How Markets React: The Reaction Function, Consensus Dispersion, Pricing-In and First and Second Moves

What you will learn

• How to standardise a surprise with the consensus dispersion so releases become comparable.
• What the reaction function is and why the same number can be good or bad news depending on the regime.
• How "priced in" is measured in basis points.
• How first and second moves differ across rates, bonds, equities and currencies.

Explanation

The foundations course explained that the surprise (actual minus consensus) drives the reaction; the day-trading and risk courses covered spreads and slippage around releases. This lesson goes deeper: how large a surprise really is, how it becomes a price move, and why the first move is often not the last.

Standardising the surprise

A 100,000 miss in payrolls and a 0.1-point miss in core CPI cannot be compared directly. Analysts divide the surprise by the dispersion of forecasts, usually the standard deviation of economists' estimates in the consensus survey, or by the historical standard deviation of surprises. The result is a z-score: 2 or more is unusual, around 0.5 is noise. Commercial "economic surprise indices" aggregate such surprises over a rolling window; a high value means data have been beating expectations, which are now higher and easier to miss. Dispersion itself carries information: a wide range of estimates signals uncertainty, and the reaction is usually larger.

The reaction function

A central bank's reaction function is the rule, written or implied, by which it moves policy rates in response to inflation and growth data. Markets react to data through the reaction function, not to the data itself. Three regimes follow:

• Inflation-fighting regime: strong data imply higher rates for longer; equities often fall on "good" data, yields rise, the currency strengthens.
• Growth-worry regime: weak data raise recession fears faster than cut hopes; equities fall on "bad" data and long yields fall.
• Balanced regime: inflation near target, growth moderate; surprises produce small, short-lived moves.

Identify the regime from recent central-bank statements and the stock–bond correlation: when stocks and bonds fall together on strong data, you are in the first regime.

Pricing-in, in numbers

"The market has priced in 20 basis points of cuts for the next meeting" means the overnight index swap (OIS) or futures-implied rate for that meeting is 0.20 percentage points below the current policy rate (the central-banks course shows how to read those curves). A release changes that number: if a strong print moves the implied cut from 20 to 8 basis points, 12 basis points of easing were "priced out". This also explains anticlimaxes: when regional surveys or a strong ZEW already pushed expectations, a print that merely meets the whisper number produces no move or a reversal.

First and second moves

The first move (seconds to minutes) is algorithmic and reacts to headline versus consensus. The second move (ten minutes to hours) follows as humans read the details: revisions, composition, core versus headline. Reversals are common when headline and details disagree. Two-year yields and rate futures react most directly; the currency follows rate differentials; long bonds mix the rate path with growth and term-premium effects; equities react last and most ambiguously, weighing rates against earnings. Write down before the release what each asset should do, then compare: if the market does the opposite, the regime or the positioning differs from what you assumed.

Worked example

Hypothetical example: payrolls consensus +150,000, standard deviation of estimates 30,000. The print is +250,000; the previous two months are revised down by a combined 60,000; wages are in line. Before the release the market priced 20 basis points of cuts for the next meeting. Assumptions: inflation-fighting regime; a hypothetical rule of thumb of 1 basis point in the two-year yield per 10,000 of surprise.

1. Surprise = 250,000 − 150,000 = +100,000. z-score = 100,000 / 30,000 = 3.3, an unusually large beat.
2. Expected first move in the two-year yield ≈ 100,000 / 10,000 × 1 bp = +10 basis points.
3. Pricing: cuts priced for the next meeting fall from 20 to about 8 basis points; 12 basis points of easing are priced out.
4. Equities: first move down (higher rates), the dollar up.
5. Second move: traders note the −60,000 revisions; net new information over three months is +40,000, an "effective" z-score of about 1.3. Part of the yield rise is given back and equities recover some of the drop.

Common mistake

Practice activity

On paper: core CPI month-on-month consensus is 0.3 % with a standard deviation of estimates of 0.08 points. The print is 0.4 %, driven mainly by airfares while rents slowed. Before the print, 15 basis points of cuts were priced for the next meeting. (a) Calculate the z-score. (b) Describe the likely first move in two-year yields, the currency and equities in an inflation-fighting regime. (c) Describe the likely second move. (d) If the implied cut falls to 10 basis points, how much easing was priced out?

Key takeaways

• Standardise surprises with the consensus dispersion; a z-score above 2 is unusual, 0.5 is noise.
• Identify the regime before judging whether a number is "good" or "bad" for an asset.
• Pricing-in is measurable in basis points; what was already priced cannot move the market again.
• The first move reacts to the headline, the second to the details; write expectations down before the print.

Next step

In the final lesson you turn everything into a monthly data-calendar routine with a release scorecard and if-then notes you can maintain in an hour a week.