Monetary Transmission and Portfolio Rebalancing: A Cross-Sectional Approach

105 Pages Posted: 19 Apr 2023 Last revised: 30 Nov 2023

See all articles by Xu Lu

Xu Lu

University of Washington - Michael G. Foster School of Business

Lingxuan Wu

Department of Economics, Harvard University

Date Written: November 29, 2023

Abstract

We propose that institutional investors’ portfolio rebalancing across asset classes contributes to the stock market’s puzzlingly large response to monetary shocks. We identify this channel through a cross-sectional approach and find that, ceteris paribus, a stock with 10% higher ownership by “rebalancers” experiences a 3.7bp larger loss to a 10bp positive monetary shock around FOMC announcements. Our quantity-based model shows that the aggregate market reaction relates to cross-sectional return differences due to rebalancing via a ratio of two demand elasticities. Rebalancing demand accounts for about one-third to two-thirds of the market reaction attributed to expected excess returns. We consider a set of exercises to corroborate our mechanism: (1) a quasi-experimental setting exploiting within-firm variations using dual-class shares, (2) stronger price reactions after quarter/month-end FOMC meetings when rebalancing is more imminent, and (3) placebo tests discriminating between rebalancing institutions and pure-equity institutions.

Keywords: monetary transmission, portfolio rebalancing, asset classes, inelastic markets

JEL Classification: E52, G11, G12, G23.

Suggested Citation

Lu, Xu and Wu, Lingxuan, Monetary Transmission and Portfolio Rebalancing: A Cross-Sectional Approach (November 29, 2023). Available at SSRN: https://ssrn.com/abstract=4413059 or http://dx.doi.org/10.2139/ssrn.4413059

Xu Lu

University of Washington - Michael G. Foster School of Business ( email )

Seattle, WA 98195
United States

Lingxuan Wu (Contact Author)

Department of Economics, Harvard University ( email )

Littauer Center
1805 Cambridge Street
Cambridge, MA MA 02138
United States

HOME PAGE: http://www.lingxuanwu.me

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