Impact of FOMC Cycle on Market Uncertainty: Evidence From Interest Rate Derivatives

Abstract

This paper investigates how Federal Reserve (Fed) actions influence market uncertainty. We consider two kinds of Fed events: the day of the Federal Open Market Committee (FOMC) meeting -- which includes a policy statement, press conference and release of a Summary of Economic Projections -- and the day the minutes of the FOMC minutes are released -- which is typically set 3 weeks after the meeting. Unlike related papers focused on the issue, we measure market uncertainty by the implied volatility extracted from interest rate options, specifically swaptions. We use 1-month constant maturity volatility for swaptions over tenors ranging from one up to 30 years as they are reflective of how these volatilities are marked by dealers/market-makers and cover only one FOMC meeting/minutes release at a time. We use an event study approach along with extensive graphical analysis to evaluate the impact of Fed actions. The results show that 1-month constant maturity implied volatility increases marginally going into these events and falls much more significantly afterwards. Remarkably, the increase and reduction in uncertainty around a meeting is not reducing with increasing tenors, showing that the impact of information release has a similar impact over all horizons ranging from 1 to 30 years. If, on one side, this evidence witnesses the capacity of the central bank to control the long end of the curve, on the other it indicates the possibility that overreaction to news may generate the puzzling excess volatility which is observed in long term rates.

Keywords: FOMC cycle, monetary policy, swaption, implied volatility.

JEL Classification: E52, G12.