How The Fed Killed The Fed Trade

Monday is another one of those days where there’s no point in trying to live-blog the market because … well … because this administration sends so many mixed messages across the wires in such a narrow timeframe that by the time you document one algo knee-jerk, there’s already another one.

Ultimately, the default position when confusion reigns is just: BTFD. That mentality, combined with a truly epic VIX smash, today managed to transform “I’m going to break up these fucking banks” into “buy, buy, buy.” Maybe this helps to explain things:

For those looking for a more “rational” (if you can call gaming FOMC meetings “rational”) signal to trade on, you might look at how stocks generally perform in the lead-up to Fed meetings.

As it turns out, there’s money to be made. Or at least there was. The problem with what used to be a reliable pre-FOMC strategy is that, as is usually the case when everyone suddenly becomes aware of an anomaly, the opportunity has been arbed away. As Bloomberg’s Cameron Crise explains, you can thank the NY Fed for that. More below…

Via Bloomberg

While the outlook for stocks this month may not be great based on seasonality and other factors, equity longs can at least take comfort from this week’s Fed meeting. After all, the New York Fed highlighted a few years ago that equities tend to perform very well in the run-up to an FOMC announcement. Does it matter what the Fed actually does at the meeting? And how has the market behaved since the initial paper was released in 2011? I decided to take a look.

  • While the original FOMC study focused on market price action in the 24 hours before an FOMC announcement, in the absence of tick data going back to 1994 I used a slightly broader window to capture the pre-FOMC drift phenomenon. Specifically, I looked at the price change in the S&P500 from the closing price two days before a Fed announcement to the closing price on the day of the announcement.
  • Sure enough, the impact of the Fed shows up in the data. The average two-day return of the SPX since 1994 is just under 0.07%. The average “pre-FOMC” return in my study was 0.43%. What is interesting, however, is that the returns from “emergency meetings” is outsized relative to regularly scheduled policy decisions. According to my calculations, the average two-day return around emergency announcements (usually easings) is 1.80%; the return from regulary-scheduled meetings is 0.37%.
  • Does it matter what policy the Fed actually announces? The data says yes. I tabulated the average return by meeting outcome going back to 1994. I counted the initial announcements of new balance sheet measures (QE, Operation Twist) as easings and the initial announcement of a QE taper as a tightening. Unsurprisingly, equities do best when the Fed is easing policy. Perhaps counterintuitively, stocks also do much better than average in the run-up to tightenings. Unchanged announcements have also seen better- than-average returns, but by a much smaller margin.

FOMC1

  • Has the behavior of the market changed since the NY Fed published the initial pre-FOMC drift paper? Unfortunately for equity longs, the answer appears to be yes. The initial paper used a data sample of 1994 – March 2011, so I calculated the average returns before and after the end of the sample. The difference is pretty stark; while stocks have still outperformed the average two-day window, the margin is pretty thin. 

FOMC2

  • It is often the case that simply identifying a market anomaly can eliminate it as arbitrageurs take advantage of the perceived opportunity. That may well be the case here; equity longs relying on the FOMC to provide a tailwind or even to beat Warren Buffett may have a bumpier ride than in the past.
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