Relief Rallies After FOMC Announcements: How Much Do Investors Care About Uncertainty?
West Virginia University – College of Business & Economics
West Virginia University, College of Business & Economics, Department of Finance, Students
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July 15, 2016
We find substantial positive average stock returns after FOMC announcements accompanied by the release of the Summary of Economic Projections (SEP) and press conference by the Fed Chair. A simple trading strategy of buying index futures contracts five minutes before the announcement and closing the position 55 minutes after the release would have generated an annualized Sharpe ratio of 2.10. We show that the market uncertainty, measured by the VIX index, declines significantly after FOMC meetings followed by SEP releases. After controlling for changes in the VIX, the positive post-announcement returns disappear, suggesting that these returns are related to the resolution of uncertainty after the announcement.
Relief Rallies After FOMC Announcements: How Much Do Investors Care About Uncertainty? – Introduction
“The Federal Reserve’s decision to hike rates gave investors room to breathe after months of will-they-won’t-they agony. Wall Street’s forecasts for a December hike came true and markets rallied. “We got a pop on the reduction of uncertainty,” Brad McMillan, chief investment officer for Commonwealth Financial Network, told TheStreet.” – TheStreet.com, December 16, 2015
Market participants closely follow central bank announcements because these announcements move prices of financial assets.1 Federal Reserve officials have made a concerted effort to communicate their assessment of the economic outlook and provide information about the future direction of policy. On November 20, 2007, the Federal Open Market Committee (FOMC) started publishing the Summary of Economic Projections (SEP) after every other FOMC meeting. The SEPs include Fed policymakers’ projections for three major macroeconomic indicators: GDP, unemployment rate and inflation. Before April 27, 2011, the SEP was released with the FOMC minutes three weeks after the meeting. In 2011-2012, the SEP was released within two hours after the FOMC statement. Thereafter, it has been released simultaneously with the release of the statement. Beginning with January 25, 2012, the SEPs have included the FOMC members’ anonymous assessments of the appropriate monetary policy in the next few years and the longer term. These assessments, known as the “dot plots,” are widely discussed by market participants.2 The release of the SEP is followed by a press conference in which the Fed Chair explains the Fed’s actions and answers questions. These releases make monetary policy actions more predictable and help form market expectations of the future path of policy.
We show that FOMC announcements with SEP releases give rise to significant positive average stock returns. During the first hour after such announcements, U.S. stock prices increase on average by about 56 basis points. These returns are not driven by outliers or by good news about monetary policy. A simple trading strategy of buying the E-mini S&P 500 futures contracts five minutes before the FOMC announcements with SEP releases and closing the position 55 minutes after the announcement would have generated an annualized Sharpe ratio of 2.10.
We examine what drives the high average post-announcement returns. In classical asset pricing theory, positive expected excess returns represent compensation for systematic risk. However, a recent strand of literature shows that uncertainty should also influence asset prices. For example, Anderson, Ghysels and Juergens (2009) find that stock returns are related to economic uncertainty. Using a general equilibrium model capturing time-varying economic uncertainty, Bollerslev, Tauchen and Zhou (2009) argue that the market risk premium includes a premium for bearing volatility risk. When the market anticipates high volatility going forward, there is a discount built into prices, resulting in higher expected returns. Bollerslev et al. (2009) show empirically that the difference between implied and realized volatility (the variance premium) positively predicts future aggregate stock returns. Drechsler (2013) theoretically shows that the predictive power of the variance premium is due to its close relation with the investors’ uncertainty about the true economic model. He demonstrates that changes in the variance premium are driven at least in part by fluctuations in the model uncertainty.
We find that 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.3 There is no similar decline in uncertainty after FOMC announcements without SEP releases. When the implied volatility falls after the announcement, the expected variance premium declines, which may explain the immediate increase in stock prices. We show that the positive unconditional stock returns after the FOMC announcements with SEP releases disappear after controlling for the change in VIX. This finding supports the hypothesis that these positive stock returns are related to the resolution of uncertainty after the announcement and the corresponding decline in the variance premium.
There are two main reasons for greater uncertainty resolution after FOMC meetings followed by SEP releases. First, information contained in the SEP helps reduce uncertainty about future monetary policy. Second, since these meetings are followed by the Chair press conferences where the Fed can explain its actions, the FOMC is more likely to make important policy decisions at these meetings. For example, the FOMC’s decision to begin tapering asset purchases under the quantitative easing program in December 2013 and the decision to initiate lift-off from the zero bound in December 2015 were made at meetings followed by SEP releases and the Chair press conferences. The prospect of important decisions being made increases uncertainty before the FOMC meeting and leads to greater uncertainty resolution after the meeting.
Recent studies most closely related to our paper are Lucca and Moench (2015), Savor and Wilson (2013) and Cieslak, Morse and Vissing-Jorgensen (2015). Lucca and Moench (2015) find large positive average stock returns in the 24 hours before scheduled FOMC announcements. They find no significant return drift after the announcement and argue that the mismatch between the time when the news arrives and when the returns are earned makes it difficult to explain these returns by asset pricing theory. In contrast, we find sizable positive average stock returns after FOMC announcements accompanied by the release of SEP rather than before the announcement. This makes the uncertainty-based explanation more plausible. In our sample, there is no evidence of the pre-FOMC announcement drift found by Lucca and Moench (2015).
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