How markets react to central bank meetings

You can explain why markets react to the difference between a central bank decision and expectations, and how the outlook can matter more than the decision.

It seems backwards

A central bank cuts interest rates, and its currency rises. Another holds rates unchanged, and bond prices jump. Reading the headline alone, these reactions look backwards.

They make sense once you know that markets trade on expectations. By the time a decision is announced, most of it is usually in the price already. What moves markets is what was not expected. This lesson builds on the forex lesson on central bank days and looks at all markets.

The surprise moves prices

Before each meeting, traders form a view of the likely decision. Futures and swap markets show what probability they assign to a hike, a hold or a cut. A decision that matches these expectations is priced in: it is already reflected in prices.

On decision day, three things can move markets:

The decision. If it differs from what was priced in, prices adjust quickly.
The wording. A changed phrase in the statement can signal a turn in policy.
The outlook. Hints about future decisions often matter most, because they change the whole expected path of rates.

The Fed adds one more source of news. Four times a year, with its Summary of Economic Projections, it publishes the dot plot: each participant's view of the appropriate policy rate for the coming years. When the dots move higher or lower than expected, bond yields and the dollar can move more than on the decision itself.

The press conference that follows can then change the reaction again.

The SNB shock of 2015

Real shocks are rare, because central banks usually prepare markets carefully. The most dramatic exception came from Switzerland.

Since September 2011, the Swiss National Bank (SNB) had defended a minimum exchange rate of 1.20 francs per euro. On 15 January 2015, it removed the floor without warning and cut its interest rate to minus 0.75%. The SNB later explained that defending the floor would have required ever larger interventions.

The franc jumped against the euro within minutes, at one point by more than a quarter. Swiss shares fell sharply. Several brokers and traders who held positions against the franc suffered heavy losses, because prices jumped past their stop orders.

Common mistakes

Judging a decision by its headline. Compare it with what was priced in.
Ignoring the outlook. The expected path of rates usually matters more than a single decision.
Trading the first seconds. Spreads widen and prices can jump in both directions around the release.
Assuming a stop limits the loss. In a shock, prices can skip over stop orders.

The takeaway

Markets price in expected decisions, so the surprise and the outlook move prices. A real shock, like the SNB in 2015, can move a currency in minutes.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the kind of news that usually moves prices the least.

Tap the chart.

A decision everyone expected is already in prices before it is announced.
2A central bank cuts rates exactly as expected, but signals no further cuts. What can happen to its currency?

The cut was priced in. The new information is the outlook, and it points to higher rates than expected.
3What is the Fed's dot plot?

It is part of the Summary of Economic Projections. It shows views, not commitments.
4Why did the SNB's decision of 15 January 2015 move the franc so violently?

The SNB had defended the floor for more than three years. Removing it without warning was a complete surprise.

of 4 correct.

Sources

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