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. 

Analyzing technical themes

Technical themes are perhaps a little harder to grasp than fundamental themes, especially if you’re not familiar with technical analysis. But to make a long story short, sometimes currency prices move simply because currency prices are moving.

The economic or political fundamental themes may not have changed dramatically, but price levels have, and that is frequently enough to bring major market interest out of the woodwork.

In most cases, breaks of major technical or price levels will be in the direction suggested by the prevailing fundamental themes, but the timing is often suspect and can leave traders scratching their heads, asking what just happened. But sizable price movements have a way of taking on a life of their own, forcing market participants to take action based on price adjustments alone.

In addition, the prevalence of technical analysis as the basis for many trading decisions can add weight to existing fundamental-driven moves, generating yet another theme to propel the move - the technical theme. It may be a trending market movement that attracts trend-following traders who don't give a hoot about the underlying fundamentals. As long as the technical trend is in place, they keep pushing the market in the direction its going, prolonging the price adjustment perhaps far beyond what the fundamentals would dictate.

When a currency pair has broken through important technical levels, it’s also going to attract breakout traders - speculators who focus on jumping in on breaks of key price levels, looking to get in on the move for an easy trade. (But nothing is ever quite that easy, and breakout traders can suffer when the breaks are false and the ranges survive.) The additional interest entering the market in the direction of the move again propels the price farther and faster than it may ordinarily go.

Having a sense of where a currency pair stands from a technical perspective is always important, even if you’re not basing your trades on technical analysis. The technical-theme phenomenon also stems from several real-life considerations that all relate back to the relative level of currency prices:

• Option interest: The currency options market is massive and is one of  the reasons that the spot currency market is as large as it is. Option-related hedging is one of the biggest sources of spot market activity outside short-term spot speculation. When spot prices have been trading in well worn territory (a relatively narrow price range, for example), option interest tends to accumulate around the recent range. If the ranges are broken, sizeable option-related interest is frequently forced to come into the market and trade in the direction of the price breakout, either to unwind hedges or to cover new exposures created by the price break, and usually some combination of both. The amounts can be staggering, propelling the directional move in an extreme way.

• Systematic models: We look at so-called black box or algorithmic trading in “Hedge Funds”. Algorithmic trading has dramatically increased in size and number in recent years, which has added further weight to technical themes in day-to-day trading. In many cases, systematic-models trading decisions are generated based solely on price movements. They may be short a currency pair until a certain price level on the upside is traded, for example, which triggers a signal to exit the short and go long, no questions asked.

• Hedgers: Large-scale hedgers may be forced to come into the market if a rapid and unexpected price movement develops. Many firms identify an internal hedging rate for corporate and financial management purposes. As long as they’re able to sell above or buy below that rate, they’re looking good. If the market moves sharply on them, they may be forced to jump in on the direction of the move for fear of not ever seeing the internal hedging rate again. 

Putting Market Information In to Perspective: Focusing on Themes

At any given moment in the forex market, several themes dominate the market’s attention. Market themes are the essence of the real-world driving forces currently holding sway in the market. Themes are what market commentators and analysts are talking about when they explain what's happening in the market. But most important, themes are the filters through which new information and data are absorbed by the market. Or to put it another way, they’re the lenses through which the market sees events and data.

Market themes come in all shapes and sizes, and have differing impacts on the market over time. Some are long-term themes that can color the market’s direction for months and years; others may hold sway for only a few hours, days, or weeks.

Market themes come in two main forms that coexist in parallel universes but that also frequently overlap. The two types of themes that I like to focus on are fundamental themes and technical themes.

Driving fundamental themes

Each currency has its own set of fundamental circumstances in which it's being evaluated by the market. The basic fundamental environment is ever-present, but it’s also subject to change over time, just as economic conditions will change in the course of business cycles. Fundamental themes will also shift in relative importance to one another, with certain themes being pushed to the side for a period when news or events focuses the market’s attention on other, more pressing themes. Keep in mind that each theme applies to each and every currency but in varying degrees at any given moment.

Rising or falling interest rates

Interest rates are usually the single most important determinant of a currency’s value. (We go into greater detail on the significance of monetary policy and interest rates in “Currencies and Interest Rates”).  But it’s not just about where interest rate levels are now, though that’s still important (higher interest rate currencies tend to do better against lower-yielding Currencies). What matters most is their overall direction (whether they're going up or down), their future level (how high or low they’re likely to go), and the timing of any changes (how fast rates are likely to change).

Markets are constantly speculating about the direction of interest rates, even though interest rate changes are relatively infrequent. Speculation over the direction and timing of interest rate changes is one of the primary drivers of a currency’s value on a daily basis as well as over longer time frames.

The information inputs that drive the interest rate outlook are centered on economic growth data and inflation reports. The stronger the growth picture is, or the higher inflation pressures are, the more likely interest rates are to move higher, normally improving a currency’s outlook. The weaker the growth outlook or the lower the inflation readings, the more likely interest rates are to remain steady or move lower, typically hurting a currency in the process.

Bond markets also have a lot to say about the direction of interest rates and are probably the best real-time barometer of the markets interest rate expectations. Central banks can really influence only short-term interest rates, which are essentially based on the central bank’s official rate. But longer-term bond yields, with the ten-year maturity as the benchmark, reflect the market’s long-term view of an economy’s outlook and the direction of future interest rate moves. Falling bond yields (lower interest rates) point to a weaker economic outlook and the probability of lower interest rates ahead, typically denting that currency, while higher bond yields point to economic optimism and likely higher rates, usually supporting that currency.

The effect of interest rate themes is most powerful when the interest rates of two currencies are seen to be diverging when one currency’s interest rate is expected to move higher and the other lower.

When you’re looking at economic data or monetary policy rhetoric, always assess the incoming information first in terms of what it means for the interest rates of the nation’s currency - the interest rate theme. A currency that is expected to see lower rates in the near future, for example, is likely to stop declining and may even rebound if an economic growth report or an inflation reading comes in higher than expected. The market will pause to consider whether its outlook for lower rates is correct. By the same token, a currency facing the prospect of lower interest rates ahead, when hit with weaker economic data or lower inflation readings, is likely to weaken further. I say “weaken further” because it was probably already under pressure and moving lower before the latest batch of data hit the market.

Looking for growth

Economic growth prospects are the linchpin to _a host of currency value determinants, from the interest rate outlook to the attractiveness of a nation‘s investment climate (stocks and bonds). Not surprisingly, the stronger the outlook for growth, the better a particular currency is likely to perform relative to currencies of countries with lower growth outlooks. Strong economic growth increases the likelihood of higher interest rates down the road, as central bank officials typically seek to restrain too rapid growth to head off inflationary pressures. Weaker growth data increases the prospect of potentially lower interest rates, as well as dampening the outlook for the investment environment.

Many growth data reports reflect only a particular sector of a nation's larger economy, such as the manufacturing sector or the housing market. Depending on how significant that sector is to the larger national economy, those reports will tend to be interpreted as correspondingly more or less significant. Industrial production data in Japan, for example, is more significant to the Japanese outlook than it is to the U.S. outlook because of the more prominent role manufacturing plays in Japan.

There’s no set recipe for how growth data will impact a currency’s value, but when the interest rate outlook is generally neutral, as in no solid conviction on the direction of two countries’ rates, the growth theme becomes more important.

Fighting inflation

Inflation is the bogeyman that all central bankers have nightmares about. Even when inflation is low, they still worry about it - it’s just part of the job. When inflation is running too high for their comfort, fuhgeddaboutit. As a currency trader attuned to monetary policy developments, you need to monitor inflation readings as well.

The inflation theme is far more nuanced than the growth theme in what it implies for a currency’s value. Depending on the bigger picture, it can produce starkly different outcomes for a currency. In general, if growth is good, and inflation is too high, it's a currency plus. If growth is low or weakening, and inflation is too high, it’s a currency negative. Come again? Both scenarios point to steady-to-higher interest rates, which should typically be a currency plus, right? The rub is that the low-/slow-growth scenario coupled with high/higher interest rates increases the risks of an economy dropping into recession, which would ultimately result in interest rate cuts farther down the road. In this sense, currencies are a bit fickle in that they like higher interest rate some of the time, but not all the time.

The same phenomenon can happen when a central bank holds rates too high for too long, usually based on fighting inflation, and the market begins to sense that an economic downturn is ahead. The response is actually not that bizarre if you consider that the forex market is, first and foremost, always anticipating future interest rates.

When factoring inflation data into the interest rate theme, be aware of how the overall growth theme is holding up. If growth is good, and inflation is high because of economic strength, higher inflation readings will be currency supportive. If growth is slowing, and inflation is still too high, the currency impact will be decidedly less positive and very likely downright negative.

Gauging the strength of structural themes

Beyond interest rates, growth, and inflation, several other prominent themes regularly assert themselves, mostly in the structural sphere (the big-picture elements of how an economy is performing or national events are playing out).

Structural themes are the most fleeting - they can be in full force one day or for several weeks or months and then drop from the radar screen altogether. These themes are also usually secondary to the three we above (interest rates, growth, and inflation), but structural themes can still exert significant influence on a currency on their own. Most important, they can amplify the impact of the primary themes, like throwing salt in a wound. Following are frequently recurring structural themes: 

• Employment: Employment is the key to an economy’s long-run expansion and a primary driver of interest rates. As long as employment is rising, the longer-term economic outlook is supported. But if job growth begins to falter, as reflected in incoming labor market reports, economic prospects will tend to be marked down. Sharp increases in unemployment are among the fastest triggers to interest rate cuts by central bankers, going back to the primary interest rate theme.

• Deficits: Both fiscal and trade deficits are typically currency negatives. The USD has been especially prone to weakness based on recent increases in both the federal deficit and the ballooning trade and current account deficit. During times of low/slow growth, the impact of deficits can be magnified, as the very credibility of a currency can be questioned. During times of steady/high growth, their impacts tend to be more muted but are still a negative hanging over the outlook.

• Geopolitical issues: It seems like a fact of life now, but geopolitical tensions weren’t always ever-present, as they seem to be today, from North Korean nuclear tests to conflicts in the Middle East or trade disputes with China. Geopolitical issues typically used to develop in relatively short order and tended to influence currency values on the margins, limiting gains in a currency's appreciation or increasing losses during a weakening phase. The USD is the most vulnerable to geopolitical issues, given the size of it economy, reliance on world trade, and potential military involvement. After geopolitical tensions subside, the market is quick to revert to pre-existing themes.

• Political elections or uncertainty: Changes of government and political uncertainty in the major-currency countries can certainly dent the market’s sentiment toward the affected currency. The impact on the currency will usually be felt on the margins, hurting a softening currency and restraining an appreciating one. But shortly after the political situation is resolved, political issues tend to fade quickly into the background.