Riaz Academy
ECONOMIC INTUITION
What is Capital Market Dynamics
From the following, you will understand Economic Intuition and What is Capital Market Dynamics. Market dynamics are pricing signals resulting from changes in the supply and demand for products and services around us.
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1. WHAT DRIVES ASSET PRICES?
The idea is that asset prices are mostly random in the very short term due to the different participants dealing in the markets for many reasons. In essence, if we ignore short-term pattern recognition trading algorithms, we can say that it’s impossible to predict stock prices in the very short-term (seconds to minutes and possibly hours). Thus, the random walk theory applies perfectly here. What moves asset prices in the medium-term are mostly capital flows economic changes. These can be fairly predicted but require a tremendous amount of expertise and a very robust model. Even with the perfect combination, the user should not expect more than a 75% success rate (which is still phenomenal). In the long-term, fundamentals take the lead in determining what the assets’ values will be. Nothing else can substitute this type of analysis in the long term. Intrinsic value can only be approximated through fundamental (or financial) analysis. Technical and sentiment analysis takes a back seat in this situation; however, they are still very useful to time the entry of the investment. Notice how we have used the term investment and not trade, as a long-term transaction using fundamentals is really an investment and it goes beyond the realm of trading (speculation).
2. GROSS DOMESTIC PRODUCT – GDP
Gross domestic product is the output of a country given a certain period (generally quarterly or yearly). It’s the most important (although lagging) indicator of the country’s economy. A rising GDP means that the company is producing more and more. GDP is a lagging indicator because it comes out after market participants have already priced in the changes anticipated in the markets and thus it will not be very useful for news trading (not that news trading is perfect). A rising GDP also has consequences on inflation rates and that is what market participants truly watch out for. We discuss inflation in a later section but for now, be sure to understand that a rising GDP is generally accompanied by an increase in inflation. One type of inter-country analysis is to make a relative GDP spreadsheet between two countries to identify which is doing relatively better than the other. Of course, the GDP being a lagging indicator, will not give us a piece of useful predictive information, but it’s still interesting to compare on a national level.
3. MONEY SUPPLY & INTEREST RATES
The amount of money supply and the level of interest rates is primordial when analyzing currencies. A rule of thumb is that when the money supply increases, interest rates decrease, thus rendering the currency less attractive and will then depreciate naturally. When a trader is anticipating an increase in money supply (a decrease in interest rates) he or she will have a short bias over the currency analyzed. The money supply is considered a leading indicator even though it’s literally the reaction of the central bank to economic events. Another intuitive way to think about interest rates and their relationship with domestic currency values is that if interest rates increase, the yield the currency will be providing will increase, and hence, carry trades involving being long this currency will be attractive and more flows will pour thus increasing the demand and the final result will be an appreciation of the currency. Quantitative easing is a monetary policy tool in which the central bank buys government debt securities in order to flood the market with money, thus increasing money supply and lowering interest rates.
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4. EMPLOYMENT
The level of employment of a country determines its future output and GDP. The more people work the more productive a country is. The most important US indicator is the non-farm payrolls. This indicator measures the number of net jobs added to the economy in a month. Sometimes, the wages indicator can be a more deterministic factor and will be the one providing the volatility to the markets because it can give ideas about future inflation. A lower unemployment rate can have a positive or negative effect on currencies. If it was simple to predict the effect of indicators on currencies and asset prices, everyone will be rich. Sometimes, positive employment data will make the stock market plummet in value. It depends on the investor’s perception of the future, remember, it’s always about expectations as everything you’re seeing on your screen is most probably already priced-in. Market efficiency is coming for us all, make sure you get to the nearest lifeboat. Unemployment rate and NFP data use different statistical populations and can diverge from time to time.
5. INFLATION
First things first, we have to acknowledge that we need inflation to move further, thus, it’s not necessarily a bad thing. The bad kind of inflation is when it gets out of hand (hyperinflation). An interesting inflation indicator is the inflation expectations that can be obtained from the difference between treasury yields and TIPS (treasury inflation-protected securities). Data is freely downloadable online. Inflation data can be obtained through the CPI (consumer basket index) which is measured differently in each country, so it might not be the best tool to use if you’re planning a regression analysis.
Core CPI is a less volatile version that excludes oil and food data to measure national inflation. PPI (producer price index) and core PPI are also used to measure inflation. However, these 4 indicators tend to be coincident/a bit lagging and they are mostly used to confirm or negate views.
Inflation expectations data is a forward-looking measure and is a better tool to use when gazing through the inflationary horizon.
Inflation forecasting is extremely important, especially to fixed-income and currency traders. Rising inflation is generally associated with higher equity prices, higher commodity prices, and lower FX rates for the domestic currency. Forecasting inflation is extremely difficult as many variables should be included and even with that, shocks and errors are still present.
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6. GLOBAL DEMAND & SUPPLY SHOCKS
Demand and supply are not always in equilibrium, and we are thankful for that (yeah, I said it). This is exactly what we are trying to predict through our sentiment analysis with the COT reports. When there is too much demand (prices rose too much), markets tend to correct to the long-term equilibrium. In other words, when there is too much demand, prices might reverse soon or at least correct, that is, if there isn’t a switch in the fundamentals. Wars and natural disasters can cause demand and supply shocks and this is common in the oil market.
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