Today the US Fed's rate decision will take place, and it may be a potential market mover, giving a pretty good indication about what to expect from the Fed in H2/2019.
According to the Fed Watch Tool, 100% of market participants expect a rate cut. The only question is "Will the Fed cut 25 or 50 basis points?"
After the Non-Farm Payrolls at the beginning of the month came in better than expected and a 50bp rate cut was completely priced out, Fed chairman Powell's testimony before the House Financial Services Panel brought a deep rate cut (50bp) back on the table by saying that a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit. And there is a risk that weak inflation will be even more persistent than the Fed currently anticipates.
While this may be of interest for analysts, our question as traders is: is there a chance to somehow profit from this knowledge and the Fed statement in any direction?
The Pre-FOMC Announcement Drift
The answer is: "Yes". In fact, several studies show that a trading strategy called the 'Pre-FOMC Announcement Drift' has been successful since 1980 and the profitability has even intensified in recent years.
In particular, when the US yield curve flattened out (right now, the 2-10-year US yield curve finds itself around its flattest levels since 2007) and the volatility in US equities (measured via the VIX) was relatively high, the 24 hours prior to the FOMC announcement could have been traded very profitably.
On average, nearly 80% of all profits in the S&P500 were made within eight days leading up to the interest rate decision.
In other words: if you bought the S&P500 just 24 hours before the FOMC announcement, you would have earned around 80% of the income of a buy-and-hold investor, but at a much lower risk because you were invested only on eight days a year.
What is particularly interesting: it didn't matter if the Fed has raised or cut interest rates. The actual interest rate decision brought no overall return. Instead, the anticipation of an equity-markets-friendly decision of the Fed was of higher importance.
Why does such a simple strategy work so well?
First of all, the reason is found in the fact that In the week before the Fed decision, there is a so-called "blackout period". That means, that voting FOMC members are not allowed to make any statements, or give interviews or speeches, which usually results in a drop in trading volume and liquidity thins out, putting it below average.
Second, professional investors usually have a risk-overweight in their portfolio. Before a risk event like a Fed rate decision, these market participants tend to reduce their risk exposure, and rebuild it after the rate decision. So, once the "blackout period" begins, the reduce their engagements and instead buy insurance for their portfolios via futures and options. Due to the low liquidity in the markets during that period, small purchases of equities result in a drift higher in equity markets.
How to Trade The Pre-FOMC Announcement Drift
But now the interesting question: how can we trade this?
We will use the following plan:
- We enter a long position in the SP500 CFD on Tuesday, July 30, 2019, at 20:00 CET 'Market' at the respective price at this time.
- A big disadvantage of the strategy is that it usually works without a Stop Loss. Since working with no clearly defined risk is no option for us as professional traders, we want to work with a worst-case stop based on volatility.
Therefore, we look at the Daily chart in the SP500 CFD, the indicator ATR(14) and at the average daily trading range of the last 10 trading days.
The Daily ATR(14) reads ~22 points while the average daily trading range of the last 10 trading days has been ~22 points, too.
Therefore, our worst case stop should be in the range between 25 to 30 points from our entry point in 1.
- We exit the Long position in the SP500 CFD on Wednesday, July 31, 2019, at 19:55 CET, if it is not stopped out earlier.
Source: Admiral Markets MT5 with MT5-SE Add-on SP500 CFD Hourly chart (between July 15 to July 26, 2019). Accessed: July 26, 2019, at 10:00pm GMT - Please note: Past performance is not a reliable indicator of future results, or future performance.
In 2014, the value of the SP500 CFD increased by 11.39%, in 2015, it fell by -0.73%, in 2016, it increased by 9.54%, in 2017, it increased by 19.42%, in 2018, it fell by -6.24%, meaning that after five years, it was up by 36.8%.
Source: Admiral Markets MT5 with MT5-SE Add-on SP500 CFD Daily chart (between December 1, 2017, to July 26, 2019). Accessed: July 26, 2019, at 10:00pm GMT - Please note: Past performance is not a reliable indicator of future results, or future performance.
Check out Admiral Markets' most competitive conditions on the SP500 CFD and start trading on the SP500 CFD with a low 0.4 point spread. To test Admiral Markets DAX offering in combination with the described strategy above register for a free demo account today and experience the live market risk free!
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