News from the Federal Reserve System that the interest rate will remain unchanged causes stocks to shake.
Aug 11 2010 - 10:15am
WASHINGTON (ISNS) -- Chairman Ben Bernanke unveiled the latest news from the Federal Reserve System board at 2:15 p.m. on Tuesday: short-term interest rates will remain unchanged, remaining low to help the economy recover.
Following the announcement, a small financial earthquake struck U.S. financial markets -- which happens almost every time Bernanke mentions interest rates. Stock prices shook, jumping up by one percent, and kept fluctuating as the market closed.
These aftershocks are likely to continue, according to scientists who study econophysics and look for connections between the natural and financial worlds. That's because the math behind market tremors is the same math that describes actual earthquakes.
Before most earthquakes, plates of rock push against each other and build up tension along a fault line where the sliding plates meet. In the financial market, the tension comes from weeks of buzz and speculation before each new interest rate announcement from the Fed. Tremors are triggered by a sudden event that releases a burst of energy, causing market prices -- or tectonic plates -- to bounce up and down.
Bernanke's words can unleash long-lasting aftershocks, especially when their content is unexpected, said Alexander Petersen, an econophysicist at Boston University. His calculations have shown that market fluctuations fade away over time according to the same equation that describes earthquake aftershocks. This newly-quantified "power law" forecasts an extended series of small fluctuations.
"Power law decays in the market can last for a very long time, maybe a week to month," said Petersen, who published the findings in the scientific journal Physical Review E. "That's pretty phenomenal considering all the new news coming in every day."
Petersen discovered this by analyzing announcements made by The Federal Open Market Committee from 2000-08. The FOMC schedules eight meetings a year to set interest rates and to give advice that influences the availability of money and credit.
Lowering the interest rate -- typically a sign of poor economic growth to come -- had a bigger impact on stock price volatility that raising it, but the top 100 stocks by sales of the S&P Index reacted even if the interest rate remained unchanged.
The size of each shock to the market, according to Peterson, was determined by how surprising the news was -- how much the new target interest rate differed from the interest rate on the 6-Month Treasury bill, a simple indicator of where the market thinks this rate will be.
In the days after every announcement, stock market volatility slowly calmed out in a series of ever-smaller aftershocks.
Other studies have shown that large financial events, such as the 1987 crash, can leave legacies of earthquake-like aftershocks, as well. Similar patterns have also been found in the reaction of a single company's stock price to breaking news articles about that company.
"It seems to be ubiquitous, from the scale of a single company to the reaction of the whole market," said Peterson.
Earthquake science offers a word of caution to the financial world, said H. Eugene Stanley, a physicist at Boston University who published the first earthquake-based explanation of financial markets in 1998. Big, catastrophic events are more common with power laws than they are in other mathematical distributions commonly used on Wall Street.
The science can't predict when that inevitable big one will hit -- as recent disasters in Haiti and Chile tragically illustrate. But Stanley hopes that it will give governments the same motivation to reinforce their financial infrastructure that Californians living near the San Andreas Fault have to reinforce their homes.
"Our society must recognize that very big financial fluctuations will definitely occur and take steps to protect society when they do occur," said Stanley. "Instead, we wait for a big fluctuation or crash, and then rush to respond fast, making mistakes along the way."