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Don’t Fight the Fed!

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  • Paulo Maio

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.

Suggested Citation

  • Paulo Maio, 2014. "Don’t Fight the Fed!," Review of Finance, European Finance Association, vol. 18(2), pages 623-679.
    • Handle: RePEc:oup:revfin:v:18:y:2014:i:2:p:623-679.
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    File URL: http://hdl.handle.net/10.1093/rof/rft005
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    Cited by:

    1. Chia-Lin Chang & Jukka Ilomäki & Hannu Laurila & Michael McAleer, 2018. "Long Run Returns Predictability and Volatility with Moving Averages," Risks, MDPI, vol. 6(4), pages 1-18, September.
    2. Maio, Paulo & Philip, Dennis, 2015. "Macro variables and the components of stock returns," Journal of Empirical Finance, Elsevier, vol. 33(C), pages 287-308.
    3. Maio, Paulo, 2016. "Cross-sectional return dispersion and the equity premium," Journal of Financial Markets, Elsevier, vol. 29(C), pages 87-109.
    4. Jamali, Ibrahim & Yamani, Ehab, 2019. "Out-of-sample exchange rate predictability in emerging markets: Fundamentals versus technical analysis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 61(C), pages 241-263.
    5. Jukka Ilomäki, 2018. "Risk and return of a trend-chasing application in financial markets: an empirical test," Risk Management, Palgrave Macmillan, vol. 20(3), pages 258-272, August.

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