How can I benefit from trading the markets following speeches by Greenspan?
Written by Tony Crescenzi , CEO BondTalk.com
Federal Reserve Chairman Alan Greenspan is perceived as an enigma, a man whose message is cloaked behind a wall of obtuse language. The markets spend an inordinate amount of time trying to break down that wall, hoping they might at last find the Holy Grail on Greenspanisms. But for most, understanding Greenspan to the point where both he and the Fed are even semi-predictable, and hence, tradable, is an elusive challenge. Greenspan is therefore seen as a distraction to investors who would rather focus on companies and industry fundamentals than monetary policy. But Greenspan’s influence is too powerful to be ignored, so investors must labor over his every word.
Is Greenspan, in fact, unhittable—throwing the markets curveballs when they are looking fastball, or is he telegraphing his pitches first? I, for one, fully believe that he reveals his pitches so that anyone, including you, can pick them up before he delivers them. When you look closely, Greenspan, and the Fed in general, are surprisingly open and their predictability far less daunting than legend has it. In fact, the Fed sometimes strains to signal their intentions before they act. Why they do this is clear (this may come as a shock to some of you): they are on our side. Incredibly, this is as forgotten as a trip to the dentist.
Don’t fight the Fed; follow them
The old adage, “don’t fight the Fed,” is Wall Street lore. History is strewn with periods where the performance of both the stock and bond markets was significantly impacted by Fed policy (2000 is the most recent example). Along the way, many investors have either profited from or been harmed by the Fed during these periods, depending upon the degree of respect these investors showed toward the Fed’s influence. It is astonishing to think about how often the Fed is sometimes ignored. This ignorance is usually the result of excess optimism—as was seen in the midst of the Fed’s most recent rate hikes—or excess pessimism—as seen in 1994 toward the end of the Fed’s last rate hike cycle. Basically, the market sometimes can’t see past its own emotions, but it almost always comes around.
One important insight into Trading Greenspan can be gleamed by looking at the bond market’s historical behavior in the aftermath of the Humphrey-Hawkins testimonies that Greenspan has delivered twice yearly to Congress. These testimonies, which are mandated by law, require the Fed to give their view on monetary policy and the economy to Congress. The detail to which Greenspan describes the Fed’s sentiments almost always pushes him into sensitive topics and this spurs sharp reactions in the markets. The below table illustrates these reactions and provides insight into just how you might consider Trading Greenspan in the future.
Testimony: / Bond futures (32’s)February
/July
/ Eurodollars futures (ticks)February
/ July / Next closest EurodollarFebruary
/July
1993 / +7 / -5 / Unch / -3 / -3 / -101994 / +14 / -31 / Unch / -9 / Unch / -16
1995 / +30 / -58 / +7 / -5 / +8 / -8
1996 / -68 / +43 / -13 / +4 / -13 / +6
1996 / -55 / +40 / -6 / +3 / -12 / +7
1998 / -29 / +18 / -2 / Unch / -9 / Unch
1999 / -29 / -34 / -3 / -8 / -4 / -9
Averages:
(absolute changes) / 33/32 / 33/32 / 4.4 bps / 4.6 bps / 7 bps / 8 bps
As the table shows, sharp reactions have generally followed Greenspan’s initial testimony (Greenspan appears before both the House and Senate—usually just a few days apart—but the text of his speeches on both days is the same, as is required by law). The table shows that the front-month bond contract has averaged an absolute change of 33/32 on the first day of Greenspan’s testimony. That there have been sharp reactions should not be too surprising. But what stands out, and what is the most tradable, is the follow-through; the market usually continues to move in the same direction as it did on the first day of testimony and the cumulative reaction is usually double that of the initial reaction. It goes on: one month later the reaction nearly doubles again (also in the same direction).
Ostensibly, the reaction is so sharp because the market believes that what it hears from Greenspan is an unmistakable reflection of the Fed’s policy leaning. And since Fed policy doesn’t change on a dime, the market’s reaction generally continues for weeks on end. Therefore, the next time Greenspan delivers a Humphrey-Hawkins speech, or any other policy speech for that matter, reflect upon what he said (read his entire speech!) and gauge your response. If the market trades sharply higher or lower following a Greenspan speech, place a trade in the same direction of that reaction and wait for follow-through. Give it at least one week. Reassess after one week but keep in mind that the markets’ move can generally go on for at least a few weeks.
Employing the use of both eurodollars and U.S. Treasuries has been a successful approach toward profiting from this volatility. It is important, however, to choose the area of the curve that appears to be attracting momentum traders (usually the long-bond, but this spec flow is increasingly shifting to 5-and 10-year T-notes). Also consider long straddles and strangles on bond futures. Although both tend to richen in price (due to increases in implied volatility) ahead of Greenspan’s testimony, the ensuing volatility usually sustains much of the richness.
Of course, since the stock market pays particularly close attention to the bond market, similar reactions can be anticipated there, too, especially in the interest rate sensitive groups such as financials and consumer cyclicals.