Spending 8 Days With Bernanke

by: Jeroen Blokland

This Wednesday, the FOMC, the Federal Reserve's monetary policy-making body, will get together again to decide upon the appropriate central bank policy. By law, the Federal Reserve conducts monetary policy to achieve its objectives of maximum employment and stable prices. But, while employment and stable prices are very much macro-economic objectives, the Fed actually uses financial instruments to achieve them. Its main instrument is the Fed Funds Target Rate, although recent years have shown that the FOMC has many other financial instruments at its disposal. The use of financial instruments to reach macro-economic goals raises the question whether the FOMC decisions are also of any use to investors.

Unexpected changes in the Fed Funds Target Rate

To find an answer to that question, let's ask the Chairman of the Fed and of the FOMC, Mr. Bernanke, first. He should know right? Well, actually he does. Together with Kenneth Kuttner of the National Bureau of Economic Research, Bernanke has analyzed the impact of changes in monetary policy on equity prices. At first sight the impact seems to be non-existent. Bernanke & Kuttner (2005) conclude that, although the relationship has the expected negative sign, the response to the 'raw' Fed Funds Target Rate change is small and insignificant.

But this approach is a bit too easy. Like with many other macro-economic and financial data, investors tend to react only to the surprise element they carry. Luckily, isolating the surprise element in the monetary policy decisions of the FOMC is not that hard. To obtain a measure of surprise for the Fed Funds Target Rate Bernanke & Kuttner use the Fed Fund futures. These futures, which trade on the Chicago Board of Trade, are used to extract market expectations of future FOMC fund rate actions. The unexpected or surprise target rate change is calculated as the difference between the market expectations, derived from the Fed Fund futures, and the actual target rate set by the FOMC.

When the target rate is broken down into an expected and a surprise component the results become highly significant. An unexpected 25 basis points rate cut would, on average, lead to an increase in stock prices of approximately one percent and vice versa. Hence, Bernanke & Kuttner demonstrate a negative relationship between the equity market and the Fed Funds Target rate.

Perfect foresight

Satisfied? Not completely. Because, in order to adopt a profitable trading strategy you still have to know if the target rate surprise will be positive or negative. You have to weigh the accuracy of the market expectations against the actual decisions of the FOMC. In other words only perfect foresight in what the FOMC announces will enable you to capture the price reaction that Bernanke & Kuttner find. And that's not all. Since December 2008 the Fed Funds Target Rate has been almost zero, between 0-0.25% to be exact. But more importantly everybody knew from December 2008 on that the rate was not going to change for a very long time. So the Fed Fund futures have become more or less useless to measure the surprise rate change, because there simply is no change. Bernanke has taken away this tool from investors.

8 * 24 hours

But what if I would say that Bernanke is in fact one of your best friends in the market. And, even better, that it is completely irrelevant what he will do at the FOMC meetings. What if spending only eight days with Bernanke is enough to realize a very tidy equity return with very little risk.

Sounds too good to be true? Just last year Lucca & Moench (2012) of the Federal Reserve Bank of New York published a research study that implies just that. Lucca & Moench look at the relationship between the FOMC pre-scheduled meetings, which are held eight times a year, and the S&P500 index. Their results are pretty remarkable. Since 1994, the time when the FOMC began announcing its monetary policy decisions, the S&P500 index has on average realized an excess return, the return over the risk free rate, of 0.48% in the 24 hours prior(!) to the announcement. In other words, no matter what the FOMC decides, you get almost a half percent equity return each day before the meeting.

Perhaps the half percent does not sound so spectacular. But it actually is. As mentioned above, the FOMC holds eight meetings a year which are pre-scheduled. You know exactly when the FOMC will decide on the monetary policy. Therefore, eight days of investing with the FOMC would have resulted in a total excess return of 3.89% per year. When this number is put into perspective the importance of the FOMC meetings becomes even more distinct. Lucca & Moench compute that the excess return on the S&P500 index for all other, non-pre-FOMC, trading days has only been 0.89%. Since 1994, the total US equity premium has thus averaged 4.8% per year. This means that, since 1994, more than 80% of the total US equity premium was earned in the 8 * 24 hours before the scheduled announcement.

Puzzling superior investment strategy

Lucca & Moench have no strong explanation for their findings. So the 'Pre-FOMC announcement effect 'remains a bit of a puzzle. It is, however, a pretty robust puzzle. Outliers, possible data-snooping, different horizons, or looking at returns of different industry groups, do not reject the conclusion that a very large part of the US equity premium is realized in the 8*24 hours before the FOMC meetings[1]. On the contrary, the results become even more remarkable when they look at stock exchanges outside the US. For the German DAX, the British FTSE, the French CAC40, The Spanish IBEX and the Swiss SMI Lucca & Moench also find a significant excess return in anticipation of the FOMC meetings. Interestingly, only the Japanese Nikkei index does not feature a significant announcement day return.

The findings of Lucca & Moench are highly significant for equity investors. First, it is relatively easy to put their strategy into practice. You buy the S&P500 future 24 hours prior the announcement and sell it again just before the FOMC decisions are made public. Second, from a statistical perspective, this strategy of buying and selling the S&P500 future eight times a year is superior to a buy-and-hold strategy. While adding an average of 0.89% of excess return by holding stocks throughout the year, you also bear the risk of the equity market during the whole year. In Lucca & Moench's data sample, investing on only eight pre-FOMC days would have resulted in a much better risk-return trade-off than that of a buy-and-hold strategy. Finally, you don't have to be a FOMC expert. It simply doesn't matter what Bernanke decides. And that is probably for the best with all the unconventional policy decisions that the FOMC took in recent years.

Bernanke, B. S., and K. N. Kuttner (2005): What Explains the Stock Market's Reaction to Federal Reserve Policy?," The Journal of Finance, 60(3), 1221{1257.

Lucca, David O. and Moench, Emanuel, The Pre-FOMC Announcement Drift (June 2012). FRB of New York Staff Report No. 512. Available at SSRN: ssrn.com/abstract=1923197 or http://dx.doi.org/10.2139/ssrn.1923197.

[1] James Saft, a Reuters columnist, seeks the explanation in the Fed put. He states that "Traders aren't using any sort of asset pricing models to justify their speculation ahead of Fed meetings any more than kids on Christmas Eve believe their good behavior drives their upcoming rewards: they are just betting on Santa Claus coming through with the presents."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.