Tuesday, December 12, 2006

How Do Federal Reserve Announcements Affect The Markets?

Life is full of unpleasant surprises. Few events are as eagerly anticipated among traders as Federal Reserve announcements of monetary policy. I decided to go back to 2005 and examine what surprises, if any, have been in store for the markets following the last 15 announcements.

One surprise from my findings was that the equity index market (S&P 500 Index; SPY) has not been as volatile on Fed days as might have been expected. The high-low price range for the S&P 500 Index on Fed days exceeded the 20-day average price range on only 8 of the last 15 occasions. Overall, the range on Fed days has been 15% greater than its 20-day average, or about 2 futures points. Three of the last five Fed announcements have led to daily ranges less than the 20-day average.

We do see enhanced volume on Fed days. I looked at volume in the SPY ETF and found that 11 of the 15 Fed days showed volume above the 20-day average. In all, volume on Fed days was about 19% greater than the 20-day average. So what we've seen is elevated volume, but not necessarily elevated ranges. That's a potential formula for whipsaw price action in markets.

I also looked at the high-low ranges for 10-year interest rates on Fed days. One would expect quite a bit of interest rate movement on those occasions. Surprisingly, however, only 7 of the 15 days had a wider range than their 20-day average. Overall for the sample, the interest rate range on Fed days has been about 7% wider than normal, but this is skewed by one particularly large reading.

Now here's the really interesting part: Over the 15 Fed days, the correlation between the day's price range in stocks and the day's range in interest rates is a very strong .56. In other words, when rates move, stocks move. When Fed policy is affecting bond and bill yields, stocks tend to be repriced. That is something to watch carefully today.

Here's another interesting note: Five days after the Fed meeting, the S&P 500 Index (SPY) has averaged a loss of -.18% (7 up, 7 down, 1 unchanged). That is weaker than the average five-day gain of .19%. Five days after Fed day, 10-year interest rates ($TNX) have declined by an average of -.62% (7 up, 8 down). That is a much weaker performance than the average five-day change in interest rates of .07%.

So there you have it. Fed days aren't quite as volatile as they are made out to be, largely because Fed policy has not changed greatly from meeting to meeting over that time and has been effectively signaled in advance. When Fed statements do move rates, stocks also tend to move. After the Fed meetings, we've seen some bond strength (interest rate declines) and stock weakness, although this is based on an admittedly small sample.

I will be watching the response of rates and the dollar to the announcement to seek real time guidance for the likelihood of sustained repricings of equities. If there are any unpleasant surprises, they will be priced into bonds and currencies quickly.