New academic paper analyses #75 - Federal Open Market Committee Meeting Effect on Stocks Thursday, 27 August, 2015

#75 - Federal Open Market Committee Meeting Effect on Stocks

Authors: Nilsson

Title: The Pre-FOMC Drift Explored

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2640477

Abstract:

The pre-FOMC drift was first published in 2011 and is a strong driver of equity market performance over the last 30 years. The effect is able to explain approximately half of all the equity market returns over the measured period. We verify the results of prior studies. Furthermore, the report dives into conditional factors; equity market trend and monetary policy action to see if there is any difference in terms of macro variables. We find that FOMC is rather stable throughout time, macro conditions and has not been dependent on a particular Fed Chair.
 

It seems as if the markets are expecting that the FOCM will infuse optimism into equity markets as the majority of the gains occurs before the actual announcement. The effect can be due to behavioral issues and herding among market participants but can also be due to information leakage. The effect remains unexplained.

Notable quotations from the academic research paper:

...

"Making things even more interesting is that returns from the FOMC day are virtually uncorrelated to equity market returns on a monthly basis. This is despite the fact that the FOMC anomaly is a long-only effect. The effect is rather indifferent to the general equity market direction. The strong performance during the equity market drawdown of 2008 speaks to the faith in the US Federal Reserve as the “buyer of last resort”.

The size of the effect could very well be due to a specific influence of the Chairperson. Was the “Greenspan Put” worth more than the Bernanke Put? Unfortunately the sample set only gives us two full length periods and one that have barely started. From Chart 4, we note that the FOMC days seem to have been as profitable during Ben Bernanke’s reign as during Alan Greenspan’s. Despite the fact that Ben Bernanke ran the Fed for a much shorter period. Janet Yellen’s impact on the equity market is a bit too early to tell, but so far, it has been positive. The fact that Ben Bernanke comes out on top, is partially related to the fact that he was the chairman of the Federal Reserve during the financial crisis of 2008.

We set up a quick study, examining the year-over-year equity market perfect prior to the meeting (using monthly data). While not a sophisticated momentum indicator, it is fairly robust and gives an overall indication if the market is moving up or down. In general, we find that the percentage return on each of the FOMC is day is approximately the same. Risk on the FOMC day, is generally higher during declining equity markets, reducing the efficiency of the anomaly. The FOMC day drift does not seem to be related to the overall equity market. If anything, the pre-FOMC drift seems a bit friendlier to upward trending equity markets. It is difficult to disentangle the two effects.

Like in the prior section, we study the impact of the most recent interest rate decision. We are interested to find out if the effect is weaker or stronger when the FOMC is deciding to increase, decrease or hold the policy rate. The policy rate, is only one of several variables in the US Fed’s toolbox. There is no larger difference in the returns depending on the environment for the pre-FOMC drift. The returns from the pre-FOMC anomaly is slightly larger when the committee is reducing rates, but the difference is small. We cannot determine any larger negative impact on the FOMC day when the rate cycle is changing. Potentially this is due to the fact that the decision is widely communicated and the number of surprise decisions is low."


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