My daughter Lily started primary school in September. During the first few days, she had been so eagerly diligent with her first homework assignments, that I decided to surprise her.
One day, I took her from school directly to her favourite brownie shop; pink and decorated wall-to-wall with purple flowers, for Lily the place is magical. After she gulped her awesome pastry, we headed home.
It was 6pm and there was plenty of time to finish her 15-minutes-a-day homework. The moment the little one, however, realised that she was doing homework anyway, she burst into tears. It took more than an hour to calm her. The reaction was not anticipated. She never cried when she had to do just homework.
Homework = bad. Brownie + homework = good, or at least much better. So why the tears? Because by changing her routine, I inadvertently changed her expectations. Surprises do not always play out the way we think they might.
Markets are a lot like that.
A few weeks ago, the US central bank positively surprised the investment world by performing a double (0.5 per cent) cut on its basic interest rate. Of 113 economists surveyed by Bloomberg, only 9 had called the double cut, whereas the rest expected a single (0.25 per cent).
The double cut has some implications for investors. Not the actual percentage, but more the surprise itself.
On the one hand, the fact that a lot of investors had not positioned for it, allowed a late-September rally in equities and bonds. At the time of writing, global stocks were up 19 per cent (more than twice their annual average) and global bonds up 4 per cent for the year.
On the other, surprises, even positive ones, come with consequences – the most important of which is a change in the pace of rate expectations.
While bond markets were being positioned for four to five cuts by the end of the year, this was more a consequence of traders bidding aggressively to secure a yield before rates go down, rather than a conscious bet on interest rates.
Many investors were still in the sidelines. The positive surprise means that equity markets, as well as the 'slow money' are now also positioning for more cuts by the end of the year and the beginning of the next. This sets investors up for potential disappointment.
If the absolutely most positive rate path is being priced in early, the probability is that in the next turn the markets could be negatively surprised if the Federal Reserve delivers less.
Second, the move officially entombs so-called 'forward guidance'. Since the 2008 global financial crisis, the Fed had preferred not to surprise markets where that could be avoided. It communicated its rate and quantitative easing/tightening questions well ahead of any decisions.
Even during the rate hike cycle, it frequently guided investors as to how much and how fast it was going to increase the cost of money.
