Market participants obsess over the Federal Reserve, and over every speech and testimony given by Chair Janet Yellen, looking for a hint about the direction of interest rates.
Research by University of Notre Dame’s Andreas Neuhierl and Chicago Booth’s Michael Weber provides a way for those market participants to quantify and trade on expectations about what the Fed will do.
The Federal Open Market Committee (FOMC), responsible for setting monetary policy, holds eight meetings per year. Investors eagerly await those meetings to hear whether there will be changes to the Federal Reserve’s benchmark interest rate, the federal funds rate.
But investor expectations about changes to that rate are also reflected in the Chicago Mercantile Exchange’s federal funds futures contract. Prices for fed funds futures indicate the market’s predicted interest rate.
The researchers use weekly changes in one-month and three-month fed-funds-futures data to develop a variable—coined a “slope factor”—that measures investors’ evolving expectations about the future path monetary policy. “The slope factor allows us to get market expectations on how fast or slow the FOMC will increase or decrease future fed funds target rates,” write the researchers.
And Neuhierl and Weber find that the slope factor predicts the returns of a broad stock index from the Center for Research in Security Prices, Chicago Booth’s provider for historical stock market data. The CRSP value-weighted index of stocks includes all common stocks trading on the New York Stock Exchange, American Stock Exchange, and Nasdaq, which means the slope factor predicts the returns on almost the entire market capitalization of US-traded companies.
“The predictive power of the slope factor is large in economic terms,” the researchers write, claiming investors can use the slope factor to increase the weekly Sharpe ratio (which measures risk versus return) by 20 percent compared to a buy-and-hold investor, meaning investors can use the information to obtain higher returns for a comparable amount of risk.
They can do so year round, not just during periods when the Fed’s policy makers determine federal-funds-rate changes. The research suggests that monetary-policy decisions happen continually throughout the year, confirming a widely held view that policy deliberations are always evolving. The predictive power of the slope also holds in the data “when we exclude weeks with FOMC meetings and decisions, and does not vary with turning points in monetary policy or policy decisions on unscheduled meetings,” write Neuhierl and Weber.