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Why Markets Trade on Expectations

20 Years ago | March 20, 2014 11/27/21, 12:00 AM

Markets have always traded on expectations and discounted future events. This is especially true in the current world of very low interest rates where there has been little chance of central banks hiking interest rates and the focus has been mainly on policy measures designed to increase liquidity (e.g. quantitative easing). Well, the end of this era of near zero interest rates appears to be coming on the horizon and this has made markets highly sensitive to any shifts in expectations over the timing of changes in monetary policy.

Expectations Drive Markets

This is what happened on March 19 when FRB Chairwoman Yellen surprised the market in her answer to a question on what is meant by considerable time in the following part of the FOMC statement:

...The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. ..

She responded that considerable time was around 6 months and when combined with her earlier comment that Fed tapering would end in the fall saw expectations of the first rate hike move up from the generally expected second half of 2015.

This caught a market where some expected a shift lower from the 75bp median of rate hikes closer to 50bp at the end of 2015 to a shift higher in the median from 75bps up to 1.00% at the end of 2015.

The debate is now whether she sent an intentional signal or whether it was a slip of the tongue. If the latter, then be on alert for damage control in the days to come. If the former, then markets will factor in an earlier than expected US rate hike and this will increase attention on economic data and what signals Fed officials send.

In any case, markets will continue to be driven by expectations (as opposed to actual policy changes), not just in the US but elsewhere as well. This is life in a near zero interest rate world where the light is at the end of the tunnel as it is a matter of when, not if rates will rise. Expectations of when (and by how much) are what will drive markets as the light draws nearer on when interest rates will be hiked.

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