Lowering Risk Trading Federal Annouoncements

There are significant short-term gains to be made in the stock markets by using a simple trading strategy based on monetary policy announcements from the US Federal Reserve.

The approach, which was proposed by researchers at the University of Notre Dame, could net investors a much greater return than any standard buy-and-hold strategy without exposing them to higher risk.

Surprising Gains

The researchers found gains of roughly 4.5% for investors who either bought or shorted in a 40-day window pre- and post-Federal Open Market Committee announcements which didn’t align with market expectations.

These “surprises” can yield strong gains for investors even if they have not taken up a position prior to the announcements being made.

It is routine for markets to forecast FOMC announcement content, and there is often a response when the Fed acts in contrast to what was predicted.

An announcement is defined as an expansionary surprise when the new target rate fails to meet market forecasts, and a contractionary one when it surpasses expectations.

Predictable Movements

Share prices are predictable both before and after either type of surprise – they will rise approximately 25 days before the announcement of an expansionary surprise for a gain of around 2.5%. Before a contractionary one, prices tend to fall. These movements are thought to affect every industry with the exception of the mining sector.

Over a period of 15 days, share prices are also seen following the same path, which leads to a difference of 4.5% between share prices following either type of surprise announcement.

International Ripples

US policy announcements affect share prices overseas too, with similar patterns materialising in the UK, Canada, Germany, Spain, France and Switzerland. Investors don’t need insider knowledge to be able to benefit from this pattern.

They may buy shares immediately following an expansionary surprise, shorting them when the surprise is contractionary.

Being prepared to sell those shares after a period of 15 days results in an annualised Sharpe ratio that is greater by a factor of four compared to any conventional approach of buy-and-hold.

The study took into account FOMC announcements from 1994, when the Fed initially began communicating interest-rate intentions publicly, to 2009. The pre-announcement movements indicate that a handful of investors have an inside track on whether or not an announcement from the FOMC will fall in line with market forecasts.