On Friday, US Non-Farm Payrolls came in over twice what was expected. The unemployment rate dropped as well, if only by a decimal point. Yet US stocks (as measured by the S&P 500 and Nasdaq) dropped. Why would it be a “bad” thing for US businesses that more Americans have jobs, and have more disposable income?
This is a recurring phenomenon in financial markets that can disrupt trading strategies. It’s not exclusive to the US. in Europe, indices have been responding differently, but that could change. Since there is a direct correlation between equities, commodities, and forex, this could affect us currency traders as well.
What’s going on?
When central banks get involved in the economy, this changes the dynamic of the markets. Because most day-to-day trading is conducted on margin, the cost of credit plays an important role in trader decisions. And central banks try to influence the economy by manipulating the interest rate, which in turn manipulates financial markets.
Generally, central banks aren’t interested in the short-term ups and downs of financial markets. They only care in terms of price fluctuations being a sign of liquidity in the markets, which could have broader economic effects. So, if the Fed, for example, raises rates, this could make it more expensive to invest on margin. Which in turn means traders will buy and sell less stocks. In general, that means the stock market goes down. The Fed doesn’t really care about a slight drop in stock prices caused by less liquidity, because part of the reason for raising rates is to cut back on “excess” liquidity that could be driving inflation.
The markets are most sensitive
Inflation, of course, is rising prices and that concept also applies to the stock market. If stock prices are increasing above the valuations of the companies, then prices are getting “inflated”. Last year, companies were reporting disappointing earnings because of the lockdowns, but stock prices were rising. Meaning that stock prices were getting inflated.
The Fed’s move to raise rates is the driving force behind lower stock prices, and that’s what the Fed is trying to achieve in the broader market. The stock market is simply the quickest to respond.
Interpreting the data
Better economic data is a sign that prices will keep rising, and more effort by central banks is necessary to control inflation. The stock market responds to that first, meaning that the good economic news ends up being bad news for the stock market. Even if companies themselves have good news, like Tesla’s stock split, they could still be pushed down by the broader market. In turn, currencies get stronger, as the market behaves in a risk-off pattern.
As long as central banks are highly active, markets are likely to have an inverse news pattern. That bad news makes the market behave in a more risk-on way, and good news leads to a more risk-off behavior pattern. This might mean trading strategies need to be inverted. But traders need to be wary of when central banks will step back from intervening, and the usual “good news is good news” dynamic suddenly returns.