What Does Data Dependent Central Bank Policy Mean for Trading?
With the ECB taking a data dependent approach and Fed Chair Powell indicating something similar following the 50bps rate hike, it pays to take a look at what it means for a central bank to be data dependent.
What does data dependent mean?
When a central bank indicates it is taking a data dependent approach to monetary policy, it means that it will make its decisions based on evaluating recent economic reports and trends rather than following a predetermined path to change interest rates (e.g. 25bps per month, etc).
In this way a central bank has the flexibility to react to trends in key economic indicators, such as inflation, employment, GDP, etc. rather than being wedded to a fixed schedule of interest rate adjustments.
However, this is a two-edged sword.
On one hand it allows traders and investor to anticipate future changes in policy based on the trend in certain economic indicators. On the other hand, it puts a central bank in a position where it may be reacting to backward looking data, which could make it prone to policy mistakes. It also can make a central bank more reactive rather than proactive where it will tend to follow market pricing rather than leading it.
What does this mean for trading?
Simply put, a data dependent monetary policy increases volatility around economic news releases, especially when they vary from the consensus forecasts. It sometimes feels like traders treat a specific economic report as a trigger for a change in monetary policy while central banks look at the full picture, not just one report. The volatility may also be exacerbated by news algos that react to keywords more than the substance of a report.
Whatever the case, each piece of data seems to increase in significance when in a data dependent environment,
Take the release of U.S. Weekly Jobless Claims This report, once considered 3rd tier data, can sometimes see a reaction that treats it as if it is tier 1 data given the Fed’ focus on the employment side of its dual mandate (i.e. stable prices and maximum employment).
Take the release of Weekly Jobless. Claims on September 19, one day after the Fed cut rates by 50bps. Claims were reported at 319,000 vs. forecast of 231,000. This saw bond yields firm and the dollar reverse its earlier fall (see the chart below).
Source: The Amazing Trader
So, the bottom line is that a central bank data dependent approach allows traders/investors to anticipate changes in monetary policy based on economic data. On the other hand, it increases volatility around economic news when there is a surprise, either one that supports the current market view or one that triggers a counter trend reaction.
Whatever the case, trader love volatility and thus have a love affair with the news. Just be aware that central banks do not react to one piece of the puzzle while the market may seem to react that way. In addition, be wary of surprise in economic release as markets move most when there is one. This is the life in a data dependent monetary policy world.
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