We're all, everyone including Uncle Tom Cobbleigh, expecting the Federal Reserve to announce a rise in interest rates at their meeting next week. The very fact that we are all expecting this to happen means that if they announce no rise then there will be market turmoil: if they announce a rise then things will be really rather calm.
The economic insight behind this is the efficient markets hypothesis (EMH). This does not, as some seem to think, tell us that markets are always the efficient way of doing things, nor that markets are always efficient. Rather, it simply says that markets are efficient at processing information.
The EMH comes in three flavors; weak, semi-strong and strong. Strong is pretty extreme and insists that all information, public and private, is already in prices. The semi-strong that all public information is already in the prices, the weak that most of the public is. Among economists the weak is regarded as almost a tautology, near obviously true, the semi-strong tends to get supported by the more free market types and the strong is reserved for real headbangers like Eugene Fama, who got the Nobel for making the point in the first place.
Which version is true doesn't really worry us here: the Fed has been trailing that it's highly likely to raise interest rates at the next meeting for some time now. It's the received and expected wisdom by this point. But what that means is that the information that the Fed will raise rates is already known: and thus, as already and widely known information, it's already in prices. Thus, assuming that the rise goes ahead, we shouldn't expect much change in prices.
As an example of this, one prediction about a raise in US rates is that we would expect a flow out of developing country $ bonds and into domestic US $ bonds. People took the extra foreign risk in search of yield, now that yield is returning in the US we would expect them to drop that risk. And we are already seeing a move (a large one in fact, one analyst calls it a stampede) out of foreign $ bonds into domestic.
The EMH therefore means that markets are forward looking. Prices move before the thing we expect to happen. And the EMH also means that it's only new information that changes markets. And the Fed not raising rates would be exactly that. New information that changes market prices.
We can see this nicely in the actions of the European Central Bank last week and how markets reacted. The ECB said that there would be lots more QE type activity. They were talking as if there would be lots and lots in fact. And we would expect, if that happened, that the euro would fall in value and that stock markets would perk up. So, the ECB announced their more QE style stuff and what happened? The euro rose and markets fell.
•The ECB cut its deposit rate by 0.1pp to -0.3pc and extended QE to March 2017 or "beyond if necessary". •Asset purchases will now include regional and local government debt, and be reinvested upon maturity. •There was dissent, from the head of Germany's Bundesbank among others. •The biggest news though was a surge in the euro and government bond yields. The single currency climbed by 3pc against the dollar today.
This is not what we might expect. Except what the ECB actually announced was rather less action than they had seemed to be promising. What the market was expecting was already in prices. When the action was less than expected then prices reversed. Markets really are forward looking, processing the information of what people think will happen into prices. It not happening is thus the new information that moves prices once again.
And so it will be if the Fed doesn't raise rates next week. That they will is already in prices. It's if they don't that we'll see a shift as a result of incorporating that new information into prices.
The lesson being don't trade on what everybody already knows: it's new information that provides opportunities. What everyone already knows is already in prices.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.