Premium for Heightened Uncertainty: Solving the FOMC Puzzle

Abstract

The substantial stock market return prior to FOMC announcements without major increase in conventional measures of risk, as documented by Lucca and Moench (2015), presents a "puzzle" to the simple notion of risk-return trade off. We hypothesize that the arrival of macroeconomic news, with FOMC announcements leading the list, brings heightened uncertainty to the market as an additional source of risk. While this heightened uncertainty may not be accurately captured by common risk measures, its dissolution occurs mostly during a short time window prior to the announcement and brings a significant price appreciation, reflecting the risk premium associated with it. This hypothesis leads to two testable implications: First, we should see similar return patterns for other pre-scheduled macroeconomic announcements. Second, to the extent that proxies for heightened uncertainty in the market can be found, we should also observe abnormal returns accompanying its dissolution. Indeed, we find large pre-announcement returns prior to the releases of Nonfarm Payroll, GDP and ISM index. Using CBOE VIX index as a gauge for market uncertainty, we find disproportionately large returns on days following large spike-ups in VIX. Akin to the FOMC result, such heightened-uncertainty days occur on average only eight times per year, but account for more than 30% of the average annual return on the S&P 500 index. We further find that there is a gradual but significant build-up in VIX over a window of up to six business days prior to the FOMC announcements.

The disappearing pre-FOMC announcement drift

“…While these results come with a small sample caveat, they are consistent with the lower pre-FOMC drift in recent years explained partially by lower uncertainty. This explanation of reduced uncertainty is also consistent with Hu et al. (2019) who explain the pre-FOMC returns by heightened uncertainty measured by VIX.…”

“…Uncertainty has also received attention in explaining the pre-FOMC drift documented by LM and BGM. Hu et al. (2019) argue that the drift arises because there are two types of risks related to scheduled announcements.…”

Market-Based Monetary Policy Uncertainty

“…We investigate the relationship between changes in uncertainty and the pre-announcement drift. Hu et al (2018) document a tight link between drop in the VIX and the pre-FOMC stock market drift, in line with the finding that the VIX falls before the announcement. By contrast, there is only a very weak link between changes in mpu and the pre-FOMC drift, as shown in Table C.1.…”

“…A second crucial difference lies in the ramp-up pattern for the VIX vs. mpu. The VIX typically increases in the days shortly before an FOMC meeting, consistent with the results documented in Hu et al (2018). This contrasts with the pattern for mpu, which tends to increase over the two weeks after an FOMC meeting.…”

Market-Based Monetary Policy Uncertainty

“…We present a comparison that shows the decline in policy uncertainty to be significantly larger than the decline in the VIX. Furthermore, the VIX increases in the days leading up to the FOMC meeting (Hu, Pan, Wang, and Zhu, 2018), while policy uncertainty increases early on in the intermeeting FOMC period. Our results suggest that around FOMC announcements and over the FOMC cycle, changes in monetary policy uncertainty are likely to be the underlying driver of changes in overall market uncertainty, including the uncertainty about the stock market as measured by the VIX.…”