One of the most confusing aspects of financial markets for new traders is that prices often move in the opposite direction to what the news suggest. Stocks can fall after strong economic data, gold can fall despite geopolitical tensions, and bonds can rise following an inflation surprise. The most important thing to know is that markets react to how new information changes expectations, not whether the news is good or bad.
Financial markets are forward-looking. Prices reflect what traders collectively expect to happen over the coming months, meaning much of the anticipated impact of an economic release or policy decision may be already priced in.
What matters the most is how the actual outcome compares to what the market expected. For example, if markets expect the Federal Reserve to signal two more rate hikes, the US dollar could still fall if the central bank delivers on expectations, simply because the outcome was already expected. If the Fed, on the other hand, signals more rate hikes than expected, the greenback can rally hard as markets reprice expectations.
Ever heard the term “good news is bad news”? Well, economic data can affect multiple variables simultaneously. Stronger growth, for instance, can support corporate earnings while increasing inflationary pressures and reducing the likelihood of monetary easing.
Suppose US economic activity accelerates unexpectedly. Depending on the economic context, this development can lead to higher interest rate expectations which could eventually slow growth and therefore push the stock market lower. So, the stock market would react based on expectations about the future economic outlook and not on the current one.
Another important factor is positioning. When a trade becomes too crowded, even a relatively small change in the outlook can trigger a significant reversal as traders take profits or rush to uwind their positions.
For example, if traders are heavily positioned for dollar weakness ahead of a Federal Reserve meeting, a decision that is just less dovish than expected could trigger a sharp dollar rally. Traders could unwind bearish positions even if the Fed has not delivered an outright hawkish surprise on expectations that in the near-future the Fed could indeed turn more hawkish. This is why the magnitude of a market move isn’t always related to the news. Positioning can play a very important role.
Remember that financial markets are in a continuous process of assessing and reassessing the future. Every new economic release, central bank comment or geopolitical development can change future expectations and trigger big moves.
Consider an unexpected increase in oil prices. Initially, traders may focus on the resulting inflationary pressures, pushing bond yields higher and increasing expectations for tighter monetary policy. If the shock persists, however, concerns about weaker consumption, slower growth and eventually monetary easing may become more important.
The dominant market narrative can therefore change over time, even when the underlying development remains the same. This also explains why an initial price reaction can reverse shortly after a major announcement. Traders (mostly algos) may first respond to the headline before reassessing the broader implications for the economy.
In conclusion, the three key questions you should always ask yourself are:
- What was already priced in?
- How does the news change the expectations?
- What could be the catalyst for a repricing?
The last question is often the most important one because markets can extend beyond the fundamentals. Such mispricings can create mean-reversion opportunities, but the timing is key because “markets can remain irrational longer than you can stay solvent”.
This article was written by Giuseppe Dellamotta at investinglive.com.