Speaking of Fed Surprises...

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Includes: DIA, SPY
by: IndexUniverse

By Heather Bell

What a bummer. This year, St. Patrick's Day landed on a Monday. That had a rather dilutive effect on the festivities - especially considering the holiday came on a Saturday last year.

So what happens when your work week starts with an obvious day for revelry? You could celebrate the weekend before or take Monday off. Another option is to party on Monday evening and take Tuesday off to recuperate.

It's a huge dilemma for the hard-partying types. Actually, I kind of am partial to the way one of my friends ended the confusion. He decided to start celebrating St. Pat's this past Saturday and end sometime before dawn on Easter.

Frankly, I find that approach kind of ambitious. So with no really good choices looming this year, I let St. Pat's gently pass me by. I must be getting old.

Speaking of a lack of choices, I spoke too soon last week. The research pickings were pretty slim this week on the SSRN site, so I am reaching back to early in the month to highlight an article that seems relatively appropriate given the 0.75% interest rate cut that occurred today.

"The Effects of Federal Funds Target Rate Changes on S&P 100 Stock Returns, Volatilities, and Correlations," by Helena Chulia, Martin Martens and Dick van Dijk and published through the Erasmus Research Institute of Management, takes a look at how the market - represented by the S&P 100 Index of large-cap stocks, in this case - responds when the Fed raises or lowers the federal funds target rate, particularly when the decision is a "surprise."

Apparently, a few studies have been done on this subject over the years, although this one takes a slightly different approach than many of them by using intraday data, with a particular focus on the 10 minutes before and the 80 minutes after FOMC (Federal Open Market Committee) announcements, and by looking at sector performance.

Please note that this article looks at 77 scheduled Fed meetings taking place between April 16, 1997, and Nov. 3, 2006. It uses the component list of the S&P 100 from June 2004. Please also note that the FOMC made certain changes in its announcement policies that have created greater transparency around target rate changes, so cuts and hikes are more likely to be expected and priced into the market by the time the announcement is made.

And it's true: Changes to the Fed funds rate are usually pretty predictable and the market has already incorporated them by the time they are announced. As a result, in such cases there isn't any remarkable reaction. However, it's another matter entirely when the FOMC does something unexpected.

Maybe we're just a nation of pessimists, but when there is a surprise, the reaction tends to be a bit more extreme for hikes in the interest rate than it is for cuts, the article notes: An unexpected 25-basis-point rate hike provokes a negative reaction that is more extreme than the positive market reaction that generally occurs after an unexpected 25-basis-point rate cut.

For example, the average change in market returns five minutes after a surprise rate hike is twice the magnitude (-20.1 basis points) of the average reaction to a surprise rate cut (10.6 basis points). In other words, the market reactions are asymmetrical. And, while all heck tends to break loose fairly indiscriminately when there is bad news about interest rates, the market reaction to positive news is more measured and correlates with just how good that news actually is, like whether it's a 50-basis-point rate cut or a 25-basis-point rate cut.

And while volatility increases around FOMC announcements in general and more so for surprises, specifically, the article finds that the economic environment has an effect on volatility as well.

In recessions, volatility levels surrounding FOMC announcements increases are unaffected by how large the surprise is, while in a period of market expansion, the size of the surprise tends to be tied more closely to the level of volatility. Similarly for correlations, the mere fact that there is a surprise rate hike causes an increase in correlations, while the strength of stock correlation during surprise rate cuts is tied to the size of the cut.

Early on, the authors find evidence in their article to support the idea that market uncertainty is much more powerful in an environment of tightening economic policy than it is in a loosening environment. Overall, the evidence, the article concludes, "suggests a more rational behaviour of market participants to good news than to bad news."

The authors also find that the Financials sector is the most sensitive to rate changes, which largely provokes a response from the reader of "well, duh." It is, after all, the sector that has the most direct exposure to the effects changes to the federal funds rate; however, the article notes that another study found that the Financials sectors reaction were not all that far off of the market average. The Information Technology sector holds second place for the intensity of its response to surprises from the FOMC. Utilities and Energy had the mildest reactions to surprises.

Surprises were unlikely Tuesday when the Fed made its announcement: Everyone was already expecting the rate cut, after all. But then, isn't the point of surprises the fact that they're unlikely and unexpected? Given the current state of the markets - re the sale of Bear Stearns for $2 a share, for example - anything is possible...