I don’t expect sympathy, but sometimes it’s tough being an Englishman in the US around July 4th. I love my adopted country and really want to celebrate alongside everybody else, but it can be difficult celebrating the inglorious defeat of your native country. Each year I have this debate with myself and each year I decide that any Holiday that involves hot dogs, hamburgers, beer and fireworks is one that is too good to miss. Over the coming months, those watching the markets are likely to become familiar with this uncertainty as to how to react to something. Each release of economic data is likely to cause similar emotions among traders; is an improving economy good or bad for the stock market? What about bonds? Should we buy Dollars on lower unemployment, or sell them? Obviously, good news is good for the economy, but in these exceptional times, good news could be bad.
The Federal Reserve’s discussion of a timetable for withdrawal from Quantitative Easing has led to this strange dilemma. Any hint of a more rapid recovery could be interpreted as likely to hasten the end of the bond buying program that has provided so much liquidity to the market over the last few years. When looking for direction, considering the news itself is no longer enough. We must also consider the effect of the news on the Fed’s intentions. How the markets will interpret data over the coming months depends largely on which market you are talking about. Let’s look at three different examples.
The Bond Market
For the sake of ease, let’s just assume that the market in US Treasuries is indicative of bonds in general and consider the likely effect of news on the Treasury market. In this case it is fairly straightforward, but of course, as it concerns bonds, everything is backwards. Good news is bad and bad news is good. Over the next couple of months we could see volatility in bond markets following data releases as the possible effect of each number is digested.
The effect of news, good or bad, will be exaggerated by the dual effects. If data show an improving economy, then the natural move is out of relatively safe bonds and into riskier markets such as stocks. The downward pressure this exerts on prices (and therefore upward pressure on yields) will be added to by the prospect of good economic news hastening the exit of a huge buyer. The Fed’s presence as a buyer of $85 Billion of Treasury bonds and Mortgage Backed Securities each month has had the desired effect of forcing rates low, so one can assume that, should they pull out, rates will rise.
For the bond market, then, each significant piece of news about the economy can be expected to have a profound effect, and a period of unusual volatility is to be expected.
The Stock Market
Almost the opposite is true if you consider the effect of US economic news on the stock market over the coming months. While a strengthening economy must, by definition, help US companies and therefore their stock prices, any move will be tempered by the possible effects on the Fed. When Fed Chairman Ben Bernanke has talked about tapering off QE over the last couple of months, the stock market has seen dramatic falls.
It is likely that these conflicting influences, a stronger economy on the one hand and less added liquidity on the other, will effectively cancel one another out. Over time, of course, a stronger economy will win out, but the positive effects of, say, an improving employment picture will be offset by worries about the end of QE in the short term. The same is true in reverse should the news be negative. Either way, the net effect is likely to be a dampening of volatility in the stock market following major economic releases through the summer.
The Forex Market
As usual, the forex market will do whatever it feels like. Moves will be more dependent upon the markets positioning prior to the numbers than anything. That said, it is likely that in forex, as in bonds, moves will be exaggerated by a dual effect. Good news for the US economy should usually lead to Dollar strength, but when coupled with the prospect of a quicker reduction in the supply of Dollars (the tapering of QE) that effect will be multiplied.
For those of you familiar with options, this exaggerated or muted effect of economic news presents an opportunity to benefit. Approaching each release with a long straddle (long puts and calls) in the bond and forex markets and a short strangle (short puts and calls) in the stock market, may well pay dividends. If options are not your thing, there are ways you can still replicate those strategies using ETFs. For bonds, you could place stop loss orders either side of the price going into numbers on, for example, the iShares Barclays 7-10 Year Treasury Bond Fund (IEF) and for forex, on the Powershares DB US Dollar Index Bullish Fund (UUP). That way, any initial reaction will trigger one of the stops, establishing a position that allows you to benefit from an exaggerated move.
Conversely, for stocks, placing simple buy and sell limit orders below and above the market on an S&P 500 tracker such as SPY or IVV will give you a decent position should the market overreact initially to any release of data.
These ideas may work for more active traders, but for long term investors the best advice is to sit tight if you are already long equities. I still believe that being overweight stocks and betting on a sustained gradual recovery is the best option for investors overall.
Investors are likely to spend most of the rest of this year deciding whether or not to celebrate as each set of numbers are released. I can sympathize entirely, but as the celebration is unlikely to involve grilled meat, beverages or pyrotechnics, I would suggest some proactive positioning rather than just going with the flow.