I'm sure we've all been there before. A trade setup that seemed so perfect, but completely went the other way. Why did it happen? More importantly, how did it happen? Scratching our head, we boggle over the situation.
As confusing as some of these situations may be, there's almost always a logical explanation. Let's walk through an example scenario to demonstrate why sometimes the opposite of the expected reaction is actually the logical reaction, too.
I've seen many traders struggle with economic data release reactions in the market. We get some seemingly bad data and yet the market pops, or vice versa with good data. But why? Isn't the market supposed to be pleased with good data and displeased with bad data?
Not so fast.
There are many variables to consider in this situation, rather than just the surface level data and reaction. That's because market participants tend to position themselves ahead of data releases and also because one must consider how central bank policy may be impacted by the econometrics in question.
Let's use CPI as one example. Last week we had a nasty CPI print, but the market popped. Why did it do the opposite of what was logical?
Going in to that CPI print we had a robustly hedged market. In fact, the volatility surface was significantly skewed toward put premium, in particular across near dated expirations. That tells us that market participants were positioned for a draw down, and when the CPI print wasn't scorching hot they began to exit those hedges (adding liquidity), sending the market higher short-term.
It's not what one would expect when looking at the CPI data release in a vacuum, per se, but when we zoom out and take a broader look at hedging flows it makes a lot of sense.
Another example, which tends to occur with more regularity earlier in the credit cycle, is disappointing data being treated as being bullish by the market. Let's say we get a soft retail sales, GDP, or other econometric print. But the market rips face higher. There's logic behind this sort of a move as well.
When we are early credit cycle the Federal Reserve is in full easing mode. Pulling out all the stops to try to support the financial system primarily and the economy secondarily. When we see weaker economic data it gives cause for the Fed to keep their foot on the gas with regards to monetary stimulus.
Thus the market prices in bad econometrics as good for markets when the Fed is dovish. This effect fades as we get deeper in to the credit cycle and the US central bank begins to pull back on easing as the strength of the economy begins to truly matter for risk asset price discovery.
In summary, market reactions that seem to be the opposite of what one would expect often have sound reasoning behind them. As traders and investors it is our responsibility to find that reasoning and ensure it comports with our strategies.
It's equally important to be flexible as reactions change throughout the credit cycle, from early cycle where weak data may be considered to be bullish, to later cycle where strong economic data tends to be important to the market as it gets off of Fed life support (at least temporarily).