What is Announcement Effect
Announcement effect broadly refers to the impact that any type of news or public announcement — especially when issued by government or monetary authorities — has on financial markets. It is most often used when speaking of a change in security prices or market volatility that results directly from a piece of significant news or a public announcement. It also could refer to how the market would react upon hearing the news that a change will occur at some point in the future.
Breaking Down Announcement Effect
The announcement effect assumes that the behavior of systems (such as financial markets) or people (such as individual investors) can change merely by announcing a future policy change or divulging a newsworthy item. The news may come in the form of a press release or report. Topics that can spur investor reaction, either positively or negatively, are things like company mergers and acquisitions (M&A); growth in money supply, inflation, and trade figures; changes in monetary policy, such as a hike or cut in a key interest rate; or developments that affect trading, like a stock split or change in dividend policy. For example, if a company announces an acquisition, then its stock price may rise. Or, if the government says that gasoline tax will increase in six months, then commuters who drive to work every day might look for other modes of transportation, or spend less money now in anticipation of the greater expense going forward.
News released by central banks can have an especially dynamic and complicated effect on financial systems. Information about monetary policy or real factors, like productivity, can hugely affect the markets for goods, equity, housing, credit, and foreign exchange. Even neutral news about monetary policy can induce cyclic or boom-and-bust responses. Moreover, central bank announcements can induce rather than reduce volatility.
The Announcement Effect and the Federal Reserve System (the Fed)
An announcement from the Federal Reserve about a change in interest rates generally correlates directly to stock prices and trading activity. For example, if the Fed raises interest rates, then stock prices are liable to fall. Prior to 1994, monetary policy objectives for the federal funds rate — any outcome of the Federal Open Market Committee (FOMC) meeting — were strictly confidential. At its February 1994 meeting, the FOMC decided to modify the federal funds rate target, which it had not done for two years. To ensure that this important policy decision was communicated clearly to the markets, the FOMC decided to disclose it via public announcement. Thus began the custom of "Fed days” — when the FMOC makes announcements about interest rates — which now is shared by numerous central banks. A practical outcome of sharing the decisions made at FOMC meetings is a kind of announcement effect — which, in this case, means that because the market knows what to expect from the Fed, the behavior of market rates can adjust accordingly with little or no immediate action by the trading desk. In general, traders eagerly await announcements that come from the Federal Reserve. On Fed days, trading volume is notably higher; and on the day preceding a Fed day, trading is usually relatively calm.
Good News, Bad News, and Market Surprises
Economists, technical analysts, traders, and researchers spend a great deal of time trying to predict the effect of news or public announcements on stock prices in order to discern, among other investing strategies, the wisdom of switching between asset classes or moving in and out of the market altogether. Although investment professionals often disagree on the finer points of technical theory, they do agree that the stock market is driven by news. Researchers have suggested that bad news has a larger impact on markets than good news; and good news does not lift the market as much as bad news depresses it. Also, bad news during a bear market has a bigger negative impact than bad news during a bull market; and negative surprises often have greater impact than positive surprises.
Whether negative or positive, the announcement effect always carries the potential to cause drastic changes in stock prices or other market values, especially if the news is a surprise. For a taste of just how volatile a reaction the markets can have to unexpected commentary, take a look at the graphic below. It shows that the dollar swung wildly between gains and losses on July 19, 2018, after President Donald Trump publicly criticized the Federal Reserve for raising interest rates — a comment that broke with the long tradition that United States presidents do not interfere with the business of the Fed.
In order to minimize surprises and defend against radical reactions like the one pictured above, companies and governments often selectively leak, or hint at, announcements before they actually occur. Leaking critical news can allow the market to find equilibrium, or to “discount the stock” — that is, to incorporate the unexpected news into the price of a stock. For instance, if a company's earnings are especially greater than usual one quarter, it might choose to leak the information to help ease the pressure for an unsustainable price spike at the time of the official earnings release. Likewise, on its Fed days, the Federal Reserve discloses what policy changes it might make before it actually makes them, so that the market can adjust smoothly to the new information.