The Dow, the Fed and your expectations

March 31, 2010 07:00 PM

The releases of economic announcements inject volatility into the futures markets on a regular basis. Perhaps the single most volatile event occurs when the Federal Reserve’s Federal Open Market Committee (FOMC) releases a statement about adjusting the Federal Funds rate.

These rate change announcements are driven by the Fed’s view of the U.S. economy and the need to expand or contract the money supply so as to better control the state of the economy. These announcements are scheduled eight times a year. However, during periods of unusual economic activity, the Fed will meet and adjust rates outside the published schedule. This was the case in 2008, when the Fed cut rates in response to the banking crisis that engulfed the nation.

As futures traders, it is paramount to maintain a situational awareness of when these announcements, as well as other news releases, are scheduled. We must balance our exposure and risk with the volatility resulting from how the news is perceived by the major market participants. A useful technique in coping with the high volatility is knowing what to expect based on the content of the announcement. By properly gauging their expectations, traders are better able to employ profitable strategies around periods of volatility.

While examining various expectations of what the FOMC will do, remember that there is a Fed Funds futures contract traded at CME Group. The Fed Funds futures generally are a better gauge of what will happen than the numerous financial experts who often are trying to affect policy with their analysis.

The relationship between the E-mini Dow futures (YM) and the Fed announcements from 2007 to present establishes certain trends. These trends are useful in framing a strategy to trade the YM starting a week before the announcement through the release of the data. In particular, analysis regarding the tendencies of market action the week prior to a Fed meeting, price action on the day of the announcement, and subsequent post-announcement market moves is the key to managing expectations.

In the week leading up to a Fed meeting, the historical trend is for the YM to trade in an increasingly contracted range. This range is dependent upon current market conditions. For example, the YM traded in a range of 500 points going into the October 2008 meeting, and the chart in “Ahead of the call” (right) shows price action leading into the September 2009 FOMC meeting. This is not to infer the direction of price action, rather the delta between daily highs and lows narrows as the announcement nears. Data suggests this tendency occurs over 70% of the time. “Slow day” shows this tendency. The major spikes — March, September and October of 2008 — occurred at the most volatile times when the question of the Fed was not if they would act but by how much.

To apply this information into a strategy, traders need to recognize the current market conditions starting the week before the scheduled announcement. This will dictate the expected daily trading range going in to the FOMC meeting. Using the September 2009 data as an example, traders are able to recognize early on that the daily range has a ceiling of 135 points and is expected to decrease as the week progresses. If a trader is mulling a short position on Friday and the daily range is at 100 points, the trader gains confidence that his directional assessment is correct because the propensity is for the range to contract. Conversely, if a long trade is being contemplated, the trader knows he must be guarded against the possibility of a quick reversal.
On the day of the FOMC announcement, market pundits are busy proclaiming their views of what the Fed will or will not do. Traders often make the mistake of getting caught up in the hype over the decision and unknowingly allow a bias to form. This type of thinking gets the cart ahead of the horse because there are almost five hours of trading time before the announcement. By recognizing the propensity of what happens in the time leading up to the 2:15 p.m. (Eastern) release, traders can better manage objectives. As the second chart in “Ahead of the call” shows, YM has a trading range between 50 and 150 points with 120 points being the average range. Knowing the range during this time period allows traders to pick their battles and make an informed decision as to whether their profit targets fit the situation. Remember to watch the Fed Fund futures as trades with real money on the line are often a better predictor than any pundit.

When the announcement is made, volatility sets in and price whipsaws. Novice traders who attempt to trade their bias rather than the chart will get stops triggered during this period. Smart traders will let the market decide what it wants to do before entering a trade. Knowing how the YM reacts based on the news helps manage the emotions triggered by major price jumps. Remember, markets often whipsaw following the announcement, so do not assume the first move is indicative of what the eventual market reaction will be.

The present Fed Funds rate is set at between 0% and 0.25%; therefore, the only current options available to the FOMC are either to maintain or raise the rate. Research has found that the trading range over the final two hours of the trading day is much greater on average when a rate adjustment is made than when the Fed opts for no change. “Change or no change” compares the effects of the actions.

Page 1 of 2
About the Author