Ataraxia Financial Newsletter - May 2022
Turkish Inflation, Covid Cool-down and a Look at the Importance of Natural Gas
“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.”
— Ludwig von Mises
May 12th, Istanbul.
The weather is nice and sunny, but for my taste it is still a bit cool.
Istanbul, formerly Constantinople, or ancient Byzantium, is the city that separates Europe and Asia and therefore witnessed a rich history of 2500 years, filled with many surges and conflicts between cultures, religions and empires.
It was the capital city of both the Byzantine Empire as well as the Ottoman Empire. Today it is a buzzing city with a population of more than 15 million (bigger than any city in Europe). It is not only the largest city of Turkey, but also the historic, economic and cultural hub of the country, as well as the major seaport. Moreover, it has huge geopolitical importance as it straddles the strait of Bosporus, which is the only passage to the Black Sea. As we are currently learning, a lot of important resources from Russia and Ukraine need to be transported on trade vessels through this passage.
This month’s newsletter will cover the following topics:
Market Analysis
A Quick Glance at the Economic Situation in Turkey
Key Indicator Rundown
The Covid Cool-down Period
Natural Gas - A Dive Into Europe’s Dilemma
Natural Gas as an Indicator
A Quick Dive Into Academic Trading Research & Technical Analysis - The Pre-FOMC Announcement Drift
Paper Summary
The FOMC Announcement
Conclusion
Market Analysis
Before we get into the markets, here is a superb chart from Fidelity’s Jurrien Timmer, perfectly summarizing the market development that we have seen unfolding since the massive Covid(hysteria) outbreak in early 2020.
A Quick Glance at the Economic Situation in Turkey
Currently, people here in Turkey are suffering the consequences of poor monetary policy over many years — resulting in an enormous increase of the cost of living.
Even though I am only staying here for a short time, I can feel the inflation. For example, a lot of the menus are filled with stickers on top of the prices, since the prices increase so rapidly that it is hard to keep printing new menus every few days. Further, passing by banks and currency exchange shops I can see every day how the Lira is loosing in value in comparison to the Euro (which itself is loosing considerably in value): When I arrived, I got 15.50 Lira per Euro, now, 12 days later, I am getting 15.90. Hence, I only withdraw a small amount of cash and try to pay by credit card wherever I can. Also, in some coffee shop chains, where I can see the price table above the counter, the actual price I get charged is actually slightly higher, which I guess is due to the fact that their system has already updated to a new price, while the wooden tables haven’t been renewed [I’m pretty sure that they aren’t trying to scam me for a few Kurus (Kurus = cents)].
Economically, the problem of living in such an inflationary environment is, that it makes it much harder to engage in economic calculation, due to uncertainty and a rapidly changing unit of account. Accordingly, making good decisions is a much harder task for any business, causing additional frictions and inefficiencies which otherwise wouldn’t exist.
Most discouragingly, Turkish people who saved up money and kept their savings in Turkish Lira, or Turkish bonds, are the ones who are getting totally screwed throughout this period.
Looking at the above chart, it can be observed that the inflation rate of the Lira was kind of stable until 2018, then had a short hike before starting its path of exponentially increasing in 2020. Note that the broad money supply grew at an average of about 25% between 2000 and 2020, which is the main fundamental input that sets the stage for huge price increases later on. This should serve as a warning also for other nations… trusting in the ability of central banks to manage the inflation rate is quite a risky endeavor… once the wheels start rolling, things can suddenly spiral out of control.
What can we take away:
People who held Lira or Turkish bonds lost most of their purchasing power by now.
People, who held their savings in the Turkish stock market also lost money over the last 3 years, but way less.
People who have kept most savings in real estate, other fiat currencies, or fixed rate securities abroad are about equal.
People who held it in gold and bitcoin over the time frame did quite well — the ones who held bitcoin actually did extraordinarily well.
For everyone who is interested to read a deeper macroeconomic analysis of the inflation in Turkey, I recommend Lyn Alden’s most recent article, “Investing During Stagflation”, in which she looks at Turkey as a contemporary case study.
Key Indicators
Rundown:
Despite positive forecasts, the U.S. economy declined by 1.4% throughout the first quarter of 2022. This came as a surprise to many since the consensus forecast had put the expectation at a 0.6% growth. The main factors contributing to the decline have been:
a reduction in stock value
a reduction in public spending
a massive increase in the U.S trade deficit (strongest factor and a new record)
The consequence is that likelihood and fears for sliding into a recession has considerably increased.
The 10-Year Treasury Rate closed the month of April at 2.96%, which is the highest level since December 2018. It even peaked through the 3% mark since then.
Inflation hit a new high with a U.S. CPI of 8.5%. The CPI number for the Eurozone stayed unchanged at 7.5%. As a response, the Fed keeps up with its tightening, by increasing the federal funds rate by 50 bps, following its 25 bps increase at the last FOMC meeting in March. Thus, the target rate is now at 0.75% - 1.00%. According to current market expectations, the Fed will keep up the 50 bp-hikes raising the rates to 2.75% - 3.00% before years end. Powell is attempting to engineer a soft landing - in which interest rates are raised just enough that it doesn't cause a recession. A difficult task.
The S&P declined by 8.8% in April and experienced its worst first quarter since the end of the Great Depression in 1939:
Chart Source: lplresearch.com To understand what is happening in the stock market, lets get a closer look at what is happening under the hood of the S&P 500:
Heat Map Source: finviz.com The above ‘heat map’ gives an overview of the S&P 500 performance, split by sector and company. The size of the squares display the market capitalization and the color presents the year-to-day gains or losses.
Overall, it is obvious, that it is not a good year so far.
Especially the sectors in the upper right (Technology, Communication & Services and Consumer Cyclical) seem to be in a bloodbath.
Further, especially the 5 biggest companies, Apple, Microsoft, Google, Amazon and Tesla, which make up almost 25% of the total index, are all in deep red.
Then, towards the right side of the bloody ocean, there is a super green island — the energy sector.
Some positive news from corporate America: Alphabet's Wing has launched its first commercial drone delivery service in San Francisco (April 7th). Seeking Alpha describes how the process is initially set up:
Retail workers will load up the drones outside participating stores - rather than a Wing facility - carrying small packages that weigh 2.6 lbs or less. They will then climb to a cruise height of around 150 feet above the ground and travel their routes autonomously (remote pilots will be on standby to take control if something goes wrong). Once a delivery drone reaches its destination, it will stay at roughly 23 feet while lowering the package on board into a customer's yard via a cable.
Amazon Prime Air and Uber Eats are also expected to launch their air delivery services in the near future.
The massive decline in the stock market and reduction of the GDP have also resulted in both, the CAPE ratio, as well as the Buffet indicator to retreat noticeably. However, even given the declines they are still on a very high level from a historic perspective. This serves as a reminder that it is not unlikely, to see further declines in the coming months.
This possibility is also underpinned by the VIX which keeps at an elevated level.
Along the S&P, also other stock market indices around the world kept declining throughout April, with the MSCI ACWI also losing more than 8% of its valuation.
Despite all of this, the USD index keeps moving upwards. Partially, this can be explained by the Fed’s strong stance to fight inflation, while the European central bank still seems reluctant to increase rates and Japan is right out engaging in yield curve control (a promise of unlimited market intervention to keep the 10-year rate at 0.25). This has led to both, the Euro and Japanese Yen declining against the dollar (as explained in the last newsletter, these are the two largest components in the basket against which the USD is measured).
Given the ongoing turmoil in the Ukraine, the uncertainty of other nations responses to it and all the speculation on the ramifications for the energy markets, the prices of oil as well as natural gas have continued to rise. Especially natural gas saw a huge surge, rising more than 28%, while gold seems to be establishing a $100 baseline. We will take a closer look at the current state of the natural gas market further down in the article.
Meanwhile, the European Commission, which is the executive arm of the EU, announced new sanctions on Russia. They unveiled that there is going to be a phase-out phase of crude oil imports within six months. However, Slovakia and Hungary are given special rights to take a longer time and there are also some worries about nations not willing to finally go along with these new sanctioning plans. It’s important to notice that while around 25% of Europe's oil is imported from Russia, there are big differences in the level of reliance among the EU members. (generally, those closer to the border are more dependent on Russia’s energy).
The Gold price has slightly declined in April (-1.6%) and retreated even more since then, currently trading in the $1,800 - $1,900 range.
Bitcoin has risen more than 5% throughout April, but has lost substantially during the early days of May, even testing its lows of July 2021. Again, the correlation to the so-called “risk on” assets (usually conveyed by the NASDAQ). is on very high levels. And since these stocks are tumbling, so does BTC. But it is important to keep things in perspective. Fundamentally, the environment for Bitcoin on its path to become the future global reserve currency is getting increasingly likely.
Furthermore, during times where the BTC price is significantly declining, the voices of its failure become louder and a common phrase goes like “Bitcoin doesn’t have a future, but blockchain technology does.”
Probably the blockchain technology has some other applicable use-cases, but the predominant one is money! And Bitcoin is the perfect manifestation of that.I have been closely following all of the blockchain-developments since early 2013. I have seen a lot of things come and go and I have also witnessed how Bitcoin has become stronger and stronger throughout all of it. It has grown like a hydra. Whereas other projects came and died, Bitcoin proved its antifragility over time. With every head that was chopped off, two new heads grew out of it.
So let’s zoom out a bit and look at the long-term track record:
Table Source: jonasoppermann.com, Data Source: coinmarketcap.com While substantial price declines can be painful and dangerous for over-leveraged entities, it does not change anything about the long-term destination. As long as the blocks keep coming every 10 minutes and the network keeps growing, there is nothing to fundamentally worry about Bitcoin’s future.
Other notable points that have happened in the Cryptocurrency universe:The Luna Foundation Guard has accumulated another $1.5 billion in bitcoin, as a reserve for its decentralized stablecoin Terra (UST).
Central African Republic announced that it has adopted bitcoin as legal tender. While it is a very small and economically not so important country, it is the second country that has implemented Bitcoin as a legal tender. It might be the second domino stone, in a long line of stones, that has toppled.
Notwithstanding the price decrease, the hash rate has reached a new ATH, making the Bitcoin network more secure than it has ever been.
So, there are also some good developments going on and not everything is doomy. Let's look at another positive recent trend.
The Covid Cool-down Period
A fortunate development is that the Covid-related death rate is really retreating now:
The daily average death rate over the past months, with a 7-day moving average now at 1,856. Unfortunately still a large number, but just to keep it in fair perspective, it puts it at roughly 1% of daily death causes. Statistically, dying in a car accident (about 3,700 daily death casualties) is now about twice as likely. Furthermore, according to the latest statistics, the likelihood of dying from Covid decreases by more than 50% for people under 75, by 93% for all people below 50 and by 97.5% for people under 40.
This leads to the following risk profile for a person under 40: The risk of dying in a traffic accident is 80 times more likely than getting killed by the Covid bug.
Of course, to be precise I would have to include other factors, such as being overweight (which has another huge impact on Covid-death likelihood!), being vaccinated (that would be a tricky one 🤠) and an age-profile for traffic accidents (I assumed it to be evenly distributed but it’s probably not). However, I am already on my mathematical limits here, without opening a spreadsheet and I guess everyone gets the point.
Thinking about traffic accidents in relationship to Covid deaths makes me remember some of the scooter drivers I saw in Taiwan last year, who didn’t wear a helmet, but made it 100% sure, to put on a mask!
Talking about Taiwan… the clear winner in preventing the outbreak so far has undoubtedly been Taiwan. But just like the other “Zero-Covid” policy countries (like Australia, New Zealand and China), it doesn’t last forever. And while the numbers are globally in decline, the ‘uncherished’ Covid-bug finally seems to conquer the last standing island.
Interestingly, Taiwan is now starting to ease up its policies a bit, right in the time that the numbers are skyrocketing. Times change and so do narratives. I was in Taiwan last year at this time and people screamed after me when I was doing a midnight run without wearing a mask. Tourism was basically closed and quarantine time was 2 weeks (for some time even 3 weeks) with GPS tracking of the phone to make sure that nobody in quarantine would leave their room. Now, you can take off the mask for sports, eating and even taking pictures. Also, tourism has reopened and the quarantine time is down to 7 days, and only 3 days with a negative test.
Personally, I really hope that Taiwan will be totally let go of restrictions soon, so I feel motivated to go there again.
I genuinely miss my ‘Ilha Formosa’ (literally: beautiful island), which is how the Portuguese deservingly called it, impressed by the sight of the scenery they were facing when they first sailed by.
China now appears to be the last country that still doesn’t accept the new reality. Good luck with that.
Unfortunately, the people in Shanghai and other major cities are imprisoned and have to suffer the government's decisions. Moreover, the already strained supply chains are further congested, leading to further global trade difficulties and upward pressure on already rising price inflation.
Here is a picture showing the congestion of cargo vessels in front of Shanghai’s ports:
This brings us to another issue about cargo vessels, political trade interference and how supply chains need to be redesigned to conform with the new geopolitical terms of international corporation.
Natural Gas - A Dive Into Europe’s Dilemma
The price of energy in Europe has surged immensely due to the war in Ukraine and the political theater that is playing around it.
Here is a chart showing the yearly percentage increase of energy costs:
Out of the different energy sources, oil and gas have gotten the most attention since those are the two energy sources where Europe has put itself into a position in which it is very dependent on Russia.
Current European import amounts from Russia:
about 25% of its oil supplies
about 40% of its natural gas supplies
And here is a pipeline map that clearly illustrates the importance of Russian energy supply for Europe:
These pipelines are running like blood vessels and veins through the whole European continent, supplying people and companies with the necessary energy supplies to survive, operate and thrive.
Now, out of the two energy sources, the price of natural gas has surged even more drastically and also gotten the most attention.
The main reason for this is that oil can be more easily shipped around via oil tankers, while the process of getting natural gas onto ships involves a more complicated process. As I wrote last month (emphasis added):
While it is possible to shift oil suppliers, it is far more difficult to change sources for natural gas. Oil can be globally transported on tankers while gas is mostly transported to Europe through pipelines. In order to ship gas from other sources, it first needs to be cooled down into liquefied natural gas (LNG). This process is complicated, more expensive and requires an infrastructure which first needs to be set up, requiring time and capital expenditures. Currently, a bit more than 50% of the natural gas is supplied via pipelines with a distinct geographical destination, which is the reason why the gas prices have way higher variations across different geographical areas than oil has.
Furthermore, unlike the oil tankers, that are unspecialized and can easily be rebuilt to serve other functions, the LNG carriers are very specialized in their design. It follows, that the whole production and operation purpose of them, requires a particularized commitment for their intended use. Their appearance is also quite unique:
Finally, once the LNG carrier arrives at the desired port, there is a regasification required, before the gas can be pumped back into the pipeline and sent to its final destination, either directly for burning, or to plants to produce electricity. This regasification process requires special terminals and the necessary pipeline infrastructure to connect it appropriately.
As pointed out in a Reuters article, Europe simply does not have sufficient infrastructure, to handle much larger LNG imports at the moment:
As can be seen, Spain does have the highest capacity at the moment with 6 LNG terminals, but the problem is that these terminals have only a limited connection to the European pipeline system and therefore the utilization of the excess capacity, shown in the bar chart, is quite limited.
Since most of the other countries with LNG terminals already run near their capacity limits, Britain and France are the main possible countries that can import additional LNG supplies and make it accessible for other European countries.
This available capacity accounts for a bit more than 40 billion cubic meters (bcm). The annual amount of Russian gas imports into Europe is estimated to be around 155 bmc, which means that roughly 25-30% of the Russian natural gas imports can currently be replaced by LNG.
This number can be increased in the future by a) building out the pipeline network especially with regards to Spain, which would allow another 40 bcm, and b) by constructing new LNG terminals.
Germany, which is the biggest importer of Russian natural gas, currently has no LNG terminal in operation. However, it is the main European country that is currently working towards the capability of getting more supplies through LNG into Europe. There are already 3 projects of constructing LNG terminals in progress, with the following capacities:
Brunsbeutel, with a capacity of 8 bmc and likely to start operations in 2026.
Stade, with a capacity of 12 bmc and forecasted to start operations in 2026.
Wilhelmshaven, with 10 bmc LNG capacity, and forecasted to operate in 2027.
In total, this could bring in an additional 30 bcm LNG import capacity to Europe, which would bring the total capacity to about 110 bcm of additional LNG and could therefore satisfy about 70% of the current demand from Russia (155 bmc). However, it still wouldn’t be sufficient to cover all of the current inflows from Russia and more importantly, it won’t be fully available for at least another 3-5 years. Thus, currently it seems an impossible dream to completely avoid Russian imports.
Other solutions would be to rely to a greater amount on renewable energy for electricity production, which also takes time, is costly and has decreased reliability, or nuclear energy, which unfortunately is still a taboo topic in some European countries (most notably Germany).
So far, we have only analyzed the demand side for Europe of the LNG story. The supply side is another issue. The LNG that is currently produced also has its recipients. If Europe goes on the market to buy more LNG, this has the consequence that they need to bid against other already existing buyers. This consequently results not only in higher prices, but also means that current importers, who are bid out of the market, must find new energy supplies. This will be especially challenging for countries like Japan and South Korea, who currently import large amounts of LNG and do not even have the option of receiving natural gas through pipelines.
Current gas production in other countries can of course increase over time, but it is not like a switch that can just be turned “on” and “off”. The Plug tweeted another revealing chart showing the LNG exports of the U.S., which is the largest LNG producer:
To summarize it, Europe is in a precarious situation, which is why Russia is energy-wise in a position where they have some room to set the terms. It was a quite obvious move to demand payment in rubles and while European politicians might cry about “contract breaches”, they have to face the reality that it is them, who want to block Russian imports, but still need their energy for now. Moreover, alongside the U.S., they have sanctioned some major Russian banks and are freezing Russian reserves held in USD or Euro. So what are the Russians supposed to do about that? It should be clear that they won’t supply countries who are clearly acting as an enemy now towards them with ‘free energy’.
The dominant position of Russia when it comes to energy is shown in:
The fact that they are able to just stop supplying gas to countries which are not willing to pay in ruble, such as Poland and Bulgaria.
The exchange rate of the ruble has already recovered from its initial decline and is now higher than before the war started.
Hence, while Europe has seen the energy prices surge astronomically, Russia so far hasn’t had any significant decline in export revenues, even though the export volumes have declined.
To be honest, the way European politicians are acting seems quite clumsy, uninformed and short-sighted. Moreover, they don’t appear to spend much time thinking through the possible implications of their actions.
Some possible long-term global ramifications of Europe’s energy policy might be as follows:
Europe finds other suppliers to import natural gas via LNG, by paying higher prices and therefore bidding out their current customers.
These current LNG customers (mainly in the Asian hemisphere) will instead be able to get cheaper prices offered by Russia who is now sitting on idle resources and therefore increasingly shift their business to Russian suppliers.
This would be in some sense a political win-win scenario, since Europe can achieve its goal of avoiding imports from Russia, while Russia can now sell those unused resources, due to elevated LNG market prices, to other bidders who need to find new suppliers since their former suppliers now ship their energy to higher paying European customers.
The main winners would be the LNG exporting producers (mainly in the U.S.A, Qatar and Australia), who can sell at higher prices to European customers.
The main losers of this scenario would be:
European companies who are now facing increasing costs of production.
European citizens, especially those who are politically agnostic and do not care so much about where their energy comes from, but are now faced with permanently elevated prices.
Other countries that rely on LNG imports due to the lack of other energy sources.
Since this is a constantly developing and changing story, It remains interesting how it all ends up playing out.
Natural Gas as an Indicator
The current cultural environment and political discourse have put the importance of natural gas into the spotlight.
This should be no surprise, considering that it is an important source of energy which is used for numerous crucial things that we take for granted in our daily life.
The above chart gives a perspective of the different energy sources that are globally used and how it has changed over the past 200 years.
After oil and coal, natural gas is with about 24% of our energy mix, the 3rd largest energy source.
In order to appreciate its importance, here are some main use cases:
The electric power sector
In most countries, a huge amount of electricity gets produced with natural gas. Although, the percentages vary a lot depending on the country (in the U.S.A 33%, Japan 20%, Germany 12%)
The industrial sector
used as fuel for heating
to produce chemicals
to produce fertilizer
to produce hydrogen
The residential sector
to heat buildings and water
The commercial sector
to operate refrigeration and cooling equipment
to cook
to dry clothes
for lightning
The transportation sector
compressors which move gas through pipelines
as vehicle fuel
To sum it up, natural gas is a very important commodity for the economy. If the price rises, it can be a good sign because, it means that the economy is expanding and therefore the demand is high.
On the other hand, it can also be an alarming sign, since it means higher costs and makes the operation of businesses more expensive, which in turn acts as a break for economic growth. Further, it is generally a negative experience for consumers who as a consequence see their electricity bills rise.
Thus, if a price increase is caused not by increasing demand, due to an expanding economy, it can be seen as a negative sign, since it has negative effects on the economy.
The chart shows the development of the natural gas price since 1990. As can be seen, it tends to have sudden large spikes in the price. These massive spikes tend to occur when there is huge market turmoil, such as during the California energy crisis, the 2008 financial crisis and now.
It is also no surprise, that natural gas has a high correlation with oil. Reasons for this correlation are:
General energy demand increases price in both energy sources
Many Exploration & Production companies also produce both natural gas and oil, therefore they will shift their focus and expenditures between them with regards to the higher profit margins.
Many oil wells produce oil with the byproduct of natural gas, hence if they increase their oil production, they will automatically increase the byproduct as well. In addition, if the gas price is high, they will focus on increasing the efficiency of getting as much of the byproduct as possible.
Substitution: From the demand side there are many use-cases in which oil and gas can substitute each other, such as electrical power. Consequently, if one energy price rises, electricity companies will shift their energy composition towards the other one.
However, the correlation is not perfect and there are also periods, in which this correlation completely ceases to exist. For instance, the spikes that happened in 2000 and 2005 did not occur in the oil market. Adila McHich from the CME Group has the following explanation:
Natural gas is more prone to short-term price shocks and supply imbalances due to seasonality, storage dynamics, and weather-related events, which tend to increase the volatility and cause disequilibria to the short run oil and gas linkage.
In addition, after the huge decline after the 2008 financial crisis, oil experienced a period of substantial price increases until it crashed in the fall of 2014, whereas the price of natural gas basically went sideways until recently.
A Quick Dive Into Academic Trading Research & Technical Analysis - The Pre-FOMC Announcement Drift
I originally planned to write on another topic, but after watching Tone Vays, one of my favorite analysts, talk about the FOMC announcement after the markets had closed on May 4th, and how he would trade it based on historical price data (and presumably make lots of money with high certainty, if he would have the time to do so), I changed my mind. Since I had watched it later, while watching the markets going south and therefore somewhat contradicting the implied trade-proposition, I decided this would be an interesting topic to write about.
Just for clarification, I am a huge fan of Tone Vays. I really admire his ability to logically analyse topics and I like his unique style to explaining things. Especially, he has done some great work around clarifying the value proposition of Bitcoin and lining out, why other cryptocurrencies are either technically flawed, or are not able to provide any real long-term value as (crypto)currencies and should rather be seen as unregistered securities. He (like me) believes that most of them are basically scams, with the ambition of founders to get rich by basically creating and printing their own money. He has a “CryptoScam” podcast in which he used to provide analysis on some of the prominent projects (here is my favorite episode about Crypto Hedge Funds). Unfortunately, in recent years his focus has been mainly on providing technical analysis — primarily for crypto-traders. I understand it, since this is the topic that most of his followers are interested in — and he can monetize it. But I think he provides way more value in his other activities.
Paper Summary
Anyway, the paper in question was “The Pre-FOMC Announcement Drift”, a report by the Federal Reserve Bank of New York, first published in 2011 and then revised in 2013. (Who is interested in reading it can do so here). It is quite a popular paper, which was cited more than 500 times.
The gist of their findings is, that the stock market gains made during the 24-hours before the FOMC announcement, accounts for about 80% of the annualized returns since 1994.
Here is the Chart depicting their main findings:
Some important points about the study:
The FOMC has 8 meetings a year and the research of the main outcome includes the data of 131 scheduled FOMC meetings from September 1994 to March 2011. The reason for this time frame is that before 1994, there were different changes in the amount of meetings, announcement time and other factors that would have added inconsistency to the examined data points.
The data shows a mean of about a 0.49% pre-announcement gain.
Accumulated, this results in a 3.89% per year, while the accumulated gain on all of the remaining trading days has only been 0.88%. Hence, 80% of the gains are made during the Pre-FOMC Announcement Drift.
They also find, that the pre-FOMC drift shows no significant differences during the time of monetary policy easing cycles and tightening cycles.
However, “it appears that pre-FOMC returns are somewhat higher around recessions and in periods of financial turbulence such as the 1987 stock market crash or the 1998 LTCM crisis”. They measured this based on the VIX level at the time and it came out that a one-standard deviation increase in the VIX increased the returns by 31 basis points.
Importantly, the return from the announcement until the market closes is “essentially zero”. And their 95% confidence level for this is about 50 basis points. Keep that in mind.
The paper also states that other major stock indexes also show similar excessive returns on their central banks policy announcement days. Interestingly, Japan is the only country where it doesn’t apply. Japan’s monetary policy is very weird and unique in many ways.
Most interesting for me is that their findings suggest that these pre-announcement drift effects are purely on equities, not on fixed income securities. This is quite surprising, because it is the meeting where the Fed announces the federal funds rate for the forthcoming months. If it has at all a market effect, this announcement should primarily affect the Treasuries and secondarily on all other fixed income securities.
It is interesting that this trade suggests putting money into the stock market before the FOMC announcement. This announcement has important implications for the future of the market and therefore bears a lot of risk. Hence, it is essentially the opposite to what a risk-averse investor might do.
I would further assume that it is actually more likely that some investors pull out their money before the announcement and based on the announcement reinvest it otherwise. This should rather lead to some pullback before the announcement and higher volatility afterwards.
Given the data results, there is just a very short period of time right after the announcement with high volatility, usually resulting in a short dip, followed by a strong upward burst and a slight retreat until the market closes.
One possible explanation for this phenomenon (also mentioned in the paper) would be that due to a downward trending federal funds rate since the 1980s, the monetary policy news have arguably had a predominantly positive feedback-loop.
One interesting side note: This study completely runs contrary to any possible EMH (Efficient Market Hypothesis) assumptions.
The FOMC Announcement
Let’s look at how the S&P behaved upon the latest FOMC statement on May 4th.
The most fascinating observation is the fact that the 5-minute candle at the announcement time is exactly straddling the 0.49% gain. And it is true for both starting points explored in the paper, a) the opening of the market on the previous day, as well as the exact 24-hour trading window (you can see the candle at 14:15 on May 3rd going through the zero-line).
Next, we see the market swings, right after the announcement, seemingly exactly follow the pattern predicted by the empirical results at first glance. But looking at it more closely, it becomes obvious that while the directions of the candles follow the suggested pattern, the magnitude of those swings is way out of whack.
Especially, the gigantic surge until the closing bell is magnitudes outside of the confidence Intervall. I am actually not even sure how they are creating the 95% confidence interval in their figure (as indicated by the grey area around the mean line). It should be 2 standard deviations away from the mean and it appears to be at around 0.25% on both sides at the announcement time. However, in their regression model their result is a standard deviation of 1.215%.
Anyway, while the mean of the model gets precisely hit at the announcement time, everything that happens afterwards, first runs directionally in line with the predicted outcome pattern, but with a way stronger magnitude (way more than 3 standard deviations, or in other words, it is way exceeding even a 99% confidence interval!).
And lastly, on the next trading day, it goes completely counter to the predicted range of outcomes: A huge downward swing with enormous magnitude, the S&P 500 loosing more than 3,5%, which based on the underlying data-set should be statistically almost impossible, thereby contradicting all data-points collected over the 17 years.
Conclusion
In a way their main finding got precisely confirmed during the latest FOMC announcement. However, all of the trading after the announcement, contradicted the reliability of the statistical data supporting their findings.
What do we learn from this analysis?
Many traders invest based on technical analysis of markets. Therefore some of these trading strategies can lead to self-reinforcing outcomes.
However, traders & investors shouldn’t have too much trust in any market phenomenons, which are based on empirical analysis and historic data.
Investors should keep in mind that all market behavior is based on human action, which in turn happens based on subjective valuations of people at any point in time and therefore cannot be predicted by historic data.
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Best regards,
Disclaimer: The content of this newsletter is for informational and educational purposes only. It contains my personal views and opinions, which are not to be taken as direct investment advise. All investments have risks and you should do your own due diligence before making any investment decision. If you require individualized advice, to review your unique situation and make a tailored advice for you, then contact a certified financial planner or other dedicated professionals.