Mr. Market at the Psychologist, Part 6: How Central Banks Impact Sentiment

February 15  

This is part six of a series on market psychology, specifically central banks impact on sentiment. Click here for part one on decoding market psychology. Click here for part two on investor sentiment and fundamentals. Click here for part three on emotional investing. Click here for part four on the herd mentality. Click here for part five on the buy low, sell high philosophy.

Another aspect of market psychology is the way investors react to what regulators say about the economy. It all comes down to interpretation of what the Federal Reserve or other central banks say. The words used can make investors feel worry or calm, so regulators must always be careful about not just what they say but how they say it. Commentary is delivered on a regular basis, including with interest rate cuts or hikes.

We already discussed a little bit in the previous article how interest rates drive market psychology, but we didn’t talk about how central banks’ commentary around interest rates changes investor perspectives of the market. Central banks control interest rates, so investors listen to what they have to say for hints about what to expect.

Dovish versus hawkish

Whenever policymakers are talking about interest rates, their comments range from dovish to hawkish. Commentary that’s generally viewed as dovish includes remarks pointing to looser monetary policies. A dovish Fed wants to spur growth in the economy, which they usually do by cutting interest rates. By cutting rates, they make it easier and cheaper to borrow money. Businesses are better able to hire employees because they have access to the working capital they need to do so.

On the other hand, hawkish commentary refers to anything that signals an intent to tighten monetary policies by raising interest rates. In other words, the Fed must reduce the easy access to money because consumers and businesses feel like they have plenty of money, so they’re spending easily, and prices are being driven up as a result. When inflation runs out of control, the Fed tends to become more hawkish to keep it from getting too extreme, which can eventually trigger a recession. However, when the economy is already in a recession, then a dovish tilt is generally noted.

Thus, investor sentiment shifts based on how the Fed views certain events.

It’s more than just commentary

It’s easier to explain how Fed commentary impacts investor sentiment about the market by showing what happened in July 2019. Fed Chairman Jerome Powell sent the markets into a tailspin with only these two words: “midcycle adjustment.” He announced an interest rate cut and called it a “midcycle adjustment” rather than an aggressive, long-term rate-cutting plan.

Usually when the Fed cuts rates, policymakers take on a dovish tone which soothes investors and calms the markets. However, by terming the rate cut a “midcycle adjustment,” Powell spooked investors into thinking it might be the only time they cut rates this year—even though the economic data released in July wasn’t quite as rosy as it had been in the previous months.

After Powell’s remarks on the first interest rate cut in more than 10 years, stock prices plunged, and the U.S. dollar soared to its highest level in two years. Bond yields soared higher too. Investors generally adopted a risk-off sentiment and sought safer investments rather than equities. CNBC reported that traders were disappointed with his statement and perceived it as more neutral than dovish, which was what they had been expecting.

In an attempt to calm investors and the markets, Powell later clarified, “What I said was it’s not the beginning of a long series of rate cuts. I didn’t say it’s just one or anything like that. When you think about rate-cutting cycles, they go on for a long time and the committee’s not seeing that. Not seeing us in that place. You would do that if you saw real economic weakness and you thought that the federal funds rate needed to be cut a lot. That’s not what we’re seeing.”

The consensus from traders and analysts was that what Powell said was confusing and displayed a lack of confidence. An economist later told CNBC that the last midcycle adjustments they saw in 1995 and 1998 were three rate cuts apiece, so it’s possible that Powell was trying to signal plans which are similar to what was observed in those years.

In short, the markets were pricing in three interest rate cuts before the Fed’s announcement, but because of how Powell talked about what they were doing, investors took his commentary to mean something entirely different. The market moved because of how he made investors feel rather than any material or fundamental change to what the Fed was planning to do.

How investors interpret Fed commentary

While it’s important to listen to Fed commentary to get an idea of what policymakers are planning to do, it’s also important not to get carried away by semantics. Investors who have a knee-jerk reaction to what others are saying could find themselves bailing on a stock after the price drops, only to rebound the next day or week. Assuming there were no fundamental changes in the company itself, there was no real reason to sell the position. Instead, you have just racked up transaction fees by trading a stock you actually liked and would not have sold otherwise. This just boils down to selling simply because everyone else is selling.

The final article in this series will focus on momentum trades and the investor euphoria that often carries the market along. Momentum can be negative or positive, and it happens when investors just do what everyone else is doing for no reason except it seems to be the thing to do. The Fed’s recent commentary triggered a round of negative momentum, and the market still appears to be on edge after that. Momentum can certainly be a dangerous thing if you let yourself get carried away by what everyone else is doing or saying.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost