Get ready for more volatility this week as the two-day Federal Open Market Committee (FOMC) meeting kicks off today (Tuesday) and investors wait for a sign of more quantitative easing, or QE3.
The Federal Reserve announces what will happen with interest rates eight times a year at FOMC meetings. FOMC meetings are scheduled well in advance and receive a great deal of attention from the media and markets, but it wasn't always this way. It was not until 1994 that the Federal Reserve started publicizing the actions of the FOMC.
Now the FOMC announcements have become trading opportunities.
In fact, under Federal Reserve Chairman Ben Bernanke, the Federal Reserve has become the most influential market maker in history.
Bob McTeer, the former president of the Dallas Federal Reserve, wrote in Forbes that investors are so glued to Fed actions they even react when minutes are released from an FOMC meeting - even when the meeting's outcome was already known.
"It used to be "buy on the rumor, sell on the news' or vice versa. Now it seems to be "sell on the news and sell again on the same news in slightly greater detail,'" wrote McTeer.
Today's FOMC Meeting and Markets
Market volatility is always more intense the week of an FOMC meeting.
In a study of how the Fed affects the markets, researchers found that most of the stock market movement is around the three-day windows for scheduled FOMC announcements.
"Since 1994, [stock] returns are essentially flat if the three-day windows around scheduled FOMC announcement days are excluded," the report found.
However, if the 24-hour period prior to the FOMC announcements is taken out, then returns fall to being practically flat.
The researchers note: "More than 80percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements."
The most volatile stocks are ones like financials that are particularly sensitive to interest rate actions. Banks with betas over 2 - which is double the average volatility for the entire market - include Deutsche Bank (NYSE: DB) and Citigroup (NYSE: C).
Insurance companies such as the Principal Financial Group (NYSE: PFG) and Prudential Financial (NYSE: PRU) are also very volatile due to the composition of the investment portfolio of each.
Bernanke's Global Power Role
Under Bernanke, the role of the FOMC has become even more important for the financial exchanges. The U.S. Federal Reserve Chairman role has become that of the central banker for the world, not just the United States.
The most obvious examples of Bernanke's influence are quantitative easing 2 and Operation Twist. QE2 consisted of the Federal Reserve inflating its balance sheet to purchase $700 billion in Treasury bonds to finance the budget deficit of the United States.
As the accompanying chart shows, the Dow Jones Industrial Average rose about 30%, or nearly 300 points, after Bernanke announced QE2. The Dow has climbed about 18% since Operation Twist was employed in the fall of 2011.
Now it's not only the policies that the FOMC chooses, but how Bernanke speaks about the economy, that can move markets. Since Bernanke started giving press conferences to discuss Fed policy statements, investors cling to every verbal and non-verbal clue possible for an idea of where markets could go.
That's why investors will be watching closely when Bernanke addresses the nation tomorrow at the conclusion on the meetings.
The Dow Jones was down nearly 20 points in the first hour of trading to 13,055 ahead of today's FOMC meeting.
Related Articles and News:
- Money Morning:
Silver Prices Ready for QE3
- Money Morning:
Expect QE3 After Geithner's Warnings
- Forbes:
Stop Releasing the FOMC Minutes