Central bank meetings are among the most important events on the market calendar, but traders do not listen to policymakers only when they announce an interest rate decision. Speeches, interviews and comments from individual central bank members can move markets just as sharply because the market is forward-looking.
Markets are constantly trying to anticipate what central banks will do next, and any comment that changes those expectations can trigger an immediate repricing that impacts bonds, currencies, equities, commodities and cryptocurrencies.
Yesterday’s reaction to Federal Reserve Bank of New York President John Williams is a good example. Before his comments, markets were pricing roughly a 70% probability of another Fed rate hike in October. Williams said that, following the September rate increase, there was “no need for urgency” and that if the economy evolved broadly in line with forecast, one further rate increase later in the year could be appropriate.
The comments pushed back against the idea of an imminent October hike and caused markets to reprice the earlier expectations, reducing the probability for a rate hike in October to roughly 50% and leading to a pullback in various assets.
Why markets reacted like that?
Markets trade expectations
Financial markets are essentially pricing machines. Investors care about where interest rates, inflation and growth are going rather than simply where they are today. Suppose the Fed has just raised interest rates and markets believe another hike is highly likely at the next meeting.
Treasury yields, the US dollar and other asset prices will already reflect that expectation to some extent. If a Fed official then says something that makes an immediate hike less likely, traders will not wait for the next FOMC meeting, they will immediately adjust their positions.
Yesterday, Fed’s Williams’ comments reduced expectations for an October hike. That represented a dovish repricing of the expected policy path. Lower expected rates can put downward pressure on Treasury yields and the dollar while supporting assets such as gold, stocks and Bitcoin.
Why a change in stance matters more
Not every central bank comment has the same market impact. Central bankers generally develop recognizable policy biases based on their previous comments and the way they assess the economy. A policymaker who consistently emphasizes inflation risks and the need for higher rates will generally be labelled as hawkish. Someone who focuses more heavily on employment risks and the need for lower rates will generally be seen as dovish. Others take a more neutral or data-dependent position.
The information value of a comment depends partly on whether it is consistent with what the market already knows about that policymaker. Imagine a policymaker who has repeatedly argued that interest rates need to remain high to bring inflation down. If that policymaker gives another speech saying that inflation remains too high and rates may need to stay elevated, there is relatively little new information. The market already expects that person to say it and the reaction will be minimal.
But suppose the same policymaker suddenly says that the economy is weakening, inflation risks are diminishing and rate cuts may soon become appropriate. That is different. The policymaker has moved away from the established stance, creating new information for the market. In this case, the market might reprice the earlier expectations based on this change. The same principle works in the opposite direction when a hawkish member delivers dovish remarks.
This is essentially the same principle that applies to economic data. A strong employment report does not automatically mean the currency will strenghten. What matters is whether the report is stronger or weaker than expectations and whether it changes expectations for monetary policy.
Not all central bankers carry the same weight
There is also an important difference between policymakers in terms of how much attention markets pay to their comments. The FOMC, for example, consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and four other Reserve Bank presidents who vote on a rotating basis. The remaining regional Fed presidents participate in FOMC discussions even when they do not have a vote that year.
This means that voting status matters, but it is not the only consideration. The Fed Chair naturally has an outsized influence because the Chair communicates the Committee’s decisions and is generally viewed as the central bank’s most important public spokesperson. The Vice Chair and New York Fed President are also particularly closely watched. The New York Fed President has a permanent vote on the FOMC and is closely involved with the implementation of monetary policy.
For this reason, markets tend to pay especially close attention to comments from the Chair, Vice Chair and New York Fed President. Traders sometimes refer to this group as the Fed’s “troika”. Fed’s Williams is influential because he serves as New York Fed President. That helps explain why his comments can generate a strong reaction in markets.
For other central banks, the permanent voters are generally the most influential.
Central banks can use communication to correct market pricing
Central bank communication can also be used deliberately to influence financial conditions without changing the policy rate itself. Suppose the FOMC delivers a decision that markets interpret as much more hawkish than policymakers intended. Treasury yields might jump, the dollar could rally sharply and financial conditions could tighten significantly.
If policymakers believe the market has overreacted, they can send one of the troika members to correct the market misinterpretation, like for example in an unscheduled television appearence. Subsequent comments from officials can provide additional guidance about how the decision should be interpreted. Communication can help ensure that financial conditions reflect the policymakers’ intended reaction function and economic outlook.
Why following central bank members is important
Following central bank members’ speeches helps a traders understand what the central bank is focused on, what is the reaction function and what is the general consensus amond policymakers. If you’ve ever asked yourself what economic data should you focus on, the answer generally lies in the central bank’s statement, press conference or members’ speeches.
By following them, you will naturally start to understand what type of economic data will be more important for their policy decisions and even what they are likely to do at the next meeting. This is why I always list the scheduled central bank speakers for the day in my “What are the main events for today?” articles at the start of the European sessions.
This article was written by Giuseppe Dellamotta at investinglive.com.