Understanding Expectations Theory The Market’s Response to Anticipated Changes
Having covered the interplay between fiscal policy and monetary policy we’ll now delve into
expectations theory.
To start with, how is the market influenced by expectations? If we take a market’s efficiency
for granted and assume that all participants have immediate and free access to information,
it follows that the market would consider all factors. As we previously looked at, the market
is highly focused on central bank actions, therefore, expected shifts in central bank policy
have a big impact on currency movements.
1st example
Let’s say you have $100K to save. The interest rate on deposits in Australia is 2% and 0,5% in
Eurozone. Wouldn’t you choose Australia? However, if you think Australia’s interest rates
will fall to 0% by year-end, you would go with Eurozone.
Traders would probably move their money out ahead of time to prevent any losses if they
think it will happen. Without anything happening just yet, that is probably going to cause
the Australian dollar to weaken, which is what makes expectations important.
2nd example
If you hold a $140 worth of Netflix stock, but you believe the company may declare
bankruptcy the following month, you would most likely sell your stock now rather than risk
it becoming worthless.
However, should a sufficient number of individuals hold this belief and simultaneously sell
their Netflix shares, the stock price will drop significantly, likely leading to an even faster
closure of the company, also known as self-fulfilling prophecy.
3rd example
Take the Eurozone’s Q4 GDP growth estimate, which is expected to have risen to +0.7%
compared to the results of the prior quarter which was +0.5%. If growth reaches exceeds
the 0.7% expectation and instead rises to +0.9% in Q4, EUR/USD will most likely rise, as the
results suggest a stronger Euro given the results. On the contrary, EUR/USD may decline if
Q4 GDP growth comes below the 0.7% expectation and instead record a rise of only +0.4%.
Finally, no reaction is expected to take place if the actual result of Q4 matches exactly the
0.7% expectation, since the market has already accounted for this projection beforehand.
Big changes in the market usually coincide with unforeseen circumstances like Brexit or
Trump’s election. Markets fluctuate ahead of expected outcomes, so if expectations are
fulfilled, there is minimal response. On the other hand, surprises cause investors to quickly
adjust themselves.
In the upcoming video we’ll focus on specific indicators for macroeconomic data, beginning
with those related to growth and output.