Changing market dynamics

“Noticing small changes early helps you adapt to the bigger changes that are to come.” Spencer Johnson

The Federal Reserve chose to keep interest rates on hold on their 18th September committee meeting. Despite improving household spending, business investment and labour market, the committee judged (correctly, in my opinion) to pay heed to economic and financial developments abroad. In response to the announcement, world equity markets fell. The S&P fell 1.6% on the day of the announcement and other equity markets followed suit.

Those who believe in market efficiency (i.e. that markets price in the ‘true value’ of the stocks at any point in time) would conclude that investors believed that the Fed made a mistake in its decision, and that the US economy was in fact strong enough to withstand a rate hike. In doing so, they would argue, the Fed has introduced more uncertainty into the economy, thereby warranting lower equity prices. The policy implication from this is that the Fed should ‘just get on with it’ and hike rates, as it should not cause too much of a disruption to the markets. A very simple bit of analysis by looking at what I call the ‘market reaction function’ to economic data suggests this isn’t quite the case.

First, a word on the data: I use the Citi US Economic Surprise index to represent ‘economic data’. It looks at every single US economic data release and compares it to what was forecasted by economists (the assumption to make it meaningful is that the economists’ forecasts closely represent what is expected by investors). Essentially, if the data release is better than expected, then a positive number is registered in the index. Likewise, if data is worse than expected, a negative number is registered. Using these elements, a cumulative index is created. The chart below shows the average (mean) return of the S&P on days when economic data releases ‘beat’ expectations (i.e. positive surprises), and days when it ‘missed’ expectations (i.e. negative surprises).

The period from 2005 onwards (which I think is a long enough sample set to think of as the long run/normality) shows how equities should react to economic surprises. Theoretically, equities should go up on days with positive releases as it signals to the market that the economy is healthier than people believe, which should translate to higher profits for companies (and therefore higher stock prices). Conversely, equities should go down on days with negative releases for exactly the opposite reason. 

Convention was turned on its head in the second half of 2013. With the Fed still conducting its QE programme and signs of its upcoming termination emerging, markets became jittery and appeared hooked on QE. Any piece of negative news that suggested the Fed would delay the ending of its QE programme was met with jubilation by the markets.  This is shown on the chart by S&P returns significantly higher on days where data ‘missed’ expectations than those where they ‘beat’. This was the very much a characteristic of the ‘taper tantrum’ that many commentators and media outlets continue to speak of. Essentially, the market would only go up if there were signs of a prolonging of QE, as there was little faith in the strength of the US recovery. The Fed subsequently ended its QE purchases in October 2014, and the market dynamics eventually returned to normal (the third pair of bars - Jan 2015 to August 2015). Until recently. 

Since the FOMC announcement in September, it seems the market has begun to be jittery again. Now, negative news is being met, on average, with positive returns in the S&P, and certainly much higher than the corresponding returns on a day with positive economic news. (Note that I have used mean returns here, but using medians produce the same results). From this, it doesn’t seem as if the market is sure about the strength of the economy at all - somewhat similar to the second half of 2013.

So what caused the S&P to fall after the announcement? Surely if the market wasn’t sure about US economic prospects, a delay of the rate hike should be push equities higher? In theory yes. In practice though, what I believe happened is that those investors who thought the Fed would not raise rates bet on this by buying equities BEFORE the announcement. The more and more people did this, the higher the price got. Once the announcement came out in favour of those investors, they cashed in and sold their stocks, having already made a profit running up to the event. And if a lot of people do this, the price falls. This is what, in ‘trader-talk’, is called ‘an unwinding of heavy positioning’. If we look at the price data, this is exactly what we see. From the 1st September to the 18th, the S&P went up 4%, as investors bought equities in anticipation of the Fed not hiking rates. Indeed this is corroborated with a various articles citing that the Fed funds rate rise expectations was being pushed out towards December/January 2016.  And then low and behold, as soon as the announcement was made, the S&P was down 1.6% the following day as those who made money on the way up sold their equities. 

The bottom line

The implication from all this is that the market reaction function has changed, and shows characteristics similar to that of H2 2013. Now, to be clear, I do not believe that we will get a ‘taper tantrum’-style scenario, with violent swings in all asset-classes, if the Fed does raise rates - the economy is certainly a lot healthier than it was back then, and I think everyone is aware of that. The point is that there again seem to be doubts creeping into markets as to how strong this recovery is. If the FOMC care at all about the market reaction to its decisions, it may well benefit from not normalising policy just yet. Indeed, noting this small change early on could save the Fed from a disastrous normalisation of policy that is to come.