This paper from David O. Lucca and Emanuel Moench at the New York Fed, concluding that 80% of excess returns to U.S. equities come in the 24 hours before Fed monetary policy announcements, is pretty amazing. Here is the money chart; what does this tell you about the effect of the Fed’s actions on stock prices?

I guess one answer is:
(1) Fed actions push stocks up.

But I submit to you that this answer, by itself, is self-evidently wrong, since the stocks go up before the Fed actions. Two better possibilities are:
(2) The Fed’s actions travel back through time to push stocks up, or
(3) The Fed’s actions are irrelevant to stock prices, but the warm fuzzy feeling people have when they remember that the Fed exists and takes actions pushes stocks up.

Weirdly several people choose self-evidently incorrect answer (1), while the Fed researchers themselves suggest a bunch of other interpretations like “volatility feedback loops” and illiquidity effects and political risk, though they’re not thrilled with any of them.

If the Fed propagates backwards through time, one possibility is I guess insider trading: the Fed’s actions generally tend to push up stock prices, and enough people find out about them in advance to do the pushing before the policies are announced. This is a pretty weak answer, though, in part because it’s only equities that have abnormal returns before announcement – in particular, the authors find no unusual results on FOMC days for interest rate products, which is what you’d trade if you actually knew secret things about the Fed’s plans. (Though they do find Fed effects on foreign stock markets, small world etc.)

Which leaves answer (3): people read a lot about the Fed the day before the Fed announcement, think fondly “oh, yeah, the Fed, I like those guys, good guys,” and buy stocks. The positive drift is in part due to the Fed being mostly accomodative in the last 17 years,* and in (likely bigger) part due to the asymmetric effect of the “Bernanke [Greenspan, whatever] put” – as the authors put it, “interest rate policy has sometimes been characterized as having an asymmetric impact on riskier asset values through implicit floors, or so called ‘government puts’” – so if you think that the Fed will ease you buy stocks and if you think it will tighten you don’t necessarily sell them.**

One model of how that works – recently, anyway – is:
1. Terrible thing happens
2. Stocks go down
3. Goto 1
4. …
5. It’s the day before the FOMC day
6. “God, with all these terrible things happening, the Fed just has to ease.”
7. Stocks go up

Lucca and Moench refer to this, or something like it, as “rational inattention,” and are pretty un-thrilled by it: it’s fine for retail investors to think like that but seems sort of dumb for everyone to do so. In theory each time a terrible thing happens you should react not only with terror but also with a small compensating expectation that the Fed will ease, and you mostly do,*** so there’s no reason to do all your buying the day before the Fed announcement.

One thing you might ask about any economics paper that identifies a colossal and tradeable market inefficiency is: why on earth would you publish this? Here is what I would do if I worked at the New York Fed and ran this model and found these results:
1. Quit
2. Buy stocks 25 hours before FOMC announcements, hold for 24 hours, and sell****
3. Be rich

But they didn’t, which is public-spirited of them.***** I guess it’s safe to assume that tombstone for “the pre-FOMC announcement drift” will read “1994-2011″: if, going forward, you can make a free 3.89% excess return by buying on pre-Fed days, you will, so you can’t. And I guess it’s also safe to assume that the Fed won’t be too broken up about that: while Ben Bernanke probably is happy to support equity prices, he’s probably not so thrilled to read headlines about how he’s supporting equity prices. This paper’s detailing of how much – and how strangely – equity prices are tied to Fed actions is, on that theory, an embarrassment, but it’s a one-time embarrassment. And if it eliminates the pre-FOMC-day effect from now on, and replaces it with smaller but more consistent support for prices throughout the year, that’s a trade the Fed should be happy to take.

The Puzzling Pre-FOMC Announcement “Drift” [NY Fed and SSRN]

* Incidentally it starts in 1994 because that’s when the FOMC started announcing its decisions on set dates.

** A possibly related suggestive nugget:

The point estimates of 62 basis points for the recession dummy and of 33 basis points for the constant imply that pre-FOMC returns have been about 29 basis points higher in recessions than in expansions, indicating that the pre-FOMC announcement returns are somewhat counter-cyclical. However, this di fference is only statistically diff erent from zero at the 10% level.

Similar/related effects for “market expects tightening” vs. “market expects easing,” all consistent with “if you think that the Fed will ease you buy stocks and if you think it will tighten you don’t necessarily sell them.”

*** Pretend that here I’m linking to all the times someone has said “stocks rally because terrible [unemployment/ISM/whatever] number means that the Fed is more likely to announce QE17″ or whatever.

**** More precisely (from the paper):

The simple strategy that consists in buying the SPX at 2pm the day before a scheduled FOMC announcement and selling fifteen minutes before the announcement while holding cash on all other days would have earned a large annualized Sharpe ratio of 1.14 as reported in the Table.

***** My imaginary drama of Lucca and Moench is that they can’t stand each other and William Dudley teamed them up on to work on this paper knowing that if it found anything worthwhile and one quit to go trade on it, the other would publish. Actually maybe the paper originally had three authors and one quit to launch a hedge fund that is now going to have a lot more trouble raising money. All of this is surely false OR IS IT?

Comments (18)

  1. Posted by B2b MD | July 11, 2012 at 2:08 PM

    Lynne Tilton's Vag?

    -Dr. Rorschach

  2. Posted by Guest | July 11, 2012 at 2:15 PM

    To me, the take away is that if we just raise the minimum wage to $25/ hour and have the Fed Open Market Committee meet weekly we will end the recession in no time.

  3. Posted by Guy Who Can't Wait | July 11, 2012 at 2:23 PM

    Only 2,000 words coming up on your frustrations with the production design of econ papers, come on Matt, I know you've got more to say about it than that, let it all out.

  4. Posted by JPM | July 11, 2012 at 2:27 PM

    Matt, wow, no zerohedge source? We would all miss you, but why don't you just ask TD for a job

  5. Posted by güest | July 11, 2012 at 2:32 PM

    I don't understand, why didn't you discuss option 2?

    - Stephen Hawking Capital Management

  6. Posted by Seriously it's 2012 | July 11, 2012 at 2:33 PM

    You can also put footnotes inside the text, bro

  7. Posted by güest | July 11, 2012 at 2:35 PM

    2000 words is the new twitter

  8. Posted by guest | July 11, 2012 at 3:27 PM

    What timing – today bucks the trend.

  9. Posted by R. Fuld | July 11, 2012 at 3:55 PM

    Wanted: Somebody to go back in time with me. This is NOT a joke.
    745 7th Avenue, 24th Floor, NY, NY

    You'll get paid after we get back. Must bring own weapons and CDS. Safety not guaranteed.
    I have only done this once before.

    N.B. No Punching.

  10. Posted by Jim Simons | July 11, 2012 at 4:23 PM

    Damn those meddling kids.

  11. Posted by canadur! | July 11, 2012 at 4:33 PM

    why dont they trade on this? Because they are going long guild-like employment cutesy of tenure somewhere. Why trade in a market and maybe lose and look foolish when you can just write up nice papers and charts and then spend the rest of your life around 20 year old chicks and WSO ibank wannabes?

  12. Posted by Nick | July 11, 2012 at 6:49 PM

    Nice article.

  13. Posted by 2 cubes over | July 12, 2012 at 10:24 AM

    My question is why all the asterisks everytime? Why not use a sub or super script? Other than that, I have no concerns.

  14. Posted by Your not a trader | July 12, 2012 at 12:29 PM

    Incorrect analysis..
    (1) Fed actions "have a possibility" to push stocks up.
    during periods of high volatility one might not necessarily have the ability to realise profits, but if holding long positions ahead of possible ease annc/ long move, and being long gamma you can realise that vol by buying ahead of news

  15. Posted by MrMan | August 9, 2012 at 6:10 PM

    "In theory each time a terrible thing happens you should react not only with terror but also with a small compensating expectation that the Fed will ease, and you mostly do,*** so there’s no reason to do all your buying the day before the Fed announcement."

    I don't know why this is confusing or surprising. People WANT to believe that the Fed will help when the economy is bad, so like blatting sheep, we all think, "Surely this time, the Fed will help"
    And remember, "help" doesn't always mean just lowering interest rates. Sometimes, we want the Fed to raise interest rates.

    The economy has been bad long enough that this hope-against-hope belief is happening more than ever. It looks like simple speculation-driven buying, driving the market up, to me.

    Oh, and as for there being "no reason at all" to delay your buying until the day before the announcement, SURE there is! You always want to hedge your bets. What if there's some good economic news before the Fed's announcement? That could spike the market, thus minimizing how much more it can rise on the Fed's announcement. No, you want to wait until just before the Fed announcement if you want the best chance of realizing a bounce based just on their announcement with no intervening affects.

  16. Posted by MrMan | August 9, 2012 at 6:11 PM

    Fail…. I meant "effects."

  17. Posted by Jame Matos | October 3, 2012 at 5:06 AM

    Thanks a great deal for your recipe. I had been seeking for a few recipes with rhubarb. This one particular is actually superior a single, it’s uncomplicated and tasty. Rhubarb lowers glucose levels, so its genuinely superior for men and women suffering from diabetes. I love the combination of strawberries and rhubarb. I followed your suggestion and tried it with olive oil (simply a store bought olive oil). And, it turned out really superior. It absolutely was crunchy and gooey. I served it as night snack as well as plates had been empty in seconds. Remember to maintain posing some much more related recipes.

  18. Posted by icon package | October 4, 2012 at 1:02 PM