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Building a sector rotation strategy based on Fed’s interest rate policy

Gonzalo Sainz Ponce

11/01/2023

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Fed’s interest rate actions, which have been a topic of much discussion recently, can be very valuable information when making investment decisions. In particular, this post shows how to improve our sector allocation following Fed’s announcements.

Introduction

The Federal Reserve System (FRS), better known as the Fed, is the central bank of the United States and, among all its tasks, the most important one is to conduct national monetary policy, for which it has the Federal Open Market Committee (FOMC) that is responsible for managing the country’s money supply. The historical list of interest rate actions taken by the FOMC since 2000 can be found here. Anyway, they are summarized in the following graph, where the announcements are categorized into increasing, holding, or decreasing interest rates, without taking into account the magnitude of the action.

Fed's interest rate actions
Fed’s interest rate policy evolution.

Every investor should be aware of the Fed’s decisions because, being one of the most important financial institutions in the world, its actions not only affect the United States, as shown in this previous post, but also the rest of the world. Anyway, in this case we will also focus on the U.S. market and the idea is to try to improve our sector allocation using these interest rate decisions.

In particular, we will use the impact of the Fed’s decisions on the S&P 500 to make a sector rotation strategy, which is nothing more than moving money invested in stocks from one sector to another depending on which economic phase we expect will come next.

The idea is not to anticipate Fed’s announcements, but rather, once they are known, to try to go long/short in those sectors that historically have performed better/worse than the index itself in the face of a Fed decision of the same type.

It is worth clarifying the following issues before going into the results:

  • We have data available since the year 2000, but we will start the strategy in the year 2006 in order to have several decisions of each type prior to calculate each of our signals.
  • Announcements are categorized into increasing, holding, or decreasing interest rates, but the magnitude of the action is not taken into account.
  • Throughout history, the same sectors are not bought/sold for the same Fed decision, because in each case all the announcements available to date are taken into account, so that the most recent announcements have more information than the announcements at the beginning of the strategy.
  • In order to avoid signals overlapping with each other, only the month following the announcement is considered, as in many cases announcements occur very close together. In any case, those announcements that occur less than a month after the previous announcement are not taken into account (only 12 out of 108 times since 2000).

Results

Let’s see what each thing refers to in the following graphs/charts:

  • pf_L_sectors (long positions only): portfolio resulting from investing in the S&P 500 when there is no Fed announcement and only in sectors that have historically done better than the index following that type of Fed decision when there is one.
  • pf_S_sectors (long positions only): portfolio resulting from investing in the S&P 500 when there is no Fed announcement and only in sectors that have historically done worse than the index following such a Fed decision when there is one.
  • pf_L_S_sectors (long and short positions): portfolio resulting from having a long position in the S&P 500 when there is no Fed announcement and having long/short positions in the sectors that have historically done better/worse than the index following that type of Fed decision when there is one.
  • S&P 500 (long positions only): portfolio resulting from being continuously invested in the index.

Let’s take a look at the results obtained now that we have all the necessary information to understand them:

Cumulative returns
Cumulative returns evolution for each of the portfolios.
Financial metric obtained by each portfolio in different periods.

Notice how the strategy provides value in terms of profitability both in choosing “good” and “bad” sectors in the face of each of the types of Fed decisions, as annualized returns of pf_L_sectors and pf_S_sectors are higher/lower than that of the index, respectively.

However, the most favorable result of those analyzed comes from combining the “bad” and “good” sectors in the same portfolio (pf_L_S_sectors), since by significantly reducing the risk (both in terms of volatility and maximum drawdown), a higher return than the index and a similar one to the pf_L_sectors is achieved, resulting in the best return/risk relationship.

Finally, for those of you who are curious to know which sectors have been chosen to go long/short at each moment, I leave the sector exposure of the pf_L_sectors and pf_S_sectors portfolios. Note that when they are invested in all sectors it is because there has not been a recent Fed announcement.

pf_long sector exposure
pf_L_sectors exposure evolution to each of the sectors.
pf_short sector exposure
pf_S_sectors exposure evolution to each of the sectors.

Conclusion

The idea of this post was to show how the Fed’s interest rate decisions can be used to achieve an appropriate sector allocation, and it seems that we have succeeded. Still, I am sure you can think of many ways to improve this strategy, for example, by looking at the magnitude of the decisions or considering more specific sectors. Similarly, do you think it could also work for asset picking within each sector?

Thanks for reading!

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