Does the Fed, or any News, Matter to Traders?

With limited test data, we can say that news matters in the short-term, but doesn’t generally have a long-term impact.

Stock markets, along with bonds and futures markets, seemed to react negatively to the announcement from the Federal Reserve that they would be launching Operation Twist. From the moment the news was announced stocks fell. Bonds rose while gold and other commodities fell. All of this prompts a few interesting questions:

– The Fed did mostly what was expected. How does their action impact different investments like stocks, bonds, and commodities?

– If markets really discount the future, why do they react so much to news?

– Can any of this be tested?

– Should traders follow news events?

More than just being an interesting thought exercise, we need to think about whether or not we can make money trading based on any of this.

The Fed announced that they would buy Treasury securities with longer maturities and finance the purchases with sales of short-term Treasuries. Total purchases will be about $400 billion between now and next summer. The Fed will also be reinvesting the proceeds from mortgage-backed securities that are on their balance sheet. Nothing much different here related to money supply questions and pretty much exactly what everyone in the media expected to happen.

Operation Twist is an attempt to twist long interest rates lower. This is all intended to push down the rates consumers pay on mortgages and other loans which will increase consumer spending and put the people back to work. Traders seemed concerned that this will really have very little economic impact.

Stocks and interest rates plummeted on the news and continued falling the next day. Global markets, already reeling from the slowly unfolding euro crisis, plummeted from the time they opened. Stocks would be expected to fall if the economy was going to slow dramatically, as would interest rates. Traders seemed to be showing concern that the Fed’s action wouldn’t help a struggling economy, if we believe that short-term market action truly reflects long-term thinking.

Commodities also fell. Oil fell, which would be expected if the economy was slowing. Silver was down more than 10 percent the day after the Fed announcement and gold was off more than 3 percent.

It is more than likely that traders did not develop a detailed long-term analysis after the Fed announced what it would do. They reacted to the charts, in all likelihood. As selling started in stocks, it created a downtrend, which pulled trend followers into the market on the short side. As the downtrend accelerated, momentum traders kept selling and prices kept falling.

In bonds we saw the opposite action. Prices rose, and kept rising.

Commodities were following the same script. Selling brought on more selling. At some point margin calls come in. Highly leveraged, short-term traders monitor their positions continuously and they will sell before their broker calls for more capital. Gold actually seemed to serve its traditional role as a crisis hedge – as the crisis unfolded in the markets, traders were able to take profits in their gold positions to raise cash. It declined less than many other markets, which is relative strength. In down markets, all too often institutional traders will tout relative performance meaning they lost less than the market. Traders that trade their own accounts can’t pay their bills with relative performance, they need absolute and positive returns which means short-term traders would be short when the markets turn lower.

We can see what the markets did in the charts. What the Fed did mattered as stocks and commodities responding by selling off. Bonds and the dollar rose, as investors looked for safe investments. Markets move every day, but usually on a smaller scale. The Fed’s announcement meant that they would do their best to bid bonds higher and traders took advantage of that.

According to conventional wisdom, lower interest rates cause a currency to decline. That didn’t happen. The dollar may not be a sound currency based on the fundamentals, but it might be the soundest of the available bad options. The euro is a problem and traders again might be selling the euro to take profits to help cover losses in other markets. The dollar index has significant exposure to the euro, more than 50 percent. In the long-term, fundamentals matter but traders react to the price action and if they are selling the euro, the dollar has to go up solely because of the weightings.

News matters in the short-term, at least based on anecdotal evidence, but news events are actually relatively rare. There are usually only 8 or 9 Fed meetings a year and most end without a significant announcement. Black Swan events, those rare but significant events defined by Nassim Nicholas Taleb in his 2007 book, “The Black Swan: The Impact of the Highly Improbable,” are by definition unpredictable and therefore we can’t back test their impact.

History shows a single instance of a Twist-like Fed operation. According to news reports, it seemed to lower interest rates by about 0.1% at the time. This time is certainly different since the federal debt is so much higher now. Stocks in the early 1960s were marked by wide market swings. A four year bull market began in late 1962. None of this applies to the current market environment. The Fed’s purchases will absorb only several months’ worth of new Treasury supply this time. That alone makes the analogy with the earlier time suspect and means there is no reliable precedent to apply to trading.

We can complete at least one limited test on a news event. Every month, the Bureau of Labor Statistics reports on unemployment. The report is widely followed by market participants. It is generally released before stocks open on the first Friday of the month. An hour after the report, the stock market opens and the first Friday of each month does display an unusually high degree of volatility.

Since 1990, the range from the open to closing price in the S&P 500 is three times greater on the first Friday of the month than on other trading days. This does not capture each unemployment report because occasionally it is released on the second Friday of the month as it was in September 2011. But this test offers more than 240 data points, and at least 95% of them include the release of an unemployment report, so we have enough data to generate statistically significant results.

High volatility is actually an unexpected result. Markets, in standard financial theory, are complex discounting mechanisms. Traders incorporate forthcoming news into current prices. When the Fed does exactly what is expected, the theory holds, the markets should not have a large reaction. Testing and experience shows otherwise.

Academic testing shows that there is some degree of efficiency in pricing, with sudden and large moves limited to truly unexpected events. The unemployment report is an expected event with the exact release time known at least a year in advance. Wide ranges shouldn’t be happening in response to the news.

Furthermore, the unemployment report is also known to be inaccurate. On the first Friday of the month, the number provided is just an estimate. It is refined at least three more times, and the date of each revision is also known well in advance. Historically, the first estimate is overly optimistic by an average of about 0.17 percent. That is a significant margin of error, but the market moves dramatically nearly every month based only on the initial report which is wrong with a great degree of regularity.

The conclusion, backed with some testing, is that news events drive markets and in the short-term, markets are not as efficient as they are in the long-term.

Markets usually close in line with the longer term trend. If prices are above the 10-month moving average, we tend to see higher closes on high volatility days. In down markets, with price below the 10-month moving average, closes on news days tend to be down.

What does all this mean to traders?

Short-term traders need to realize and accept that markets react to news. If they are looking to capture short-term trends or use a mean reversion strategy on a short time frame, they need to be aware of news events as they offer the best opportunity for quick gains. They don’t need to know the news, they just to need to react to the short-term price moves. Stocks moved higher on QE2, which was also widely known to be coming but stocks fell on the news of Operation Twist.

Long-term traders need to understand and accept that their positions will be impacted by news but they need to resist the temptation to override long-term strategies in reaction to short-term events. Trends prevail in the long-term even though volatility may increase in the short-term.

By Michael J. Carr, CMT