Monetary Policy Shocks, Investor Sentiment, and Stock Returns: Firm-Level Evidence from China

The most direct and prompt influences of monetary policies are on financial markets. Investigating how monetary policy shocks impact stock returns is important for understanding the policy transmission mechanism. In this work, we explore the stock market’s responses to different monetary policy shocks in China. Empirical results indicate that 1% unanticipated increase of expansionary shock yields the next-day stock returns rising by over 17 basis points on average. Channel tests show that investor sentiment plays a partial mediating role in the short-term transmission from expansionary policy shocks to stock returns. Notably, economic policy uncertainty can weaken the effects of monetary policy shocks on stock returns. Moreover, monetary policy shocks have more pronounced effects on stock returns for growth-type firms and those with higher investor attention. Further analyses reveal that, in the short term, the stock market overreacts to positive shocks but underreacts to negative ones, and then reverses over time as the market adjusts to its fundamental level. Overall, our findings enrich the extant understanding of the complex interplay between monetary policies and stock market, as well as offer valuable insights for investors and policymakers.