The impact of narrative: The power of Fed speak

 

We expect that the Fed speeches have an impact; however, the measure of their effect on equity and bonds has not been precise. A paper, "Mind your language: Market responses to central bank speeches," shows that from the speeches, there are forecast revisions that can then explain volatility and tail risk in major asset  classes. Fed chairman speeches will have more impact than others through larger forecast revisions, but the Fed chairman can also calm markets with the right speech. 

The paper utilizes NLP, or natural language processing, to aid in identifying information that causes changes in macroeconomic forecasts. The critical point is analyzing the continuous flow of central bank communication, not just an isolated speech. There are clear regimes in Fed speak, and it is good to identify these trends. 

Quants focus on what is countable, yet the non-countable, like we see in speeches, is essential. If you can turn the non-countable from narrative into something measurable, there is an opportunity to form probabilities and make better trades.

I have taken the view that you want to avoid FOMC and major Fed speeches because there is too much uncertainty; however, if we decompose what is said, investors may be able to tilt their positions to their advantage.