Trader Talk

Welcome to the Fed's stock rally

Federal Reserve Chair Janet Yellen listens during a reception for her on Capitol Hill in Washington.
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Some of Tuesday's rally could likely be attributed to traders front-running a well-known Wall Street phenomenon: the tendency of stocks to rise in the 24-hour period before an Federal Open Market Committee announcement.

It's called "The Pre-FOMC Announcement Drift." Traders have been aware of this phenomenon for years, but the observation was given a research imprimatur in 2013 when David Lucca and Emanuel Moench, two officials with the Federal Reserve Bank of New York, published a paper on the phenomenon, noting that the move up was real and "orders of magnitude larger than those outside the 24-hour pre-FOMC window."

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They not only said the phenomenon was real, they quantified it. Since 1994, the is up an average 0.49 percent in the 24 hours before an FOMC announcement.

Lucca and Moench not only noted this was an outsized return, they made an even more startling claim: the returns over those eight yearly FOMC meetings accounts for 80 percent of annual realized excess stock returns.

That got a lot of attention on trading desks.

Moreover, Lucca and Moench concluded that some other major foreign stock markets exhibit "similarly large and significant pre-FOMC returns" but that no similar effect in Treasuries was discerned.

Other macroeconomic news releases, such as the employment report, GDP and initial claims, also don't have the same effect on stocks.

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Why does this effect exist? Lucca and Moench speculated that it may be a premium required by investors for bearing "non-diversifiable risk." That is, investors want more to hold stocks going into an uncertain policy announcement. However, they ultimately conclude that they aren't quite sure why the effect occurs and conclude that the drift remains "a puzzle."

Regardless, the phenomenon is certainly real, and we have even begun seeing attempts to jump ahead of the trend, which may explain a good part of yesterday's rally.