Why Day Traders Need to Pay Attention to Central Banks

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Day traders, particularly retail/individual day traders, tend to focus predominantly on technical analysis and don’t typically pay that much attention to central banks. These institutions are directly responsible for determining monetary policies that help achieve results in line with their statutory mandates, such as stable inflation, maximum employment, and financial stability.

Central banks have the largest lever on global liquidity and the most influence on global markets.

While global elected leaders also have strong influence, as do heads of special organizations like the IMF, many decisions they make cannot be enacted unilaterally and they must work alongside legislators.

Oftentimes, ideological differences prevent heads of state from doing what they’d like to do, leading to a compromise or no legislative action at all. It can also lead to infighting, polarization, and general dysfunction when the political left and right split further apart.

Central bank policy changes can be made more swiftly and without partisan wrangling. Accordingly, they remain the top way to respond to an economic downturn.

The US Federal Reserve is the world’s most important central bank. The US economy is around 22 percent of the world economy and the US dollar is the world’s primary reserve currency.

Globally, we know that US dollars are 62 percent of foreign exchange reserves, 62 percent of international debt, 57 percent of global import invoicing, 43 percent of FX turnover, and 39 percent of global payments.

As global growth slows in developed markets, it become progressively harder for central banks to tighten in any form (i.e., raising rates and/or selling assets from its portfolio, which are measures taken to slow down money and credit creation).

In late 2017 in the US, you saw an easing of fiscal policy through tax cuts and deregulation. But once on the backside of those cuts, there was a follow-up tightening in fiscal policy, as the positive productivity outcomes faded yet borrowing continued to grow.

By mid-2019, in the corporate sector alone, there was $520 billion worth of debt maturing that year. That could be managed. Companies had the assets and income; many companies having problems would be able to refinance. Defaults were low and very little of the maturing debt was of the high-yield variety.

But as time goes on the debt calculations projected to get stodgier because there’s a big maturity wall coming up from 2020 through 2023, with $700 billion, $750 billion, $690 billion, and $700 billion coming due, respectively. And for each increasing year, the high-yield portion of that debt grows in a material way.

Then the coronavirus pandemic happened that shutdown activity and caused a huge drop in markets.

The household sector’s debt situation looked fine going into the Covid-19 pandemic, though it was underestimated in the data because much of mortgage debt has been converted to rent. Rent isn’t debt, but it’s a non-discretionary expense nonetheless. This shows up in the data by tracking household debt service payments as a percent of disposable income alongside the homeownership rate:

debt homeownership

(Sources: Board of Governors, Census)

 

But taking aggregate figures can mask what’s going on at a more granular level. The balance sheets of the top 5 percent of earners look very different from the balance sheets of the bottom 95 percent. A substantial number of US households are financially distressed and living paycheck to paycheck. A big drop in the economy tends to exacerbate the weakness of those living in more tenuous conditions and tends to create more social conflict, which was already in abundance before the crisis.

 

Traders versus Central Bankers

As a whole, “financial people” think differently from central bankers. While central bankers tend to focus on variables like employment and business investment, financial types focus on debt, asset prices, and cash flow and have views that are more closely molded by trading experience rather than formal economics training.

The difference in perspectives is why we currently see a material disconnect between what the financial markets think the Fed will do and what Fed officials plan on doing. Traders see high levels of debt and leverage throughout developed market economies as a constraint on how long central banks can keep their policy rates at the current levels as economic growth slows.

In the US rates market in mid-2019, traders were expecting nearly four 25-basis-point cuts over the next year from the Fed. They eventually did eleven because of Covid-19.

Fed officials, on the other hand, saw low levels of unemployment. In the context of the Fed’s statutory dual mandate of maximum unemployment and price stability, traditional economists are likely to lean heavily on the academic catechism of low unemployment presenting upside risks to inflation.

The theory behind this is that workers have bargaining power to increase wages in a tight labor market. This causes firms to increase the prices of goods and services and pass off most of the resultant higher labor costs to consumers, stoking inflation. In general, anywhere there is a shortage of something relative to demand, this tends to create price pressures, whether its materials, labor, financial assets, and so on.

Higher rates discourage credit creation at the margin and help to cool down an economy. As a result, most FOMC members viewed rates as mostly holding steady or down 25-50 basis points by the end of 2019.

Federal Reserve Chair Jerome Powell has business experience and can theoretically help to bridge the two worlds. He was a former private equity executive and had previous work on the sell-side as well.

But the Fed is a very academic central bank and Powell’s been in that environment for over a decade. In any clique, the dominant form of thinking tends to win out so there’s an element of groupthink.

Sometimes, some market commentators will make the unconvincing argument that central banks should strive to move rates higher such that they have “more ammunition” in the next downturn. This is nonetheless poor logic because tightening policy is not a costless thing.

The current term premium of rates is built into the price of all financial assets and these flow into capital market borrowing rates, which feed into debt servicing costs, and so forth. If they go faster than what’s discounted in the curve and there is not a pickup in growth to offset the effect, asset prices decline. This is due to the present value effect by which their cash flows are calculated.

The reason why we have recessions in reserve currency countries (which have debt mostly denominated in their own currencies) is typically because monetary policy tightens, usually to fight inflation. This produces a dip in the economy, which is followed by central banks easing once inflation is under control to produce an expansion. Tightening too fast or failing to heed financial market signals discounted in the curve increases the odds of making a policy blunder and need for large quantities of easing in the future to atone for the mistake.

 

Conclusion

As such, it’s most important for the average trader to understand what the central banks are doing.

Are the central banks easing policy? Are they lowering rates, are they buying assets? If so, this puts money (liquidity) into the system. If central banks provide sufficient liquidity, it inevitably goes into assets. If they’re tightening monetary policy – i.e., raising interest rates and/or selling assets – this takes liquidity out of the system and takes away from financial assets.

And it’s important to know that financial markets are information discounting mechanisms. There’s an element of thinking ahead. To use the mid-2019 example, the Federal Reserve and European Central Bank may have been preparing to ease, but markets already discount this fact. If they ease but don’t ease sufficiently relative to market expectations, this will actually be a drag to financial assets, holding all else equal.

As a day trader, or someone with a short timeframe, understanding central banks, what they’re doing and what they plan to do, is still of critical importance. Their decisions, words, guidance, and rumored intentions drive markets in a material way.