Hawkish or Dovish? How Central Bank Language Shapes Market Expectations

Context

Central bank communication has become one of the most influential tools of modern monetary policy. Beyond adjusting interest rates, institutions such as the Federal Reserve (FED) and the European Central Bank (ECB) actively shape market expectations through policy statements, forward guidance, and public communication.

Following the COVID-19 pandemic, financial markets experienced a period of exceptional uncertainty. Inflation surged, interest rates increased at an unprecedented pace, and investors closely monitored every signal issued by central banks. In this environment, market participants increasingly focused not only on policy decisions themselves, but also on the language used to communicate them.

This thesis investigates whether the linguistic tone of central bank communication influences short-term stock market performance. Specifically, it examines whether hawkish communication, signalling tighter monetary policy, and dovish communication, signalling a more accommodative stance, generate measurable reactions in equity markets.

Goal

The objective of this research was to examine the relationship between the linguistic tone of monetary policy communication and short-term abnormal equity returns between 2020 and 2025.

The study focused on the following research question:

Do equity markets react differently to hawkish and dovish communication from the Federal Reserve and the European Central Bank, as measured by abnormal returns in the S&P 500 and Euro Stoxx 50?

To address this question, the thesis pursued four main objectives:

• Analyse the linguistic tone of official monetary policy statements issued by the FED and ECB.
• Examine the relationship between communication tone and actual interest rate decisions.
• Measure abnormal equity returns around central bank announcement events.
• Evaluate whether linguistic tone provides additional explanatory power beyond the policy decision itself.

Methods

The research adopted a mixed-methods approach, combining quantitative and qualitative analysis.

The quantitative component consisted of a textual sentiment analysis of 40 monetary policy statements released by the Federal Reserve and the European Central Bank between 2020 and 2025. A specialised hawkish-dovish dictionary was developed to classify and score the linguistic tone of each statement.

To evaluate market reactions, an event study methodology was applied. Abnormal returns were measured for a sample of twenty publicly traded real estate companies from the United States and Europe, using the S&P 500 and Euro Stoxx 50 as benchmark indices.

The qualitative component included semi-structured interviews with financial market practitioners from both retail and institutional environments. These interviews provided additional insights into how market participants interpret central bank communication and incorporate it into investment decisions.

The theoretical foundation of the study combined the Efficient Market Hypothesis (EMH) and Behavioural Finance, allowing for a comparison between market-efficiency explanations and sentiment-driven market behaviour.

Results

The analysis confirmed a clear relationship between monetary policy actions and communication tone. Periods of rising interest rates were generally accompanied by more hawkish language, while accommodative policy periods were associated with dovish communication.

However, the event study results did not reveal a stable or systematic relationship between linguistic tone and short-term abnormal equity returns. Although individual announcement events occasionally coincided with notable market reactions, no consistent pattern emerged across the sample period.

The expert interviews supported these findings. Financial professionals generally agreed that the tone of central bank communication carries informational value and can influence market expectations. Nevertheless, they argued that modern financial markets rapidly incorporate anticipated policy developments, limiting opportunities for investors to generate abnormal returns based solely on communication tone.

Overall, the findings provide stronger support for the semi-strong form of the Efficient Market Hypothesis than for behavioural explanations. While linguistic tone serves as an important signalling mechanism and reflects the direction of monetary policy, the research does not provide convincing evidence that hawkish or dovish communication systematically drives short-term equity market returns.

The study highlights the growing importance of central bank communication in modern financial markets while demonstrating the challenges of translating qualitative policy signals into predictable investment outcomes.