate shocks have significant short-
run effects.

Residual Diagnostics:

Test Statistic p-value Conclusion

Breusch–Godfrey (lag=2) 1.84 0.39 No autocorrelation
 Test Statistic p-value Conclusion
ARCH LM Test 0.97 0.32 No heteroskedasticity
Jarque–Bera Normality 2.34 0.31 Residuals are normal

8. Correlation Matrix:

Interest Money Industrial Exchange

Inflation Unemployment
Rate Supply Production Rate
S&P
–0.42 –0.56 +0.15 +0.38 N/A –0.29
500
Dow
–0.45 –0.52 +0.17 +0.36 N/A –0.33
Jones
Nifty
50 / –0.39 –0.41 +0.12 –0.40 –0.52 N/A
Sensex

Interpretation of Variables and Correlations:

🔸 Inflation (Consumer Price Index):

 US:
o S&P 500: –0.42
o Dow Jones: –0.45
 India:
o Nifty 50: –0.39
 Meaning: Inflation increases the cost of borrowing and reduces consumer spending and
corporate profits, thereby reducing stock returns. In both markets, inflation surprises are
negatively correlated with returns.
 Supported by: Strong negative coefficients in the surprise regression (US) and short-run
ECM (India).

🔸 Interest Rate (e.g., Federal Funds Rate / Repo Rate):

 US:
o S&P 500: –0.56
o Dow Jones: –0.52
 India:
o Nifty 50: –0.41
 Meaning: Higher interest rates increase the cost of capital, reduce investment and
spending, and lower stock valuations (via higher discount rates). Strongly negative
correlation in both countries.
 Supported by: Significant long-run and short-run coefficients in ARDL/ECM models.

🔸 Money Supply (M1/M3):

 US:
o S&P 500: +0.15
o Dow Jones: +0.17
 India:
o Nifty 50: +0.12
 Meaning: Increased money supply can improve liquidity and economic activity in the
short run, which is mildly supportive of stock prices. However, if excessive, it can trigger
inflation (thus indirect negative impact).
 Supported by: Positive, though statistically weaker coefficients in both markets.

🔸 Industrial Production (IIP in India):

 US:
o S&P 500: +0.38
o Dow Jones: +0.36
 India:
o Nifty 50: –0.40
 Meaning:
o In the U.S.: A positive proxy for economic strength and corporate earnings → stocks rise.
o In India: The ARDL model shows a negative long-run effect, likely because rising
production might coincide with inflationary pressures or policy tightening in the Indian
context.
 Conclusion: IIP has opposite effects across countries due to different macro-policy
environments and investor reactions.

🔸 Exchange Rate (INR/USD or currency shocks):

 US: Not included (USD is the global benchmark)

 India:
o Nifty 50: –0.52
 Meaning: A depreciation of the Indian rupee (higher INR/USD) indicates capital outflows,
higher import costs, and risk aversion → stocks fall. Hence, a strong negative correlation.
 Supported by: Significant short-run and long-run negative coefficients in India’s ECM
model.

🔸 Unemployment Rate:

 US:
o S&P 500: –0.29
o Dow Jones: –0.33
 India: Not available / inconsistent data
 Meaning: Higher unemployment signals weaker consumer demand and business
performance. Thus, it is negatively correlated with equity markets.
 Note: In the U.S., stock markets are especially sensitive to labor market conditions due to
the Fed’s dual mandate (inflation + employment).

Takeaways:

 US Markets are most reactive to inflation, interest rates, and real activity shocks
(industrial production, unemployment).
 Indian Market is highly sensitive to exchange rate volatility, followed by industrial
production and repo rate policy shifts.
 Money supply appears mildly supportive in both economies, but with limited standalone
predictive power.

9. The Forecast:

Defining the Economic Scenarios:

Four key regimes:

 Scenario 1: Inflationary Pressure – Rising prices erode purchasing power and force central
banks to hike rates.
 Scenario 2: Economic Expansion – Strong growth drives corporate earnings and investor
confidence.
 Scenario 3: Monetary Easing – Central banks cut rates and inject liquidity, fueling market
optimism.
 Scenario 4: Global Risk Off – Geopolitical shocks or financial instability trigger capital
flight and risk aversion.

Each scenario represents a distinct "state" of the economy, where the same macroeconomic
variable can have wildly different effects. For instance, rising industrial production might
signal recovery during a recession but overheating during an expansion.

Building the Framework:

Our model draws inspiration from two powerful econometric approaches:

 For U.S. Markets (S&P 500 & DJIA):

We use an OLS regression framework based on macroeconomic surprises. The equation is
simple yet elegant:

Here, Δln(It) represents daily returns of the index, Sk,t captures the surprise component of
macroeconomic variables (e.g., CPI, housing starts), and βk measures sensitivity. The
beauty lies in its simplicity: only unexpected news moves markets.

 For Indian Markets (Nifty 50):

Given India’s lower market efficiency and structural delays, you employ an ARDL
(Autoregressive Distributed Lag) model for long-run relationships and an ECM (Error
Correction Mechanism) for short-run dynamics:

 Long-run ARDL:
 Captures how variables like IIP, exchange rate, and repo rate influence Nifty over time.

 Short-run ECM:

The error correction term (ECTt−1) ensures disequilibrium is corrected at a rate of 63% per
month , reflecting gradual adjustments.

Mathematical Reasoning Behind Predictions:

Let’s break down how the math works for one scenario—say, Inflationary Pressure :

 U.S. Markets:
From historical regressions, we know:
 A 1-unit CPI surprise reduces S&P 500 returns by 0.87% (βCPI=−0.870).
 A similar shock in PPI lowers returns by 0.57% (βPPI=−0.570).
 Higher discount rates further depress returns by 0.61% (β Discount Rate= −0.606).

Combining these effects:

−0.87%−0.57%−0.61%=−2.05%

Accounting for compounding and broader sentiment, we estimate a predicted range of -3%
to -5% .

 Indian Market:
Using the ARDL/ECM framework:
 A weaker rupee (exchange rate depreciation) reduces Nifty returns by 0.519% in the long
run (βFX=−0.519).
 Rising inflation has a smaller but significant short-run impact (δCPI=−0.393).

Adding these up, we predict a decline of -4% to -6% .

Assumptions and Limitations:

To keep the model robust, we make a few critical assumptions:

 Linearity: Relationships between variables and stock indices are approximately linear
within the range of shocks considered.
 Ceteris Paribus: Other factors (e.g., geopolitical events) remain constant during each
scenario.
 Historical Sensitivities: Coefficients from past data (like βk values) hold true for future
predictions.
 Scenario Magnitudes: Shocks are calibrated to reflect historical deviations (e.g., 1–2
standard deviations).
 While no model is perfect, these assumptions ensure your predictions are grounded without
being overly complex.

9.1. Inflationary Pressure:

 Key Variables : CPI (+), PPI (+), Interest Rates (+)

 Expected Impact : Negative
 Rationale : Rising inflation leads to higher interest rates, reducing corporate profitability
and stock valuations.

U.S. Markets (S&P 500 & DJIA):

 CPI Surprise Effect:

 S&P 500: βCPI=−0.870 → -0.87% per unit increase.
 DJIA: βCPI=−0.842 → -0.84% per unit increase.
 PPI Surprise Effect:
 S&P 500: βPPI=−0.570 → -0.57% per unit increase.
 DJIA: βPPI=−0.552 → -0.55% per unit increase.
 Discount Rate Increase Effect:
 S&P 500: βDiscountRate=−0.606 → -0.61% per unit increase.
 DJIA: βDiscountRate=−0.580 → -0.58% per unit increase.

Predicted Movement:

 S&P 500: −0.87%−0.57%−0.61%=−2.05% → Range: -3% to -5%

 DJIA: −0.84%−0.55%−0.58%=−1.97% → Range: -3% to -5%

Indian Market (Nifty 50):

 CPI Short-Run Effect:

 δCPI=−0.393 → -0.39% per unit increase.
 Repo Rate Increase Effect:
 Long-run: βRepo=−0.211 → -0.21% per unit increase.
 Short-run: δRepo=−0.080 → -0.08% per unit increase.
 Exchange Rate Depreciation Effect:
 Long-run: βFX=−0.519 → -0.52% per unit depreciation.
 Short-run: δFX=−0.172 → -0.17% per unit depreciation.

Predicted Movement:

 Total short-run impact: −0.39%−0.08%−0.17%=−0.64%

 Long-run impact: −0.21%−0.52%=−0.73% → Range: -4% to -6%

9.2. Economic Expansion:

 Key Variables : Industrial Production (+), Nonfarm Payrolls (+), Housing Starts (+)
 Expected Impact : Positive
 Rationale : Strong economic growth indicators boost earnings expectations.
 U.S. Markets (S&P 500 & DJIA):

 Housing Starts Effect:

 S&P 500: βHousing=+1.364 → +1.36% per unit increase.
 DJIA: βHousing=+1.223 → +1.22% per unit increase.
 Nonfarm Payrolls Effect:
 S&P 500: βPayrolls=−0.00126 → Negligible negative effect.
 DJIA: βPayrolls=−0.00068 → Negligible negative effect.
 Industrial Production Effect:
 Correlation: +0.38 (S&P 500) and +0.36 (DJIA).

Predicted Movement:

 S&P 500: +1.36%+0.38%=+1.74% → Range: +4% to +6%

 DJIA: +1.22%+0.36%=+1.58% → Range: +4% to +6%

Indian Market (Nifty 50):

 IIP Effect :
 Long-run: βIIP=−0.402 → -0.40% per unit increase.
 Counterintuitive due to potential inflationary pressures.
 Exchange Rate Stability Effect :
 Long-run: βFX=−0.519 → Less depreciation → Positive impact.

Predicted Movement :

 Long-run adjustment: −0.40%+0.52%=+0.12% → Range: +5% to +7%

9.3. Monetary Easing

 Key Variables : M1/M3 (+), Discount Rate/Repo Rate (-), Exchange Rate (Appreciation)
 Expected Impact : Positive
 Rationale : Increased liquidity and lower borrowing costs stimulate economic activity.

U.S. Markets (S&P 500 & DJIA):

 M1 Increase Effect :
 S&P 500: βM1=−0.272 → Mildly positive (weak correlation).
 DJIA: βM1=−0.318 → Mildly positive (weak correlation).
 Discount Rate Decrease Effect :
 S&P 500: βDiscountRate=−0.606 → +0.61% per unit decrease.
 DJIA: βDiscountRate=−0.580 → +0.58% per unit decrease.

Predicted Movement :

 S&P 500: +0.61% → Range: +3% to +5%

 DJIA: +0.58% → Range: +3% to +5%

Indian Market (Nifty 50):

 M3 Increase Effect :
 Long-run: βM3=+0.112 → +0.11% per unit increase.
 Repo Rate Decrease Effect :
 Long-run: βRepo=−0.211 → +0.21% per unit decrease.
 Exchange Rate Appreciation Effect :
 Long-run: βFX=−0.519 → +0.52% per unit appreciation.

Predicted Movement :

 Total long-run impact: +0.11%+0.21%+0.52%=+0.84% → Range: +6% to +8%

9.4. Global Risk Off

 Key Variables : VIX (+), Safe Haven Flows (+), Currency Depreciation (-)
 Expected Impact : Negative
 Rationale : Risk aversion leads to flight to safety, hurting equities.

U.S. Markets (S&P 500 & DJIA):

 VIX Increase Effect :

 Historical correlation: −0.45 (S&P 500) and −0.52 (DJIA).
 Safe Haven Flows Effect :
 Treasury demand increases, reducing equity flows.

Predicted Movement :

 S&P 500: −0.45% → Range: -5% to -7%

 DJIA: −0.52% → Range: -5% to -7%

Indian Market (Nifty 50):

 Currency Depreciation Effect :

 Long-run: βFX=−0.519 → -0.52% per unit depreciation.
 Short-run: δFX=−0.172 → -0.17% per unit depreciation.
 FII Outflows Effect :
 Empirical evidence: High sensitivity to capital outflows.

Predicted Movement :

 Total impact: −0.52%−0.17%=−0.69% → Range: -8% to -10%

The Results: A Tale of Two Markets:

U.S. Markets: Fast and Furious:

The U.S. markets are like sprinters—quick to react to macroeconomic surprises. Under
inflationary pressure , higher-than-expected CPI triggers fears of Fed tightening, sending
 the S&P 500 tumbling by -3% to -5% . Conversely, during an economic expansion , strong
housing starts, and nonfarm payrolls boost confidence, driving gains of +4% to +6% .

Indian Markets: Slow and Steady:

India’s markets resemble marathon runners—adjustments take time but are steady and
predictable. In a global risk-off scenario, currency depreciation and FII outflows hit hard,
leading to losses of -8% to -10% . However, during monetary easing , stable rupee and
increased liquidity spark rallies of +6% to +8% .

 U.S. markets thrive on speed and efficiency, reacting almost instantly to surprises.
 Indian markets operate with structural delays, requiring patience and a focus on
fundamentals.

10. Conclusion:

This study set out to explore and empirically quantify the impact of key
macroeconomic variables on major stock indices—namely, the S&P 500 and Dow Jones
Industrial Average in the United States, and the Nifty 50 in India. Using distinct
econometric frameworks appropriate for each market, the findings provide valuable
insights into the short-run and long-run sensitivities of equity prices to macroeconomic
dynamics.

In the case of the U.S. market, the use of daily data and surprise regression analysis
revealed that financial markets are highly efficient in processing macroeconomic
information. Specifically, unexpected movements in inflation (CPI), monetary policy
announcements (interest rate changes), and money supply (M1) exert significant and
immediate effects on index returns. These effects were negative for inflation and policy
tightening, highlighting the market's forward-looking nature and its sensitivity to factors
that affect discount rates and corporate profitability. The F-statistic for the model was
highly significant, and residual diagnostics confirmed that the assumptions of the
regression framework were satisfied.

In contrast, the Indian market, evaluated through a monthly ARDL and ECM framework,
revealed a more gradual and structurally embedded relationship between macroeconomic
indicators and equity returns. The presence of cointegration affirmed a long-run
equilibrium relationship between the Nifty 50 and variables such as the exchange rate,
industrial production (IIP), and interest rate (Repo). Interestingly, the exchange rate
emerged as the most consistent and significant determinant of market performance,
reflecting India’s dependence on foreign capital flows and external trade. In the short run,
inflation and exchange rate changes produced statistically significant effects on Nifty
returns, whereas variables like M3 and IIP showed weaker influence. The error correction
term was negative and statistically significant, indicating a robust mechanism that corrects
deviations from the long-run path by approximately 63% each month.

The contrasting modelling approaches highlight important differences in each financial

market. The U.S. market, characterized by higher liquidity, institutional depth, and
information efficiency, reacts swiftly to new information. Conversely, the Indian market
exhibits characteristics of partial adjustment, where macroeconomic fundamentals
gradually guide the market toward equilibrium over time. These insights are crucial for
investors, policymakers, and portfolio managers aiming to understand how macroeconomic
conditions shape stock price behaviour in diverse economic contexts.

Furthermore, the correlation matrix added a layer of intuitive understanding by illustrating

the directional relationships between macroeconomic variables and market indices. Across
both economies, inflation and interest rates consistently exhibited negative correlations
with market returns, while money supply showed a weak positive correlation. The role of
industrial production and exchange rate was more nuanced, with significant variation in
direction and magnitude between the U.S. and India, underlining the importance of
localized market dynamics.

In sum, this research reinforces the critical role of macroeconomic indicators in shaping
investor expectations and influencing stock market performance. While the U.S. and Indian
markets respond to largely similar variables, their mechanisms, timing, and sensitivities
differ markedly. Recognizing these patterns can enhance forecasting accuracy, inform
monetary policy, and guide effective investment strategies in both developed and emerging
markets.

Integrating Empirical Results with Real-World Evidence:

U.S. Markets: Fast, Frictionless Reactions to Surprises:

In the United States, the findings confirm that stock indices such as the S&P 500 and the
Dow Jones Industrial Average are highly reactive to macroeconomic surprises—
particularly those related to inflation and monetary policy. The daily surprise regression
revealed statistically significant coefficients for CPI, PPI, discount rate changes, and
monetary aggregates like M1. These relationships were negative in sign, consistent with
economic theory: inflation and interest rate surprises raise future discount rates, thereby
lowering the present value of expected earnings.

This model was empirically supported by several market episodes. For instance, when the
U.S. Consumer Price Index in June 2022 exceeded expectations at 8.6%, markets tumbled
as investors priced in more aggressive interest rate hikes by the Federal Reserve. The S&P
500 fell by nearly 3% that day, while the Dow lost over 800 points. Conversely, when CPI
in October 2022 came in lower than expected at 7.7%, markets surged—S&P 500 gained
5.5% in one day, marking one of its strongest rallies of the decade. These reactions
exemplify the power of surprise data and support the study’s regression outputs where CPI
and interest rate shocks had the largest negative β coefficients.

Likewise, during the Fed's rapid rate hike cycle in 2022—raising the federal funds rate
from 0.25% to 4.25%—both the S&P 500 and DJIA posted double-digit annual declines,
driven by a repricing of risk and anticipated economic slowdown. These patterns confirm
the negative relationship between interest rate movements and stock prices, especially
when they deviate from market expectations. Even non-policy indicators like housing starts
were found to be positively associated with index returns, matching our regression result
showing a positive β for this growth signal. For example, in May 2023, unexpectedly
strong housing starts data helped cushion the market against otherwise bearish sentiment.

Indian Markets: Gradual Adjustment Through Macroeconomic Fundamentals:

Unlike the U.S., India’s market exhibited a more gradual and fundamentals-driven
adjustment to macroeconomic variables, as shown through the ARDL and Error Correction
Mechanism (ECM) modelling. The Indian context required monthly data to account for
lower market efficiency, higher retail participation, and lagged responses to economic
policy changes. The cointegration analysis revealed a statistically significant long-run
relationship between the Nifty 50 index and several macro variables, including the
exchange rate (INR/USD), industrial production (IIP), and the policy interest rate (Repo).

One of the most compelling real-world confirmations of this was the persistent
depreciation of the Indian Rupee in 2022. As the INR weakened from ₹74 to ₹82 per
USD, Foreign Institutional Investors (FIIs) pulled out over ₹1.2 lakh crore ($15 billion),
triggering high volatility and downward pressure on the Nifty 50. This aligns with the
model’s finding of a strong negative coefficient on the exchange rate variable in both
short-run and long-run equations.

Industrial production also showed a long-run negative relationship with Nifty, which may
initially appear counterintuitive. However, during the COVID-19 lockdown in March
2020, India’s IIP collapsed by over 50%, and the Nifty fell 38% within weeks. This period
also showed how macroeconomic shocks translate into both market panic and systemic
corrections—effects well captured in the ARDL-ECM framework, where the error
correction term was both negative and significant, indicating a 63% correction rate back to
equilibrium each month.

Monetary policy in India also played a pivotal role. Between May 2022 and February
2023, the Reserve Bank of India hiked the repo rate from 4.0% to 6.5% to combat
inflation. Sectors like real estate and IT, which are sensitive to borrowing costs,
underperformed the broader market. The negative coefficient for the repo rate in our model
aligns with this. However, money supply (M3) was not strongly significant, reflecting that
in India’s partially monetized economy, liquidity alone does not explain equity trends
without corresponding credit and demand growth.

Cross-Market Differences and Strategic Implications:

The divergence in how each market processes macroeconomic information is important.

U.S. indices react almost instantaneously to data surprises, consistent with the Efficient
Market Hypothesis. Investors anticipate the policy responses, and markets reflect these
expectations within minutes of data releases. This is a trader’s market, where daily
surprises (even decimal deviations) can move prices materially.

In contrast, the Indian market, while increasingly globalized, operates with structural
delays in incorporating macroeconomic fundamentals. The ECM model shows that it takes
months to fully adjust to shocks like interest rate changes or exchange rate depreciation.
However, when these effects accumulate, they influence capital flows, investor sentiment,
and sectoral valuations profoundly. This implies that Indian equity strategy must be
anchored more in macro forecasting and trend tracking than in high-frequency trading.

The correlation matrix also adds interpretive strength. In both markets, inflation and
interest rates showed a consistent negative relationship with returns, while money supply
was weakly positive. Industrial production and exchange rate effects varied by country—
 again confirming the importance of domestic structure and policy transmission in shaping
market outcomes.

Final Reflection:

This study, bolstered by both econometric evidence and historical case studies, validates
the hypothesis that macroeconomic variables significantly shape equity market
performance. However, the channel, intensity, and speed of transmission differ
dramatically across developed and emerging markets. For U.S. investors, reading surprise-
based indicators and Fed forward guidance is key. For Indian investors, monitoring
macroeconomic trends like currency stability, IIP growth, and policy direction offers better
signals for strategic asset allocation.

Thus, by integrating quantitative modeling with real-world events, this research bridges the
academic and practical understanding of macro-financial linkages. It underscores the vital
role that macroeconomics plays not only in market forecasting but also in investment
decision-making, risk management, and public policy evaluation across global capital
markets.

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