The US Federal Reserve’s monetary-policy decisions invariably are closely followed by market participants worldwide since they are of great importance to the development of the capital markets. David O Lucca and Emanuel Moench have examined which patterns occur in the stock market and what these could be attributed to (download “The Pre-FOMC Announcement Drift” here). Their conclusions:
- There are large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the FOMC
- These pre-FOMC returns have increased over time and account for sizable fractions of total annual realized stock returns
- There is no such effect in U.S. Treasury securities and money market futures
- Other major U.S. macroeconomic news announcements also do not give rise to pre-announcement excess equity returns
Standard Models can`t explain the Fed Effect
Neither the classical valuation models nor other non-conventional approaches can completely explain the FOMC effect. The fact that this effect is particularly strong in recessionary phases (and hence during periods of interest-rate cuts) shows how immense the impact of the US Federal Reserve is. The hope factor is likely to play an important role in explaining the price anomaly – in keeping with the slogan, “The Fed needs to support the market“.
Let`s create a simple Back Test!
Since the named research paper examines the time period from 1994 to 2011, we would like to know whether the Fed Day effect is stable throughout time. In order to back test this idea, we created a simple Equilla code. Our simple model is:
- We buy the S&P 500 cash index at the close one day before the FOMC meeting
- We exit the long position at the close of the FOMC day
- 100 000 USD are invested for each trade
- No costs, slippage included
The only trick to program the code is using a function containing all FOMC meeting dates which can be found here. Here is an example for all Fed meetings starting in 2017 (I created a function with all dates since 1982, drop me an email and I`ll send it to you).
Once programmed, this function can be a part of any indicator or trading strategy we want to create. This could be also done for specific events like holidays etc. Here is our simple code for back testing the research paper:
Is the Edge gone?
And here are the results since 1982. As you can see, the Fed Day anomaly can be confirmed for the last decades. Although, if you take a look at the signals from the last 3 years, the edge seems to be losing ground.
Do you have some patterns you would like to be back tested? Send us your idea…
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