November 11, 2022
With the Federal Reserve signaling that its ongoing commitment to fighting inflation, market volatility could continue to create challenges for investors this year. Amid volatility, it’s worth taking a closer look at how volatility can impact the costs of buying or selling exchange-traded funds—particularly on days when big economic news is published during the trading session.
The volatility so far this year and the declines of asset prices have been quick, significant, and lasting. That is in large part because of the magnitude of inflationary pressures and the Fed’s response, which has been swift.
Upper limit of the federal funds target range
Note: The chart reflects the effects of Fed’s latest policy decision on November 2, 2022 to raise its target for short-term interest rates by 0.75%, to a 3.75%–4.00% range.
Source: Federal Reserve Bank of St. Louis FRED database
As the chart shows, as of early November, the Fed had raised the federal funds target rate by 375 basis points in less than eight months this year—a bigger change than occurred over three years of Fed rate hikes between 2015 and 2018.
Fed rate announcements are released at 2 p.m. Eastern time—during the trading day. Other economic reports, such as the Institute for Supply Management’s surveys on the manufacturing sector’s health or The Conference Board’s consumer confidence surveys, are also released during the trading session, monthly at 10 a.m. ET. Investors trading ETFs need to be mindful about how the timing of such economic announcements can affect trade executions.1
The Vanguard Global ETF Capital Markets team uses a proprietary tool, Vanguard Spread Analytics, to study spreads both in real time and historically. The tool provides insights on ETF spreads and basket spreads to help improve ETF product health, enhance pre-trade analysis, and provide more robust post-trade analysis. These insights can potentially give the Vanguard capital markets desk the ability to help investors optimize trading outcomes.
One of the clearest insights gleaned from the data is that more often than not, ETF spreads widen when economic news is released during the trading day. The second observation is that markets are much more on edge in the current post-COVID inflation-inflected environment than when the Fed announced gradual changes in interest rates between 2015 and 2018 in the context of considerably more modest increases in inflationary pressure.
The charts below show how trading spreads were affected by two Fed rate announcements a few years and worlds apart. They each show two sets of bid-ask spreads—one pair measuring those of Vanguard Consumer Staples ETF (VDC) and the wider pair measuring spreads on VDC’s underlying basket of securities.
Note: The pair of outermost lines on each chart represents bid-ask spreads on baskets of underlying stocks; the innermost lines represent bid-ask spreads on Vanguard Consumer Staples ETF.
Source: Vanguard Spread Analytics tool; May 19, 2019, and June 15, 2022, ETF bid/offer and basket bid/offer. Past performance is no guarantee of future results.
The first thing to notice is that the ETF spreads are tighter than the basket spreads most of the time. That’s one of the advantages of ETFs—they have their own secondary-market liquidity, which typically makes trading them easier and less expensive than it is for their underlying basket of securities.
Trading spreads widened in both instances. But the data also show that the widening this year was roughly twice that of 2019 and that the widening on a given day this year persisted, whereas spreads normalized quickly in 2019. In environments less volatile than this year’s, we’ve observed market makers widening out bids and offers before a Fed announcement, then quickly normalizing spreads within 15 minutes.
By comparison, Vanguard Spread Analytics has shown that this year, because of the unusually large Fed interest-rate increases, market makers have widened spreads more than during less volatile periods and kept wider spreads in play for longer periods of time—sometimes even until the end of trading sessions. Moreover, spreads this year have been wider in the hours ahead of Fed announcements than they were in 2019—another sign of greater volatility related to the Fed’s aggressive inflation-fighting posture.
The key takeaway: Investors should beware trading on days when important economic news such as a Fed announcement will come out during the trading session. They may want to avoid trading on such days, if possible.
The other factor to notice in the two charts is that at the beginning of each trading session, market makers have historically widened spreads for the first 15 to 30 minutes of the session before settling back to more normal ranges. Investors may want to avoid trading ETFs in the first half hour of every session, to minimize transaction costs.
It’s worth approaching trades with extra care in the current economic environment. Some basic factors investors should keep in mind:
A marketable limit order is one that is placed for immediate execution. For a marketable buy limit order, the limit price is set at or above the ask price. For a marketable sell limit order, the limit price is set at or below the bid price.
1 Economic announcements that fall outside of market hours, such as the U.S. Department of Labor’s nonfarm payrolls report, which usually arrives on the first Friday of every month at 8:30 a.m. ET, are priced in before the market opens, hence our focus on intraday economic news, such as Fed rate announcements.
2 A marketable limit order is one that is placed for immediate execution. For a marketable buy limit order, the limit price is set at or above the ask price. For a marketable sell limit order, the limit price is set at or below the bid price.
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