Wall Street Reads the Federal Reserve's Mind

It is in the 24 hours preceding Federal Reserve meetings that stock markets realize most of their performance.

U.S. and world stock markets overreact even before the Federal Reserve decisions are taken, according to a study (1). It is in the 24 hours preceding those meetings that stocks realize most of their performance: The annual return of the Standard & Poor’s 500 was 3.8 percent compared to 0.9 percent during a typical day.

80 percent of the risk premium (the return in excess of the risk-free rate) over a long period (1994 to 2011) is earned during those last headlight sessions of the year on which markets are focused on and that should not be missed.

The Tokyo stock exchange: indifferent

All the stocks (large and small) and sectors benefit. Overseas, all stock exchanges play the game, except the Tokyo stock exchange, which is indifferent. These markets betting on Federal Reserve decisions beforehand don’t react the same way when announcements come from their own central bank – a testimony to the preponderance of the Fed.

Across the Atlantic, volumes of stock transactions and volatility tend to decrease before the 140 studied Federal Reserve meetings and strongly rebound at the publication of the Federal Reserve statement. U.S. government bonds and currencies (euro-dollar and dollar-yen) don’t have the same anticipation phenomenon as the stocks: They react to announcements but they don’t precede them.

In concrete terms, Wall Street starts to rise just before the Federal Reserve meeting and continues into the morning. The Standard & Poor’s 500 waited until the official announcement by registering an average of 0.5 percent above its opening price the day before. After the decision, it fell for a short time and closed the day at a level comparable to the one it had just before the announcement from the authorities.

Since the crisis, Wall Street has been more likely to anticipate announcements from the Federal Reserve beforehand. Thanks to its communication, it has been more predictable by markets. The severity of the economic situation encourages economic operators to consider the most favorable outcomes (favorable to business); that is to say, a Fed that is uniquely concerned with growth – a windfall for Wall Street.

(1) “The Pre-FOMC announcement drift,” New York Fed.