Why Markets Move: The Power of Economic Surprises

Ever notice how the economy seems to have a huge impact on the markets? It's true - economic data releases can make or break market movements. Think of these releases as new scenes added to a long-running movie series. Each piece of data tells us a bit more about what's happening with the economy, adding to the story.?

The Importance of Surprises??

Imagine you're at a movie theater, excited to see the latest suspense thriller. But, instead of edge-of-your-seat action, you get a bunch of clichés. You'd be disappointed, right? That's exactly how the markets feel when economic data fails to surprise them. This "failure to surprise" is the key phrase here for our context.??

Markets thrive on surprises. If a new data release matches expectations, it's like watching a movie plot you've seen a hundred times — boring! For markets to move, the data needs to catch them off guard. This can even happen if the new data is significantly higher or lower than the previous release. If the markets anticipated those numbers, there's no surprise and thus, no movement.?

Setting Expectations and Market Reactions?

But who's setting these expectations? It's not us regular folks; it's professional economists. They use sophisticated models to estimate things like next month's GDP or inflation rates. They can be wrong, of course. In fact, they often are. But it's not just about being right or wrong; it's about how close their estimates are to the actual data. The closer and more consistent their estimates, the better they are considered. These economists are even ranked by specialized agencies for their accuracy. Their expectations are collected by companies like Bloomberg, who then release a median figure — basically, the middle number of all estimates. This median is called the expectation.?

Now, if the actual data release is way off from this median, it's a surprise! The bigger the surprise, the more the market is supposed to react. And this reaction isn't limited to just one market. Stocks, forex, derivatives — you name it, they all function on the same principle.?

Take, for example, a recent CPI inflation release, and imagine that the previous month's release was 0.9%. If economists expected a 0.3% rise for the current month, but the actual increase turns out to be 0.6%, that's a big surprise even though it is less than the 0.9% of the previous month. Markets would likely immediately jump in response. Conversely, if the release was exactly 0.3%, markets might yawn and stay put.?Below is a recent data release from the US and its impact on markets:?

The above table shows that annual and monthly CPI inflation for the US during the previous month (June 2024) was 3.3% and 0.0%, respectively. For the month of July 2024, economists had expected CPI to be 3.1% and 0.1%, while the actual official data for July 2024 turned out to be 3.0% and –0.1%, respectively. In simple words, official data showed even lower inflation than economists' expectations, clearly a positive news for markets such as the stock market of the US and, in general, for the US economy.

The following graph shows the impact on the short-term yield (or interest rates, in simple words). See that long red on the chart below. Notice how large the move is compared to all the moves before and after. That's the market movement right after the above positive surprise-released on 11 July 2024. You may be wondering why it is not a big green. That's because this is an interest rate market?that is priced in an interest rate cut by the US Federal Reserve (the US central bank). Basic economics: 'Lower inflation generally gives firepower to central banks to reduce interest rates.'?

Well, that's the crux of it. It might sound simple, but there's no objective formula to it. Even if there was a clear edge, news-based algorithms would have already taken advantage of it. Plus, economic data releases are just one of many factors that can impact the market at any given time. You see, professional investors and traders act on these expectations even before the data is officially out. They "price in" their predictions, moving money around based on what they think the data will be. So, when the actual data is released, it's not just the "surprise" factor that matters but also how much the market has already moved based on those expectations.?

Conclusion?

Understanding this can feel like a lot, but the best way to grasp it is by watching it happen. Follow a few economic data releases and see how markets react. We'll dive into some exciting contemporary examples in future posts. Till then, keep reading and stay curious!?

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