Interest Rate Strategies: Trade Smarter with Fed Rate Decisions

26 set

Interest Rate Strategies: Trade Smarter with Fed Rate Decisions

Trading interest rates may seem straightforward at first: buy when cuts end and sell when they fall. However, this approach often defies expectations, as determining when rate cuts truly end isn't as simple as pointing to a rate pause following a cut. While today’s Federal Reserve rate decisions are made during scheduled (and unscheduled emergency) Federal Open Market Committee (FOMC) meetings, this wasn’t always the case. Before the 1990s, the Fed often made changes outside of meetings. The shift to exclusively deciding rates during FOMC meetings was implemented to provide greater transparency and predictability for markets.

Topics Covered:

• How Are Interest Rates Traded?
  
• Three Interest Rate Trading Strategies.
  
• Key Insights from Backtesting Interest Rate Trading Strategies.
  
• Interest Rate Trading Indicator (Backtest For Yourself).
  

█ How Are Interest Rates Traded?

This strategy focuses on trading around Federal Reserve interest rate decisions, including hikes (increases), cuts (decreases), and pauses. These decisions are believed by many to have both short- and long-term effects on the market.

Key Strategy Concepts Backtested:

• Buy on Rate Pauses or Increases: Go long (buy) when the Fed pauses or raises interest rates, typically signaling market stability or optimism.
  
• Sell on Rate Decreases: Go short (sell) or close longs when the Fed cuts rates, often indicating economic concerns or slowing growth.
  
• Buy on Specific Rate Decreases: Enter trades when the Fed implements specific rate cuts, such as 50 basis points (bps) which represents 0.5%, and analyze market reactions over different time horizons.
  

█ Strategy: Long during Pauses and Increases, Short during Decreases

This section examines the effectiveness of going long on rate pauses or increases and shorting during decreases. This strategy performed well between 2001 and 2009, but underperformed after 2009 and before 2001 compared to holding positions. The main challenge is the unpredictability of future rate changes. If you could foresee rate trends over two years, decision-making would be easier, but that’s rarely the case, making this strategy less reliable in certain periods.

2001-2009

• Trade Result: 67.02%
  
• Holding Result: -31.19%
  

2019-2021

• Trade Result: 19.28%
  
• Holding Result: 25.22%
  

1971-Present

• Trade Result: 444.13%
  
• Holding Result: 5694.12%
  

█ Strategy: Long 50bps Rate Cuts

This section evaluates trading around 50 basis point (bps) rate cuts, which is a 0.5% decrease. Large cuts usually respond to economic stress, and market reactions can vary. While these cuts signal aggressive economic stimulation by the Fed, short-term responses are often unpredictable. The strategy tends to perform better over longer timeframes, as markets absorb the effects.

1971-Present

• Trade Duration: 10 trading days — Average Return: -0.19%
  
• Trade Duration: 50 trading days — Average Return: 2.41%
  
• Trade Duration: 100 trading days — Average Return: 2.46%
  
• Trade Duration: 250 trading days — Average Return: 11.4%
  

2001-Present

• Trade Duration: 10 trading days — Average Return: -2.12%
  
• Trade Duration: 50 trading days — Average Return: -1.84%
  
• Trade Duration: 100 trading days — Average Return: -3.72%
  
• Trade Duration: 250 trading days — Average Return: 1.72%
  

2009-Present

• Trade Duration: 10 trading days — Average Return: -15.79%
  
• Trade Duration: 50 trading days — Average Return: -6.11%
  
• Trade Duration: 100 trading days — Average Return: 7.07%
  
• Trade Duration: 250 trading days — Average Return: 29.92%
  

█ Strategy: Long Any Rate Cuts

This section reviews the performance of buying after any rate cut, not just large ones. Rate cuts usually signal economic easing and often improve market conditions in the long run. However, the size of the cut and its context greatly influence how the market reacts over different timeframes.

1971-Present

• Trade Duration: 10 trading days — Average Return: 0.33%
  
• Trade Duration: 50 trading days — Average Return: 2.65%
  
• Trade Duration: 100 trading days — Average Return: 4.38%
  
• Trade Duration: 250 trading days — Average Return: 8.4%
  

2001-Present

• Trade Duration: 10 trading days — Average Return: -1.12%
  
• Trade Duration: 50 trading days — Average Return: -0.69%
  
• Trade Duration: 100 trading days — Average Return: -1.59%
  
• Trade Duration: 250 trading days — Average Return: 0.22%
  

2009-Present

• Trade Duration: 10 trading days — Average Return: -3.38%
  
• Trade Duration: 50 trading days — Average Return: 3.26%
  
• Trade Duration: 100 trading days — Average Return: 12.55%
  
• Trade Duration: 250 trading days — Average Return: 12.54%
  

█ Key Insights from Backtesting Interest Rate Trading Strategies

The first assumption I wanted to test was whether you should sell when rate cuts begin and buy when they end. The results were inconclusive, mainly due to the difficulty of predicting when rate cuts will stop. A rate pause might suggest cuts are over, but that’s often not the case, as shown below.


One key finding is that the best time to be fully invested is when rates fall below 1.25% or 1.00%, as this has historically led to stronger market performance. But this can be subject to change.

█ Interest Rate Trading Indicator (Backtest For Yourself)

Indicator Used For Backtesting (select chart below to open):

The 'Interest Rate Trading (Manually Added Rate Decisions) [TANHEF]' indicator analyzes U.S. interest rate decisions to determine trade entries and exits based on user-defined criteria, such as rate increases, decreases, pauses, aggressive changes, and more. It visually marks key decision dates, including both rate changes and pauses, offering valuable insights for trading based on interest rate trends. Historical time periods are highlighted for additional context. The indicator also allows users to compare the performance of an interest rate trading strategy versus a holding strategy.