With the Federal Reserve making no material changes to its stance of monetary policy at the July meeting of the Federal Open Market Committee (FOMC) this week, attention now turns to its September meeting as well as to the results from its ongoing review of monetary policy strategy, tools, and communications. Since the start of the year, the central bank has greatly expanded its balance sheet to support the economy, and financial market participants generally expect to gather more clarity on further monetary policy actions in the coming months. Meanwhile, stock markets have risen substantially since their March lows, supported, in part, by expectations around the path of Fed policy. As the Fed considers its next measures in this complex environment, JPMC Institute research on past central bank actions provides a perspective on the opportunities and risks of policy alternatives.
JPMorgan Chase Institute Take:
JPMC Institute research has examined how the timing of central bank announcements may impact the response of institutional investors and movements in financial markets. In January 2015, for example, the Swiss National Bank (SNB) made a surprise announcement to remove its foreign exchange market floor. As documented in the report, hedge funds had exhibited a trading pattern around scheduled SNB announcements that left them exposed to such an unscheduled policy change, potentially exacerbating market volatility. Our findings suggest that market preparedness and investor positioning can be important considerations for when policy changes are communicated by central banks.
Moreover, a recent Institute report focusing on the Fed’s tapering of its asset purchase program in 2013 found that reduction in policy accommodation can set off momentum trading dynamics and herding behavior with important consequences for markets. The research focuses on the context of emerging market foreign exchange, and finds that a relatively small pocket of hedge funds and banks usually trade in a way that is highly correlated with price action. These investors were joined by a number of asset managers that began trading in a more synchronized way during the period of elevated volatility, selling EM currencies as they depreciated. These findings suggest that momentum trading and herding can influence the magnitude of the market reaction to Fed policy changes.
As policymakers at the Fed seek to adjust the stance of policy in the post-COVID environment, they can use these features of the institutional investor landscape to their benefit to the extent they are able to align the incentives of market participants so that they are more likely to move in the desired direction. However, the same tendencies can work against policymakers, because market positioning and expectations are uncertain. Policy measures should therefore take into account the potential responses of market participants to avoid unintended consequences at times of policy adjustment.
We thank George Eckerd, as well as Melissa O’Brien, Shantanu Banerjee, and Carolyn Gorman. The opinions expressed are those of the authors alone and do not represent the views of JPMorgan Chase & Co.