Santa Claus Fed and equity returns
Since 1994, according to the New York Federal Reserve, 80% of US stocks’ excess returns occurred in the 24 hours before scheduled announcements by the Federal Open Market Committee.
There can be no single data point that better explains the madness of official monetary policy in its interaction with financial markets.
As explained in a recently updated paper by New York Fed economists David Lucca and Emanuel Moench, an enormous proportion of the equity risk premium – the extra return investors get for holding stocks – occurs in the window directly around Fed policy announcements.
This is both shocking and totally unsurprising.
While excess returns are 80% concentrated in the 24 hours before announcements, the afterglow period is good for stocks too. Since the Fed began making scheduled policy announcements in 1994, equity returns are “essentially” flat if you exclude the three-day window around the big day. That’s right, the correct strategy is sell two days after the Fed announces and come back a day before the next big news.
The authors consider and reject a variety of potential explanations for what they call “pre-FOMC drift”, from the idea that heightened political risk drives excess returns around the Fed to the possibility that increased media coverage draws investors in.
“In sum, as of this paper’s writing, the pre-FOMC announcement drift is a puzzle.” Lucca and Moench conclude, saying it is “difficult to explain with standard asset pricing models.”
I have a simple explanation for this phenomenon: the Fed Put.
Traders aren’t using any sort of asset pricing models to justify their speculation ahead of Fed meetings any more than kids on Christmas Eve believe their good behaviour drives their upcoming rewards: they are just betting on Santa Claus coming through with the presents.
FOMC day is a kind of secular Christmas for the asset-owning class.
Since 1994, if not before, first Alan Greenspan and now Ben Bernanke have pursued an asymmetrical ’heads you win, tails you win anyway’ monetary policy, always stepping in with an easing or other remedy when financial markets suffer. This has been justified, at least recently, as an attempt to get money moving around the economy better by encouraging overly conservative holders of funds to take on more risk.
Patently, these figures illustrate that this policy, called the Fed Put, has not escaped the notice of investors who, figuratively, have been leaving some cookies out for the Fed on FOMC eve.
Fed a global power but only in equities
Fascinatingly, this phenomenon is not seen ahead of other central bank announcements (frankly, you’d probably want to sell ahead of the more Grinch-like and error-prone ECB). Foreign stocks do rally ahead of the Fed, however, a clear illustration of its power in setting the global price of money and with it the relative nominal value of risk assets.
The authors are surprised to find that the Fed effect does not extend to foreign exchange and fixed income markets. That is probably because the concept of a free lunch is less well accepted in fixed income, which also during much of the period was dominated by central bank investors like China which were in it not for profit but for currency manipulation. As for foreign exchange, that market is just too big and too ugly to be driven predictably by any single force.
So what are we to make of this?
As monetary policy the Fed Put is deeply flawed and has a truly terrible record. It has helped to fuel a series of successive bubbles, from south east Asia, to Silicon Valley to Main Street, always attempting to bail out investors when the party ends. While lax regulation and financial services chicanery have also played important roles, the Fed must accept substantial responsibility for a series of misallocations of resources that have left the economy encumbered by debt.
As an investor, this “phenomenon” also has to give you pause. First off, the results are appalling. While equity gains in the early days of the Fed Put were strong, five-year returns on the S&P 500 index are essentially flat and many investors are no better off than they were a decade ago.
Moreover, if most of your gains come courtesy of official sources, you are an investor with a very big central dependency, and with very little to insulate you if ever that point of vulnerability fails. What on earth can we expect to happen if ever the Fed decides, or is forced, to abandon its bias towards risk investors? Excess returns may be pretty hard to find.
At some point this Santa Claus charade will have to end, and when it does, growing up will not prove easy.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)