Stock Market Anomalies: The FOMC 'Drift' Effect

In earlier research, we have looked at several anomalies in the US stock market, such as:

• the Tax Day anomaly,
• the Monday effect,
• the turn-of-the-month effect,
• the insider trading anomaly,
• the “Sell in May and go away” effect.

Today, we will study the FOMC “Drift” effect.

In July 2011, commissioned by the Federal Reserve Bank of New York, David Lucca and Emanuel Moench published a study on the effect of "drift" FOMC (The Puzzling Pre-FOMC Announcement "Drift").

The authors describe the studied effect as follows:

‘’since 1994, more than 80 percent of the premium on U.S. stocks has been received in the twenty-four hours leading up to scheduled Federal Open Market Committee (FOMC) announcements (which occur only eight times a year) - a phenomenon we call "drift" before a FOMC announcement.”

Considered US Stocks:

Strategy

Open a long position on indices and stocks:

• on the opening of an hour, 8 hours before the FOMC meetings;
• on the opening of an hour, 12 hours before the FOMC meetings;
• on the opening of an hour, 24 hours before the FOMC meetings;
• on the opening of an hour, 36 hours before the FOMC meetings;
• on the opening of an hour, 48 hours before the FOMC meetings.

Close the position at the end of the hour just before the FOMC meetings.

We will evaluate the trading strategy according to the following criteria:

• The average rate of return reflects the relative change in quotes of financial instruments in percentage. A positive value of the average return indicates the profitability of the strategy, a negative one indicates a loss.

The average rate of return (R) of a financial instrument is given by the formula:

where:

n - the number of transactions;

P (%) – the percentage of change in the quotation of the financial instrument at the time of fixing the position, is calculated as follows:

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%

• The total rate of return (TR) is the sum of the returns from all trades. The greater the value of the total return, the greater the profit brought by the signal during its testing period.

• Max drawdown (MaxDD) is the maximum loss in percentage terms from fixing losing trades for the entire testing period. The smaller the value of the maximum drawdown, the better the trading signal works.

where:

n - the number of trades;

TR_n - total rate of return of n trades;

DD_n – drawdown at the time of closing the nth trade;

MaxDD – max drawdown.

Analysis of the obtained results 

Let's look at the results of the transactions according to the strategy:

So, as expected, the US stock market indices and stocks really grow in the 24 hours leading up to the FOMC meetings. The exceptions are the stocks of Walmart (_WMT) and Travelers (_TRV) (see the appendix for more details).

The average return for indices is 0.38%, for stocks - 0.27%.

In addition, a higher return of the strategy with the entry into the market 36 hours before the FOMC meetings is noticeable. For the indices, the return increases to 0.49%, and for stocks - up to 0.43%.

At the same time, the value of the total return grows for both indices and stocks, except for JPMorgan Chase (_JPM) and 3M (_MMM).

The value of the maximum drawdown for indices slightly increases. The maximum drawdown of stocks increases, but for most of them its value does not exceed 20%. The exceptions are Boeing (_BA), Caterpillar (_CAT), Cisco (_CSCO), JPMorgan Chase (_JPM) and UnitedHealth (_UNH) stocks.

Let's see how the average return of the strategy changes when closing positions after FOMC meetings:

Obviously, the growth of indices and stocks is higher just before the FOMC meetings.

Detailed results are shown in the Appendix:

XLSX (0.04 MB)FOMC.xlsx

See also:

Does the FOMC "Drift" Effect Work in the Oil and Gas Segment?

"Drift" of Metals Before FOMC Meetings

How Does the US Dollar React To the Upcoming FOMC Meetings?