Federal Open Market Committee Meeting Effect in Stocks

Fundamental reason

Simple trading strategy

Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)

Source paper

Tori: Federal Open Market Comitee meetings and stock market performance

Abstract: This paper examines an interesting calendar effect - a relationship between contemporaneous stocks market returns and Federal Open Market Comitee (FOMC) meeting dates. Examining S&P 500 stock market returns between 1960 and 2000, the study finds that there is a positive and significant calendar effect associated with FOMC meeting dates. The data reveal that while FOMC meeting dates only accounted for 4.42% of the trading days, FOMC meeting date returns accounted for over 13% of the cumulative returns over the time period. Using a dummy variable for FOMC meeting dates, regression results find that the FOMC meeting dates have a significantly positive effect on overall market returns.

Other papers

• Lucca, Moench: The Pre-FOMC Announcement Drift

  Abstract: Since the Federal Open Market Committee (FOMC) began announcing its policy decisions in 1994, U.S. stock returns have on average been more than thirty times larger on announcement days than on other days. Surprisingly, these abnormal returns are accrued before the policy announcement. The excess returns earned during the twenty-four hours prior to scheduled FOMC announcements account for more than 80 percent of the equity premium over the past seventeen years. Similar results are found for major global equity indexes, but not for other asset classes or other economic news announcements. We explore a few risk-based explanations of these findings, none of which can account for the return anomaly.

• Nilsson: The Pre-FOMC Drift Explored

  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.

• Cocoma: Explaining the Pre-Announcement Drift

  Abstract: I propose a theoretical explanation for the puzzling pre-announcement positive drift that has been empirically documented before scheduled Federal Open Market Committee (FOMC) meetings. I construct a general equilibrium model of disagreement (difference-of-opinion) where two groups of agents react differently to the information released at the announcement and to signals available between two announcement releases. In contrast to traditional asset pricing explanations, this model matches key empirical facts such as (1) the upward drift in prices just before the announcement, (2) lower (higher) risk, price volatility, before (after) the announcement occurs, and (3) high trading volume after the announcement, while trading volume is low before the announcement occurs.

• Hull, Bakosova, Kment: Seasonal Effects and Other Anomalies

  Abstract: We revisit a series of popular anomalies: seasonal, announcement and momentum. We comment on statistical significance and persistence of these effects and propose useful investment strategies to incorporate this information. We investigate the creation of a seasonal anomaly and trend model composed of the Sell in May (SIM), Turn of the Month (TOM), Federal Open Market Committee pre-announcement drift (FOMC) and State Dependent Momentum (SDM). Using the total return S&P 500 dataset starting in 1975, we estimate the parameters of each model on a yearly basis based on an expanding window, and then proceed to form, in a walk forward manner, an optimized combination of the four models using a return to risk optimization procedure. We find that an optimized strategy of the aforementioned four market anomalies produced 9.56% annualized returns with 6.28% volatility and a Sharpe ratio of 0.77. This strategy exceeds that Sharpe ratio of Buy-and-Hold in the same period by almost 100%. Furthermore, the strategy also adds value to the previously published market-timing models of Hull and Qiao (2017) and Hull, Qiao, and Bakosova (2017). A simple strategy which combines all three models more than doubles the Sharpe ratio of Buy-and-Hold between 2003-2017. The combined strategy produces a Sharpe ratio of 1.26, with annualized returns of 18.03% and 13.26% volatility. We publish conclusions from our seasonal trend and anomaly model in our Daily Report.

• Hu, Pan, Wang, Zhu: Premium for Heightened Uncertainty: Solving the FOMC Puzzle

  Abstract: Lucca and Moench (2015) document that prior to the announcement from FOMC meetings, the stock market yields substantial returns without major increase in conventional measures of risk. This presents a "puzzle" to the simple risk-return connection in most (static) asset pricing models. We hypothesis that the arrival of macroeconomic news, with FOMC announcements at the top of the list, brings heightened uncertainty to the market, as investors cautiously await and assess the outcome. While this heightened uncertainty may not be accurately captured by conventional risk measures, its dissolution occurs during a short time window, mostly prior to the announcement, bringing a significant price appreciation. This hypothesis leads to two testable implications: First, we should see similar return patterns for other pre-scheduled macroeconomic announcements. Second, to the extent that we can find other proxies for heightened uncertainty, we should also observe abnormal returns accompanying its dissolution. Indeed, we find large pre-announcement returns prior to the releases of Nonfarm Payroll, GDP and ISM index. Using CBOE VIX index as a primitive gauge for market uncertainty, we find disproportionally large returns on days following large spike-ups in VIX. Akin to the FOMC result, we find that while such heightened-uncertainty days occur on average only eight times per year, they account for more than 30% of the average annual return on the S&P 500 index. Conversely, we find a gradual but significant build-up in VIX prior to FOMC days, providing direct evidence of heightened uncertainty.

• Martello, Ribeiro: Pre-FOMC Announcement Relief

  Abstract: We show that the pre-FOMC announcement drift in equity returns occurs mostly in periods of high market uncertainty or risk premium. Specifically, this abnormal return is explained by a significant reduction in the risk premium (implied volatility and variance risk premium) prior to the announcement, but only when the risk premium is high, e.g., when it is above its median. Likewise, the magnitude of the FOMC Cycle and other related patterns varies with uncertainty and risk premium. Market uncertainty measures are persistent and are not related to policy uncertainty or expectations. Markets become only marginally stressed in the days prior to the announcement and changes in uncertainty appear to be of lower frequency. We also explain why recent studies suggest that the pre-FOMC drift might have disappeared in the past decade, as this moderation is due to time variation that was also present in older data. Additionally, CAPM only works on FOMC dates when the risk premium is high, e.g., implied vol above its prior median level. The results are robust to different samples and measures of risk premium and uncertainty.

• Gomez Cram, Roberto and Grotteria, Marco: Real-time Price Discovery via Verbal Communication: Method and Application to Fedspeak

  Abstract: We advance the hypothesis and establish empirically that investors’ expectations underreact to Central Banks’ messages. From the videos of post-FOMC-meeting press conferences, we extract the words, and timestamp them at the millisecond. We align the transcripts with high-frequency data for several financial assets to provide granular evidence on the investors' expectations formation process. When the Chairman discusses the changes between current and previous policy statement, price volatility and trading volume spike dramatically, and prices move in the same direction as they did around the statement release. Our approach allows us to quantify in monetary terms the value of information rigidity.

• Zhu, Xingyu, Volume Dynamics around FOMC Announcements

  Abstract: The stock market volume decreases in anticipation of FOMC announcements and increases afterward. I find, in the cross-section, that stocks with higher market risk exposure experience greater volume changes. I also find that volume dynamics around FOMC announcements are unlikely to be attributable to changes in volatility. Instead, they are linked to discretionary liquidity trading resulting from the presence of private information. I set up a model that guides my investigation of the information environment in the stock market around FOMC announcements. Consistent with the model’s implication, volume dynamics are accompanied by changes in the information environment. I find that information asymmetry increases ahead of FOMC announcements, but only for high-beta stocks.

• Baglioni, Tommaso and Ribeiro, Ruy, Corporate Bonds Distress and FOMC Announcement Returns

  Abstract: This paper documents that the ex-ante level of the corporate bond market distress is a good predictor for the pre-FOMC announcement return, subsuming the relevant information of equity market uncertainty highlighted by the previous literature. We compute the orthogonal components of distress and uncertainty, and we find that only distress can predict the pre-announcement return, which tends to be positive (negative) when distress is high (low), regardless of the level of uncertainty. These results hold also after 2011, when the average pre-announcement return is flat, but it is possible to predict it using distress.

• Golez, Benjamin and Matthies, Ben: Fed Information Effects: Evidence from the Equity Term Structure https://ssrn.com/abstract=3836206

  Abstract: Do investors interpret central bank target rate decisions as signals about the current state of the economy? We study this question using a short-term equity asset that entitles the owner to the near-term dividends of the aggregate stock market. We develop a stylized model of monetary policy and the equity term structure and derive tests of Fed information effects using the short-term asset announcement return. Consistent with the existence of information effects, we find that the short-term asset return in a 30-minute window around FOMC announcements loads positively on monetary policy surprises. Furthermore, the announcement return predicts near-term macroeconomic growth.

• Mano, Nicola: Institutional Trading around FOMC Meetings: Evidence of Fed Leaks

  Abstract: Fed leaks to the financial sector are actively exploited by institutional investors to trade ahead of the Federal Open Market Committee (FOMC) meetings. Using detailed transaction records from Ancerno, I find evidence consistent with informed institutional trading on the stock market on the days before FOMC scheduled announcements. The institutional trading imbalance on highly exposed stocks is in the same direction of the subsequent monetary policy surprise. The magnitude of this result is economically significant. I find that trades in anticipation of FOMC meetings are particularly strong before easing monetary policy shocks - when the aggregate market reaction is positive -, for the most-active traders, and for the hedge funds that are headquartered close to one of the regional reserve banks. Fed informal communication with the financial sector seems to be driven by the non-voting members of the Federal Open Market Committee. These findings contribute to an information-based explanation of the pre-FOMC drift and, from a policy perspective, suggest that any benefits of Fed unofficial communication must be balanced against the risk of giving some investors an unfair advantage.

• Mohamed, Hussein: Time-Based Trading Patterns

  Abstract: The research paper investigates the influence of various calendar anomalies on stock market returns across multiple indices, including the S&P 500, S&P 400, S&P 600, Russell 1,000 Growth, and Russell 1,000 Value. The study provides a comprehensive analysis of both individual and interaction effects of several well-known calendar anomalies, challenging the conventional understanding that these anomalies occur in isolation. The calendar effects studied include the Federal Open Market Committee (FOMC) meetings, Options Expiration Dates, the Holiday Effect, Sports Events Effect, Halloween Effect, Turn-of-the-Month Effect, January and September Effects, as well as Friday and Monday Effects. The research applies advanced regression techniques, incorporating an ARMA (1,1) model and an EGARCH (1,1) model with a t-distribution to account for both autocorrelation and volatility clustering in stock returns. The ARMA model, with exogenous variables representing the calendar anomalies and their interactions, captures the linear dependencies in return series. The EGARCH model further analyses the persistence and asymmetry in volatility, revealing how negative market shocks tend to increase volatility more than positive shocks. These models effectively highlight the impact of calendar anomalies on both the returns and volatility of the studied indices. The findings reveal that the Halloween Effect was the most significant anomaly observed, particularly impacting indices such as the S&P 500, S&P 400, S&P 600, and Russell 1,000 Value. These results suggest that this anomaly can be strategically leveraged by investors to optimize returns. While the research highlights the potential for using calendar anomalies as part of a time-based trading strategy, it also notes that the effects may vary across different indices, reflecting the unique characteristics of each market segment. The study contributes to the broader discourse on market efficiency by offering practical insights for investors and suggesting that these calendar-based anomalies may present exploitable opportunities within financial markets.