OptionMetrics Blog

The FOMC and Forward Volatility – Will Hopes of a Santa Claus Rally be Crushed?

Garrett DeSimone, PhD

December 12, 2021

Jerome Powell and the Federal Open Market Committee (FOMC) are slated to meet on Dec 14th and Dec 15th for what could be the most consequential FOMC meeting this year. Earlier this month, Powell commented on accelerating bond-buying tapering, and a shelving of the word “transitory” to describe inflation.

This hawkish commentary by the board may, at least partially, contribute to significant event risk for equities into the December meeting. A news release from this meeting also contains the Summary of Economic Projections, which is each member’s outlook on the future path of inflation and unemployment. Investors scrutinize these projections for clues regarding future policy.

OptionMetrics measures uncertainty regarding surrounding FOMC meetings in the form of “forward event volatility.” Forward event volatility is defined as the volatility expected by the options market at a point in the future. It is calculated by using volatilities from options that expire at two different time horizons. In the case of the FOMC meeting, we use volatilities from options that expire immediately before and immediately after the announcement.

Below we display the forward event volatilities and weekly market returns for all 2021 meetings. High forward event volatility typically has not translated well for the short-term equity market after these meetings. The March meeting led with the highest forward vol of the year (18.2%), subsequently foreshadowing a week of SPX losses of -1.3%. Lower forward vols have predicted milder return weeks ranging from 0% to 1.17%. This is consistent with a negative relationship between volatility and index returns.

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Currently, we estimate the forward event volatility for the December meeting at 19.2%, making it, potentially, the most volatile meeting of the year. This could imply that option traders anticipate an increase in uncertainty resulting from the news and have placed a higher premium on options. If their expectations are realized, it may put a kibosh on hopes of a 2021 Santa Claus rally.