I saw one of my undergraduate students reading the Wall Street Journal the other day. I’m a finance professor, so this was a welcome sight.
“What’s happening in the markets?” I asked. He said he wanted to learn more about this week’s Federal Reserve meeting about whether or not to raise its target interest rate, which in turn will cause an increase in other rates on the market, from credit cards to mortgages. He sounded concerned.
He’s not alone. If you Google the phrase “worrying about the Fed,” you’ll get well over 100,000 hits.
So why do we worry so much about what the Fed will do? And is there anything we can learn from this?
Primed to fear uncertainty
In theory, investors analyze all available information before making a move in the markets to buy or sell an asset such as a stock or bond.
In practice, however, that’s usually not how it works; more often than not, we go with our gut feeling. For example, most of us fear the unknown and try to avoid gambles with uncertain odds. When we don’t know what to expect, we often simply focus on worst-case scenarios. Interestingly, apes show similar behavior.
Financial markets are made up of people, and, like the rest of us, traders get anxious when faced with uncertainty. And one of their biggest worries right now is about this week’s Fed meeting. Judging from recent analysis and market data, the Fed’s Federal Open Market Committee (FOMC) will probably leave its so-called target interest rate at a range of 0.25 percent to 0.5 percent.
But how the Fed communicates its decision counts too. What it says about the economy and the future direction of monetary policy is also uncertain and may move markets independently of any change in interest rates.
The Fed’s ‘dot plots’
As it has done after every other meeting in recent years, the FOMC will publish its Summary of Economic Projections (SEP) alongside its decision on interest rates, followed by a press conference with the Fed chair, in this case Janet Yellen. The other meetings end simply with the announcement of its decision and publication of a statement providing limited additional information.
The SEP includes FOMC members’ projections for GDP, unemployment and inflation, as well as their assessments of the appropriate levels of the target rate in the next few years and over the longer term.
These assessments of future rates, known as the “dot plots,” are widely discussed in financial media, as is the press conference, during which the current chair explains the FOMC’s thinking. These communications are intended to reduce uncertainty and make future policy actions more predictable.
So what is their impact?
In recent research, we examined the impact of FOMC announcements on the stock market over a four-year period beginning with the introduction of the “dot plots” in January 2012. During this period, the FOMC raised rates just once – in December 2015 – but there was near-constant uncertainty over the timing of this return to “normal” monetary policy. In addition, changes to the Fed’s unprecedented policy of quantitative easing – aimed at lowering long-term interest rates by purchasing billions of dollars in bonds – were the subject of continual market speculation.
Our research found that U.S. stock prices increased on average by about 0.56 percent during the first hour after FOMC announcements with SEP releases regardless of what the committee members ultimately decided. Another research paper found similar results. For comparison, on occasions when the FOMC didn’t release economic projections, stocks were just as likely to go up as down.
More specifically, stocks immediately rose after 15 out of 17 announcements with SEP releases over the period. To put this in perspective, the probability of getting 15 or more heads in 17 coin tosses is approximately 1 in 1,000, about the same odds as the Earth being hit by an asteroid.
In other words, a simple trading strategy of buying a futures contract on the E-mini Standard & Poor’s 500 index five minutes before every FOMC announcement that included an SEP release and closing the position 55 minutes later would have produced a return-to-risk ratio almost as high as the one claimed by famous fraudster Bernie Madoff.
These returns look almost too good to be true and may not persist in the future, particularly as the Fed begins raising rates more frequently.
Why the market rallies
There are two plausible explanations for these post-announcement market rallies.
The first explanation has to do with resolution of uncertainty. Market uncertainty (as measured by the VIX index) stays at a relatively high level before FOMC announcements with SEP releases and then significantly decreases after the announcement.
This supports the notion that the positive post-announcement stock returns are related to the resolution of uncertainty. In effect, this explanation argues that investors breathe a collective sigh of relief after the announcement and get into a more bullish buying mood, and stock prices increase.
An alternative explanation is that the post-announcement rally happens because markets were expecting a rate increase – often seen as negative for equity markets because higher rates mean money is more expensive. When rates don’t go up, stock markets do.
Based on our analysis of the market data, uncertainty resolution is the more likely explanation for the post-announcement returns. There are two main reasons for this.
First, important information contained in the SEP – the dot plots as well as the other macroeconomic details – helps reduce uncertainty about future monetary policy after the meeting.
Second, since these meetings are followed by a press conference by the Fed chair where he or she can explain the central bank’s actions, traders know that the FOMC is more likely to make important policy decisions at these meetings. The prospect of important information being released and important decisions being made increases uncertainty before the FOMC meeting and leads to greater uncertainty resolution after the meeting.
For example, the FOMC’s decision to begin tapering its quantitative easing program in December 2013 and the one to start raising its target rate in December 2015 were made at meetings with SEP releases and the chair press conferences.
A never-ending story
Over the years, the Fed has made its policy decisions more transparent and predictable in order to reduce uncertainty in the market. It is clear, however, that achieving this goal is a never-ending quest.
And this uncertainty over the direction of monetary policy has important side effects besides the positive stock market reaction noted above. A recent study found that such uncertainty changes how stock, commodity and other markets react to macroeconomic news. For example, absent clear statements from the Fed, good news about the economy – such as stronger-than-expected GDP growth – can become bad if it makes stock traders think it increases the likelihood that the Fed will raise interest rates.
Even aside from affecting uncertainty and moving stocks at the time of its public announcements, the Fed’s communications can exert a powerful if bizarre influence on the market.
Another study shows that average stock returns in the U.S. and the rest of the world are positive only in the week of the FOMC meeting and in the second, fourth and sixth week after the meeting. In other weeks, stocks stay flat on average. The cycle repeats when the FOMC holds its next meeting.
And so, whether the Fed raises the rates or not, it’s a safe bet that market anxiety will subside soon, only to increase again as the next meeting draws closer.
So should you learn to stop worrying about the Fed and accept the uncertainty? That would work well, if it weren’t against human nature.