pre-FOMC Announcement Drift Research Articles

The pre-FOMC announcement drift: short-lived or long-lasting? Evidence from financial and volatility markets

ABSTRACT We examine the effects of Federal Open Market Committee (FOMC) announcements accompanied by press conferences (PC) on both financial and volatility markets. We find a pre-FOMC announcement drift, signifying positive excess returns on equities prior to the FOMC announcement. However, the influence of the FOMC-PC announcements is short-lived, becoming insignificant shortly after the disclosure. This contrasts with findings from Lucca and Moench (2015), who report that the FOMC announcement’s impact is persistent (or long-lasting) in their studied timeframe. Furthermore, we identify a significantly negative return of the VIX both before and after the FOMC announcement. This contrasts with the transient nature of stock returns, suggesting an evolving relationship between stock returns and VIX movements. To exploit the FOMC announcement drift, we construct a profitable trading strategy but note that such coexistence of the profitable trading strategy with the short lived impact by FOMC announcement raises a concern whether FOMC justifies a large price movement around FOMC announcement.

Bond Implied Risks Around Macroeconomic Announcements

Using a large panel of Treasury futures and options, I construct model-free measures of bond uncertainty and tail risks across different tenors from 2000 to 2020. I find that bond tail risk 1) negatively correlates with stock tail risk in general, but the correlation turns positive prior to and around three financial crises; 2) It increased dramatically before the 2008 Financial Crisis and in March 2020 foreshadowing the extreme challenges in the Treasury bond markets; 3) and has significantly decreased in recent years under zero-lower-bound and forward guidance. I then study the behavior of bond tail and uncertainty risk measures around FOMC announcements and document three novel findings: First, bond uncertainty increases three to two days prior to the announcements and reverts back upon release, due to an increase in call option prices rather than puts. Second, yields of 5, 10, and 30 year Treasuries decline by 1bps on the day before the announcement. Third, uncertainty risk cannot help explain the pre-FOMC announcement drift.

The FOMC announcement returns on long-term US and German bond futures

• We examine the impact of FOMC announcements on long-term US and German government bond futures. • Using transaction-level data during the post–financial crisis period, we observe a sizable post-announcement drift in government bond markets. • A trading strategy yields up to four times the Sharpe ratio of buy-and-hold investment. • The post-FOMC drift coincides with more informative order flows in the post-announcement period. • Post-FOMC announcement drift in the government bond futures persists for 15 days. We examine the impact of monetary policy announcements by the Federal Open Market Committee (FOMC) on long-term US and German bond futures. Using transaction-level data during the post-financial crisis period, we observe a sizable post-announcement drift in government bond markets. A trading strategy of investing in the market after expansionary shocks and shorting the market following contractionary surprises yields up to four times the Sharpe ratio of buy-and-hold investment. The post-FOMC announcement drift coincides with more informative order flows in the post-announcement period, and it persists for 15 days. Moreover, our study shows an absence of pre-FOMC announcement drift. Our findings shed some light on how the bond markets react to public news arrival.

The disappearing pre-FOMC announcement drift

Lucca and Moench (2015) document large average excess returns in U.S. equities before scheduled Federal Open Market Committee (FOMC) meetings from September 1994 to March 2011, leading to a puzzle not explained by standard asset pricing theory. We extend the sample to December 2019. We find that after first appearing before FOMC announcements accompanied by the Fed Chair press conferences, the pre-FOMC drift essentially disappeared after 2015 in both announcements accompanied by press conferences and announcements not accompanied by press conferences. We discuss a possible explanation for this change: reduced uncertainty.

The Pre-FOMC Announcement Drift and Private Information: Kyle Meets Macro-Finance

This paper proposes and tests the private information explanation for the time series of pre-FOMC announcement drift through risk reduction. Using transaction-level data, I document the informed trading is in the same direction of the realized returns in the 24-hour window before FOMC announcements, coinciding with the pre-FOMC uncertainty reduction. I integrate Kyle's (1985) model into a standard consumption-based asset pricing framework where the market makers are compensated for the risk of assets' fundamentals. Observing aggregate order flow, they update the belief about the marginal utility-weighted asset value, which resolves uncertainty gradually and results in an upward drift in market prices before announcements. I demonstrate that there is a strictly positive pre-FOMC drift if and only if the market makers require risk compensation.

Investor sentiment and the pre-FOMC announcement drift

We find that the stock market increases significantly over the pre-FOMC announcement window only during periods of high investor sentiment and low economic policy uncertainty. Buy-initiated trades associated with high sentiment are positively related to pre-FOMC returns. These findings are consistent with a behavioural interpretation of the pre-FOMC announcement drift.

Pre-Announcement Risk

I propose and test a new explanation for the pre-FOMC announcement drift puzzle. I show that such a drift arises in a model where investors interpret a given FOMC action differently based on recent news. If recent news has been good, FOMC announcements are seen as signals about economic conditions; if recent news has been poor, they are seen as signals about the Fed's own policy stance. Consistent with the model, I demonstrate that the market return prior to the announcement—a proxy for recent news—predicts the interpretation of Fed action. In the model the pre-FOMC drift represents a risk premium associated with the resolution of uncertainty about announcement type. The model does not require informational leaks or biased beliefs and can account for the seasonality of aggregate returns over the FOMC calendar.

Monetary policy communication, policy slope, and the stock market

The slope factor is constructed from changes in federal funds futures of different horizons and predicts stock returns at the weekly frequency: faster policy easing positively predicts returns. It contains information about the speed of future monetary policy tightening and loosening, and predicts changes in interest rates and forecast revisions of professional forecasters. The tone of speeches by FOMC members correlates with the slope factor. The predictive power concentrates in times of high uncertainty in line with the pre-FOMC announcement drift. Our findings show the path of interest rates matters for asset prices, and monetary policy affects asset prices continuously.

The Pre-FOMC Announcement Drift: An Empirical Analysis

Previous research documented large positive abnormal returns in US equity markets during a 24-hour window immediately preceding Federal Open Market Committee (FOMC) meetings between 1994 and 2011. This anomaly was called the “pre-FOMC announcement drift.” This article examines whether this return pattern persisted beyond the original sample end date and whether it is observed in additional asset classes. The equity return during the pre-FOMC window declined from 0.5% on average per FOMC meeting to roughly 0.1% in the out-of-sample period after 2011 and was no longer significant. Furthermore, the authors find no evidence of a pre-FOMC announcement effect in US nominal and real interest rates (US Treasuries and Treasury Inflation-Protected Securities), currencies ($/euro, $/British pound, $/Japanese yen, and $/Swiss franc), precious metals (gold and silver), and commodities (oil, heating oil, and natural gas). Results indicate that the pre-FOMC announcement drift was limited to equity markets and weakened significantly post-2011, consistent with market participants taking advantage of the anomaly or with a time-varying effect. However, the fact that the effect weakened postsample, but prepublication, rather than postpublication, may suggest this dynamic was sample specific. <b>TOPICS:</b>Security analysis and valuation, performance measurement, statistical methods

The Tone of the Beige Book and the Pre-FOMC Announcement Drift

We examine whether disclosed information from the Federal Reserve (Fed) affects investor expectations of monetary policy decisions and whether the disclosed information leads to the pre-Federal Open Market Committee (FOMC) announcement drift through investor expectations of monetary policy. We measure the tone of the Beige Books, speeches, and testimonies using text-mining techniques. We find that the tone of the Beige Books positively relates to federal funds rate (FFR) changes and expected FFR changes. We also find that expected FFR changes are negatively associated with stock market index returns in the 24 hours prior to FOMC announcement time. These results suggest that the Beige Book implies monetary policy changes and positively affects investor expectations. In addition, these results suggest that disclosed information from the Fed leads to pre-FOMC announcement drift though the investor expectations.

Pre-FOMC Announcement Relief

We show that the pre-FOMC announcement drift in equity returns occurs mostly in periods of high market uncertainty or risk premium. Specifically, this abnormal return is explained by a significant reduction in the risk premium (implied volatility and variance risk premium) prior to the announcement, but only when the risk premium is high, e.g., when it is above its median. Likewise, the magnitude of the FOMC Cycle and other related patterns varies with uncertainty and risk premium. Market uncertainty measures are persistent and are not related to policy uncertainty or expectations. Markets become only marginally stressed in the days prior to the announcement and changes in uncertainty appear to be of lower frequency. We also explain why recent studies suggest that the pre-FOMC drift might have disappeared in the past decade, as this moderation is due to time variation that was also present in older data. Additionally, CAPM only works on FOMC dates when the risk premium is high, e.g., implied vol above its prior median level. The results are robust to different samples and measures of risk premium and uncertainty.

The Disappearing Pre-FOMC Announcement Drift

Lucca and Moench (2015) document large average excess returns in U.S. equities before scheduled Federal Open Market Committee (FOMC) meetings from September 1994 to March 2011, leading to a puzzle not explained by standard asset pricing theory. We extend the sample to December 2019. We find that after first appearing before FOMC announcements accompanied by the Fed Chair press conferences, the pre-FOMC drift essentially disappeared after 2015 in both announcements accompanied by press conferences and announcements not accompanied by press conferences. We discuss a possible explanation for this change: reduced uncertainty.

Intelligent trading of seasonal effects: A decision support algorithm based on reinforcement learning

Seasonalities and empirical regularities on financial markets have been well documented in the literature for three decades. While one should suppose that documenting an arbitrage opportunity makes it vanish there are several regularities that have persisted over the years. These include, for example, upward biases at the turn-of-the-month, during exchange holidays and the pre-FOMC announcement drift. Trading regularities is already in and of itself an interesting strategy. However, unfiltered trading leads to potential large drawdowns. In the paper we present a decision support algorithm which uses the powerful ideas of reinforcement learning in order to improve the economic benefits of the basic seasonality strategy. We document the performance on two major stock indices.

The Pre-FOMC Announcement Drift

Since the Federal Open Market Committee (FOMC) began announcing its policy decisions in 1994, U.S. stock returns have on average been more than thirty times larger on announcement days than on other days. Surprisingly, these abnormal returns are accrued before the policy announcement. The excess returns earned during the twenty-four hours prior to scheduled FOMC announcements account for more than 80 percent of the equity premium over the past seventeen years. Similar results are found for major global equity indexes, but not for other asset classes or other economic news announcements. We explore a few risk-based explanations of these findings, none of which can account for the return anomaly.Since the Federal Open Market Committee (FOMC) began announcing its policy decisions in 1994, U.S. stock returns have on average been more than thirty times larger on announcement days than on other days. Surprisingly, these abnormal returns are accrued before the policy announcement. The excess returns earned during the twenty-four hours prior to scheduled FOMC announcements account for more than 80 percent of the equity premium over the past seventeen years. Similar results are found for major global equity indexes, but not for other asset classes or other economic news announcements. We explore a few risk-based explanations of these findings, none of which can account for the return anomaly.

The Pre-FOMC Announcement Drift

We document large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the Federal Open Market Committee (FOMC) in the past few decades. These pre-FOMC returns have increased over time and account for sizable fractions of total annual realized stock returns. While other major international equity indices experienced similar pre-FOMC returns, we find no such eff ect 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. Pre-FOMC returns are higher in periods when the slope of the Treasury yield curve is low, implied equity market volatility is high, and when past pre-FOMC returns have been high. We discuss challenges at explaining these returns with standard asset pricing theory.