Why Market's Reaction To Fed Announcement May Not Be What You Expect

One of the things that those new to trading and investing often forget is that prices don’t necessarily respond to actual news or performance data. What they do is respond to those things relative to expectations. That reaction to what is imagined, rather than to what actually is, could come into play over the next few days as we watch the reaction in markets to the Fed’s announcement that is expected this afternoon.

For example, if a company reports 100% year on year growth in earnings, that is excellent growth in an era of less than 3% GDP growth, but if they were expected to show 150% growth, it is still a bad miss.

The company has performed excellently, but the stock will drop on the news. It isn’t even that simple. Published expectations are one thing, but if the feeling takes hold in the market that said company will show a 200% improvement they could beat the 150% mark and still see their stock drop post earnings.

What causes the phenomenon is that markets are, by their nature, forward discounting mechanisms. Traders and investors attempt to position themselves for what is coming, and when most agree that something is likely the anticipatory move in prices can easily overshoot the actual impact of the event.

Over the last couple of weeks, all of the markets directly affected by Fed action - stocks, bonds, and currencies - have moved in a way that anticipates a rate hike. The stock market has retraced some gains, Treasury yields have spiked and the dollar has gained ground.

In many cases, the move has been such that more than the expected 25 basis point (0.25%) hike is priced in. That is because there is a growing body of thought that the Fed will make it clear this time around that they see the possibility of wage inflation in the near future given the growth oriented policies of the Trump administration and an unemployment rate below 5%, and as a result anticipate a total of four hikes this year.

That would seem to be reasonable, but pricing it in now could easily lead to what looks like an illogical reaction when the news is released.

Normally when the Fed raises rates, one would expect stocks to fall and bond yields and the dollar to jump. The first is a reaction to the fact that higher interest rates discourage borrowing, and therefore investment by businesses and spending by consumers. The bond reaction is obvious: if the short term rates set by the Fed are raised, then interest bearing instruments such as bonds will drop in price to reflect the higher rates that prevail. That higher interest rate on dollar deposits also makes the currency a more attractive hold for investors, pushing the dollar up against other currencies.

In this case, though, with everybody already positioned for those outcomes, what we may well see is what is known as a “buy the rumor, sell the fact” pattern. In effect, everybody that wants to sell stocks and bonds or buy dollars when rates jump already has and they will be looking to make a profit on their anticipatory position.

When the news actually comes out, then, there will, in the case of stocks for example, be quite literally more buyers than sellers.

In the illiquid market seconds after the news, assuming that the Fed does hike rates by the expected amount, stocks and bonds will probably be marked lower and the dollar higher, but the most likely reaction in turn to that logical reaction is a sharp move in the opposite direction, as the fast money takes profits on their positions.

Therefore, it would come as no surprise to see stocks at least making up any lost ground and actually trading higher by the end of the day.

Of course, all of this is on the assumption that the Fed does as expected, and that Yellen says nothing surprising in the press conference following the release. If they were to institute a 50 basis point hike rather than 25, or if the Chair were to say that that was a real possibility next time around, stocks would drop dramatically.

That, however, is extremely unlikely.

I agree with the market expectation for a 25 basis point hike and wording that leaves open the possibility of four raises this year, but sets out no firm intentions. That would fit with what we know about this Fed. The market reaction could be not what some would expect should that be the case.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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