Who Bears “Federal Reserve Risk”?

April 9, 2014

Actions by the Federal Reserve are having strong effects on the price of stocks, bonds, and other financial assets in the economy. You can see this effect clearly on Fed meeting days, which are associated with large market movements.

A question we tackled in an earlier post was: what assets bear the most risk of surprise Fed announcements on the direction of monetary policy? We are following up on that post because we now have another observation: the March 19th, 2014 Fed meeting which was Janet Yellen’s first meeting as Fed Chair.

The meeting released information that the Fed planned on tightening sooner than markets expected — many attributed the market’s reaction to some combination of FOMC forecasts and Yellen’s statement that there would likely be 6 months between tapering ending and increases in the target Federal Funds Rate.

So we now have three days where we observe the Fed “surprising” markets with new information on the pace of tightening:

  • 06/19/2013, or the “taper tantrum,” when the Fed announced that they wanted to begin the conversation of tapering QE purchases of long-term government bonds and mortgage-backed securities, a signal of tightening.
  • 09/18/2013, or the “taper headfake,” when the Fed unexpectedly decided to hold off on tapering, a signal of looser monetary policy.
  • 03/19/2014, or the “Yellen first conference,” when the Fed surprised the market with quicker tightening than most previously expected.


So what investments bear “Fed risk”? As we did before, we choose to look at ETFs available from Vanguard. This was an arbitrary choice–we just wanted to examine broad asset classes. We deleted a few because there were too many to see clearly on charts.

We then take the single-day returns on these three days to see which investment move the most. Those that move the most on these days are those that bear the most Fed risk. As we will show below, there is an amazing degree of consistency across the three events in the assets that bear Fed risk. This is despite the fact that the first and last event occurred 9 months apart! So there really seems to be a “Fed risk factor” on which some investments load.

We start with the punchline, and those interested can see more details below. Here is a ranking of the investments, where the investment on top of the list bears the most Fed risk, and the investment on the bottom bears the least:

1    Intermediate-Term Corporate Bond (VCIT)
2    Short-Term Corporate Bond (VCSH)
3    Intermediate-Term Government Bond (VGIT)
4    Utilities (VPU)
5    Mortgage-Backed Securities (VMBS)
6    Global ex-U.S. Real Estate (VNQI)
7    Long-Term Corporate Bond (VCLT)
8    Consumer Staples (VDC)
9    FTSE Emerging Markets (VWO)
10    Short-Term Government Bond (VGSH)
11    FTSE Pacific (VPL)
12    Long-Term Government Bond (VGLT)
13    REIT (VNQ)
14    FTSE Europe (VGK)
15    FTSE All-World ex-US (VEU)
16    Emerging Markets Government Bond (VWOB)
17    Growth (VUG)
18    Telecommunication Services (VOX)
19    Health Care (VHT)
20    Total Stock Market (VTI)
21    Industrials (VIS)
22    Materials (VAW)
23    Value (VTV)
24    Mid-Cap (VO)
25    Information Technology (VGT)
26    Consumer Discretionary (VCR)
27    Small-Cap Growth (VBK)
28    Small-Cap (VB)
29    Mid-Cap Growth (VOT)
30    Mid-Cap Value (VOE)
31    Small-Cap Value (VBR)
32    Financials (VFH)
33    Energy (VDE)

Bond funds bear a lot of Fed risk, and that shouldn’t be too surprising. The cash flows that bonds pay are pretty certain — what is uncertain is the discount rate used to value today the future cash flows, and the Fed has a strong effect on that discount rate. What is particularly interesting, however, is that it is not the long-term bond funds that bear the most risk. It is the intermediate-term bonds. John Cochrane suggested that this might be because the Fed likes to buy in the intermediate part of the yield curve.

Emerging market equity funds also bear a lot of risk, coming in 9th on the list. This one is less obvious, because the connection between actions of the Federal Reserve and emerging market economies needs a few dots in between. Hyun Song Shin has done a great job outlining what these connections might be.

When it comes to the stock funds, we are still thinking through them. The fact that financials bear so little risk seems surprising. If you have some strong views about what is going on with equities in particular, please leave comments!

There are a lot of interesting implications. For example, do investments that bear more Fed risk provide higher expected returns for investors, especially during the past 4-5 years of unconventional monetary policy? Does volume in these investments go up or down right before Fed meetings? A lot to ponder. But what seems undeniable is that certain assets bear a lot of Fed risk, and they tend to be the same assets across all three episodes.

Ok, more details for those interested. Here are the charts of the returns for the three dates mentioned above. The returns are calculated as follows — we take the single day return, subtract off the average daily return of the historical series, and scale the whole thing by the daily standard deviation of the historical series. So these returns reflect how unusually large the movement was relative to average daily movements.




It’s easy to see that the market’s reaction to Yellen’s first meeting as FOMC chair was smaller (in absolute value) than the reaction during the taper tantrum and taper headfake.

But what is remarkable is how strongly correlated the reactions are among the investments on the three dates. In other words, the same investments that react the strongest to one event also react the strongest to the other two. Here are scatter plots that show it.




Given the very strong correlation across events, our ultimate measure of risk is just adding up the returns on the three dates, where we multiply the tightening days by -1 (taper tantrum and Yellen first FOMC) before adding. The list at the beginning of the post shows you which positions bear the most Fed risk.

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2 Responses to Who Bears “Federal Reserve Risk”?

  1. Squeeky Wheel on April 10, 2014 at 11:31 ami

    Assuming that rate changes are gradual, Financials should not be much affected. Costs go up, by so do future revenues, and any variable rate revenues. So as long as the change is slow and gradual, long-term NIM is not overly impacted by adjusting rates a couple months sooner or later. Additionally, the large banks receive a considerable amount of fee income. And further, credit card rates are generally unaffected by small rate changes. Thus overall operating profit is not affected as much as one might originally think – especially when we are talking about short-term rates not even changing at all and only which month *next year* they might change.

    For long-term vs intermediate-term bonds I will guess a similar situation. Whether overnight rates increase in 12 months or 15 months have very little impact on the 30 year discount rate. 30 year discount rates depend more on long term growth and real-rate trends.

    Additionally you may have scaling effects. Longer term bonds have more daily variance than shorter term bonds so the Fed effect is dampened in your measure.

  2. jim on April 12, 2014 at 11:47 ami

    neat guys but how do you explain the dichotomy of returns since the beginning of March. There 3/19 presser indicates utilities were the hardest hit yet since 3/19 have been one of the best performers. interestingly the fed futures curve moved up 50 bps in 2015 and the market is now pricing in a full 1 point hike in fed futures. this doesn’t seem to jibe with the story your telling as your charts would make you assume a hike in rates would be negative for divined payers. i think what is more likely is the market thinks the fed is tightening too quickly. i did a chart of s and p versus inflation expectations and you’ll see the consternation around all the fed meetings. i would however note the stability of inflation expectations since the taper but relative to a year ago the situation is worse thus causing an increase in equity risk premiums hitting the highest multiples the hardest.