Interest Rate Changes and Stock Return Dynamics

The manipulation of credit in the conduct of monetary policy is receiving increasing attention in regards to the impact it exerts on asset prices and accompanied volatility. Several authors have claimed that relaxed monetary conditions can induce asset bubbles thereby distorting investment decisions on the part of economic actors, be they corporate managers or, investors. This paper explores the impact of the cost of credit on stock return dynamics in the United Kingdom. More specifically it tests the hypothesis that cheap credit (loose monetary conditions) make it easier for investors to follow trend chasing strategies, or equivalently positive feedback trading. Such strategies can lead to runaway prices or, devastating crashes. The model employed is based on the assumption that investors are not homogeneous in the sense that some of them follow expected utility maximizing behavior, whereas others follow positive feedback trading strategies. The evidence from the U.K. market suggests that there is positive feedback trading linked to the cost of credit. Specifically, the lowering of the cost of credit in the pursuit of easy monetary policies leads to positive feedback trading and possibly to unsustainable price bubbles