Don't Fight the Fed!

Abstract

Monetary policy, as captured by changes in the Fed funds rate (FFR), is a useful signal for investors. I analyze the economic significance of trading strategies based on the “out-of-sample” forecasting power of FFR for excess equity returns. A simple market timing strategy produces an annual Sharpe ratio of 0.55 and a certainty equivalent return (CER) gain of 3.37% per year, whereas a buy-hold strategy has a Sharpe ratio of 0.41. Rotation trading strategies for portfolios sorted on size, book-to-market, and momentum have a Sharpe ratio and CER gain as high as 0.73 and 9.60% per year, respectively. Dynamic strategies for other asset classes also produce economically significant gains. Generally, the strategies based on FFR outperform those associated with alternative predictors.

Keywords: asset pricing, predictability of stock returns, monetary policy and stock returns, out-of-sample predictability, economic significance of predictability, Federal Funds rate, stock rotation strategies, market-timing strategies, asset allocation, portfolio choice, size, value and momentum anomalies

JEL Classification: E44, G11, G12, G17