Reality Check: Expectations versus Actual

When it comes to reacting to data reports and market events, the forex market typically displays two responses. The first reaction is a short-term, knee-jerk price response to the data report or news itself, which is where most of the intraday fireworks in the forex market go off. The second reaction, usually more important in the bigger picture, comes in later trading, when the underlying themes (outlined earlier in Putting Market Information In to Perspective: Focusing on Themes)  are updated to reflect the latest piece of news or data.

In one case, the data or news may be in line with the dominant themes of the moment, and the initial directional price reaction may be extended even further in subsequent trading action. The market may be anticipating lower U.S. interest rates, for example, and a weak U.S. consumer confidence report is released, sending the USD initially lower against other currencies. Because the weaker confidence reading support the theme that the U.S. economy may be weakening, additional selling interest may materialize and lead to further price declines in the USD.

In other cases, the data report may fly in the face of the prevailing market themes, leading to an initial reaction in the opposite direction of the recent theme. The market may be trading on the theme that Eurozone interest rates are going higher and that the Eurozone economic outlook is improving. A subsequent Eurozone retail sales report may come in on the weak side, potentially leading to an initial market reaction that sees the euro weaken. Whether the euro’s move lower will be sustained depends largely on what the market decides the latest retail sales report means in terms of the larger theme of higher Eurozone interest rates.

The data report may have been influenced by bad weather keeping shoppers at home, for example, and may be interpreted as just a bump in the road on the way to higher Eurozone interest rates. In such a case, initial euro weakness may be short lived and eventually reverse course higher. On the other hand, the weak retail sales report may cause the market to reconsider that higher European Central Bank (ECB) rates are a sure thing and keep on selling euro.

Of course, there’s never a set recipe for how data and news are ultimately going to be acted on by the market. The potential data and event outcomes and subsequent market reactions are myriad, to say the least. That’s one reason the market reaction to the data is always more important than the data itself.

But as currency traders, we still have to understand what the data means to make sense of what the subsequent market response suggests for the bigger picture. The starting point for interpreting the market’s likely overall reaction is to understand the initial market response to the data/news in terms of what the market was expecting and what it actually got. We need a baseline from which to interpret subsequent price movements.

The role of consensus expectations

Data reports and news events don’t happen in a vacuum. Forex markets evaluate incoming data reports relative to market forecasts, commonly referred to as consensus expectations or simply the consensus. Consensus expectations are the average of economic forecasts made by economists from the leading financial institutions, banks, and securities houses. News agencies like Bloomberg and Reuters survey economists for their estimates of upcoming data and collate the results. The resulting average forecast is what appears on market calendars indicating what is expected for any given data report.

The consensus becomes the baseline against which incoming data will be evaluated by the market. In the case of economic data, the market will compare the actual result - the economic figure that’s actually reported with what was expected (the consensus). The actual data is typically interpreted by the market in the following terms:

• As expected or in line with expectations: The actual data report was at or very close to the consensus forecast.

• Better than expected: The report was generally stronger than the consensus forecast. For inflation reports, a better-than-expected reading it means inflation was lower than expected, or more benign.

• Worse than expected: The data is weaker than the consensus forecast. For inflation reports, a worse-than-expected reading means inflation was higher than forecast, or more inflationary.

Additionally, the degree to which a data report is better or worse than expected is important. The farther off the mark the data report is, the greater the likelihood and degree of a subsequent price shift following the data release.

When evaluating central bank statements and comments from monetary policy makers, the market evaluates the language used in terms of hawkish (leaning toward raising interest rates) and dovish (leaning toward steady to lower interest rates). I posted about interpreting central bank rhetoric in greater detail in “Interpreting Monetary Policy Communication”) 

Pricing in and pricing out forecasts

Financial markets don’t typically wait for news to actually be released before they start trading on it, and the currency market is no different. Currency traders begin to price consensus expectations into the market anywhere from several days to several hours before a report is scheduled. Pricing in is the practice of trading as though the data were already released and, usually, as though it has come out as expected. The more significant the report, the sooner markets are likely to start pricing in expectations.

Unfortunately, there’s no clear way to always tell whether or how much the market has priced in consensus expectations, so you need to follow market commentaries and price action in the hours and days before a scheduled report to get a sense of how much the market has priced in any forecast. And it‘s not always a case of the market pricing in an as-expected result. Market sentiment may have soured (or improved) in the run-up to the release, leading the market to price in a worse-than-expected (or better-than expected) report. Stay on top of the market reports to get a handle on the mood.

Consensus estimates can also sometimes change in the days leading up to the report, based on other interim reports. For example, Institute for Supply Management (ISM) manufacturing forecasts may be downgraded (or upgraded) if the regional Chicago purchasing managers’ index, which comes out a few days before the ISM index, is weaker (or stronger) than expected. This can lead to pricing out of consensus expectations, depending on to what degree the consensus was priced in.

When good expectations go bad

Data miss is the market euphemism for when a data report comes in outside expectations. If the consensus was for an improvement in a particular indicator, and the actual report is worse than expected or disappointing, the result may be a sharp reversal in price direction. If core U.S. durable goods orders are expected to rise, for example, but they end up falling, we may be looking at a sharp drop in the USD. If the USD has gained prior to the release on the basis of pricing in the positive consensus, those who went long are going to at be dumping their positions alongside traders selling the USD on the weak result. The same thing can happen in reverse if negative expectations are met by a surprisingly positive data report.

With as-expected data reports, it’s frequently a case of “buy the rumor, sell the fact” (meaning, traders have already priced in a strong report, and if it meets expectations and sometimes even exceeds them, traders who bought in advance will be looking to take profit and sell on any subsequent gains). This market phenomenon can also happen in the other direction - as in “sell the rumor, buy the fact” depending on the currency pair involved and the nature of the consensus forecast.

Anticipating alternative outcome scenarios

We’ve found that it frequently helps to think through the likely reactions to major data releases to prepare for how the market may react in the very likely case that the data surprises one way or the other. It’s a thoroughly academic exercise, and it won’t cost you anything, but it may just give you a significant leg up on the rest of the market if you’re inclined to trade around data reports. Considering various “what if” scenarios helps us focus our attention and our trading strategies on the major themes currently operative.

For example, if the market is expecting a drop in the upcoming U.S. consumer price index (CPI) report, we like to ask ourselves what’s the likely reaction if the CPI falls more than forecast, and also what happens if it surprises to the upside. This makes us focus on the most recent price action, and perhaps we note that the USD has declined slightly in advance of the report based on the consensus.

If CPI registers lower than expected, we’re now thinking about how many pips lower the USD is likely to fall. We pinpoint key support levels and use those as our benchmarks to gauge the subsequent market reaction. If the report should surprise to the upside, we’ve also identified key resistance levels above that may come into play and where the next resistance levels are after them.

When the data does come out, we have a fairly rational baseline to judge the subsequent market reaction. If CPI declines as expected, we already know which support levels may be tested. If they’re not being tested, we're starting to think that maybe the market is already overly short and that profit-taking short-covering may ensue. If the report comes in higher than expected, we’ve  already identified the likely upside price points that will trigger a larger reaction.

Think ahead about what the market is expecting based on consensus expectations and how much has been priced in. Be prepared to factor various data outcomes in the larger themes you’ve already identified. Think through how the market is likely to react based on those scenarios, and you’re likely to be several steps ahead of the crowd.