How to Trade the Fed Rate Decision

How to Trade the Fed Rate Decision

Reading time: 10 minutes

The US Federal Reserve’s monetary policy decisions, particularly changes in the Fed Funds target range, can profoundly influence the financial markets domestically and internationally. A mantra many are familiar with and one not to be overlooked is: ‘Don’t Fight the Fed’. Attempting to go against the Fed can significantly increase the odds of account ruin.

Rate decisions, policy statements and economic projections often elevate volatility across multiple asset classes, including equities, fixed income (bonds), currencies and commodities. This creates both opportunity and challenge for traders, investors and financial analysts.

The Fed?

The US Federal Reserve System is the US central banking authority. It performs several functions, but its primary dual mandate consists of promoting maximum employment and stable prices in the US economy.

The Federal Open Market Committee (FOMC), the Fed's policy-making body of 12 Fed officials, meets eight times yearly to discuss economic conditions and determine monetary policy actions based on the economic landscape. The most closely watched event is the FOMC's announcement of changes to the Fed Funds target range, the benchmark interest target range that banks use to lend money to each other in the overnight market to meet reserve requirements.

Note that the Fed officials set the target range, but the effective Fed funds rate, currently at 5.33%, is calculated as a weighted average of overnight lending rates nationwide. To keep the two as aligned as possible, the Fed also embarks on what is known as Open Market Operations: the buying and selling of US Treasuries.

Understanding Expectations Ahead of the Fed Rate Decision

Understanding how to trade the Fed rate decision requires comprehending the factors influencing the Fed's actions, the market’s expectations ahead of the event and the potential market reactions.

Before the Fed’s rate announcement, markets price in (forecast) through markets such as the futures and swaps market the probability of a rate increase, rate decrease or no-change. This is widely talked about among market participants. A popular way of attaining these forecast probabilities is through the freely available Fed Watch tool provided by the CME Group; it delivers an easy-to-understand probability gauge for upcoming Fed meetings. You must remember that the market works based on expectations: traders and investors trade based on what they expect. As you can see, for next week’s policy meeting (13 December 2023), the Fed Funds futures market is fully pricing in a no-change, leaving the Fed Funds target range at 5.25%-5.50%.

Alongside this, you will also find that economists are polled by major financial news outlets, like Bloomberg and Reuters, and the median estimate, as well as the estimate high-low range, is available for traders and investors to work with. Most economic calendars offer at least a median estimate.

Generally, a rate hike (cut) is bullish (bearish) for the US dollar (USD), while a no change can encourage choppy price movement. An announcement that goes against market consensus (median estimate), as you can imagine, can increase volatility exponentially and catch many off guard.

The Summary of Economic Projections (or SEP) are released four times per year in PDF form and is also a widely followed release. Here, we can view the FOMC participant's projections for key economic indicators: real Gross Domestic Product (GDP), the unemployment rate and inflation. Any revisions to these key indicators can jolt the markets and cause notable price movement.

The so-called dot plot is also extensively followed and requires understanding: it is the official median projection for the Fed Funds target range in the future according to the FOMC participants. How reliable is the dot plot? It is reliable in that it offers a look into the thinking of key Fed officials at the time of the release, but as fresh data emerges, Fed officials can change their outlook. Each column represents one year and the dots reflect the Fed official’s projection (note that this is anonymous – you will never know which Fed member projected what rate). With the current Fed Funds target rate at 5.25%-5.50%, you will note from the dot plot below that Fed members anticipate a 25 basis-point increase to 5.50%-5.75% (you look for where most clusters form) this year (unlikely). Any marked change from previous releases in the dot plot can elevate volatility as market participants readjust their positions. 

Another key talking point for many traders and investors is Fed commentary. Leading up to the Blackout period (Fed staff avoid speaking publicly between a week prior to the Saturday preceding a FOMC meeting and the Thursday following that meeting), Fed officials will participate in panel discussions and speak with financial news outlets and these comments can collectively be used to help formulate an opinion heading into the rate decision, as well as create intraday market volatility.

Once we have identified the market’s expectations for the Fed decision, traders can begin forming an approach to trade the event.

Trading the Fed Rate Announcement

Markets that are heavily traded around the Fed rate decision include the US Dollar Index, the EUR/USD, the major US equity indices (S&P 500 and the Nasdaq, for example) and US Treasuries, all of which are available to trade through FP Markets on world-class trading platforms. For example, should the Fed do as markets anticipate next week and remain on hold, this will likely weigh on US yields and the Dollar Index and underpin an already robust equity market. However, a no-change will see traders’ attention deviate more to the accompanying language in the statement and the SEP. Any marked changes here would increase volatility. Of course, also bear in mind that thirty minutes following the rate announcement, Powell and co will claim the spotlight with a prepared statement and then open to press questions.

While one can never know the outcome of the Fed’s policy decision, there are three primary ways of attempting to trade this event:

1. Based on market expectations heading into the event, you will find that some traders enter positions ahead of the release and liquidate the position shortly after the immediate reaction has materialised. However, this is considered a somewhat risky approach, particularly if protective stop-loss orders are too close to the action.
2. Another way to trade the event is to wait for things to simmer down and let Fed Chair Jerome Powell take the stage (thirty minutes following the release of the rate decision). Powell can sometimes throw curve balls and turn a bearish setup very quickly into a bullish scenario. This is where technical analysis can really help. If, after Powell has spoken, price has breached clear resistance, for example, and retests the base as support, this could open the door to a bullish play.
3. Of course, sometimes the best trade is no trade at all. If you’re unsure and the charts do not conform to your trading strategy, then the best line of attack could just be to sit on your hands and let things settle down before reassessing the economic and technical landscape.

One final point to remember is that no matter how one trades the Fed rate decision, do your homework and employ solid risk management.