FOMC Drift Trading System & Strategy completed a 2011 study commissioned by the Federal Reserve Bank of New York found that large excess returns could be found trading US equities in the run up to scheduled FOMC monetary policy meetings. This effect was shown to go back to 1980 and has increased over time.
The paper, which won first place in the 2015 Amundi Pioneer Prize, shows how US stock indices generally drift higher in anticipation of FOMC meetings.
Since 1994, the S&P 500 index has gained an average of 49 basis points in the 24 hours before scheduled FOMC meetings with a high statistical significance and high Sharpe ratio.
The FOMC drift effect is shown to be robust across other international indices but no effect was found in Treasuries.
The authors also found that the drift is stronger when the slope of the yield curve is low and the VIX is higher indicating higher equity market volatility.
The following graphic is taken from the paper and shows clearly how stock returns have gravitated upwards on FOMC days as compared to non-FOMC days. The grey ‘clouds’ in the diagram represent confidence bands:
FOMC Drift Trading System & Strategy Explanation
The FOMC drift seems to contradict the efficient market hypothesis but it is easy to form a rational explanation for this anomaly.
Since a primary goal of the Federal Reserve is to maintain market stability, FOMC policy announcements often act to suppress market volatility or give assurance to market participants. In recent years there has also been a trend of lower interest rates and accommodative monetary policy.
It’s possible, therefore, that traders and investors anticipate this soothing presence from the Federal Reserve particularly during volatile periods.
Short sellers may also refrain from entering short positions in the run up to FOMC announcements knowing that an accommodative decision may be coming up.
A possible criticism of this anomaly is that it shows strongest performance between 1980 – 2011, roughly the same amount of time that interest rates have been declining in the US.
It will be interesting to see how this pattern holds as interest rates rise.
FOMC Drift Trading System & Strategy:
An easy way to implement this strategy is to go long index futures in the 24 hours before FOMC meetings and exit trades just before the meeting gets underway.