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I was reading an article in the The Economist about interest rates being set by the Bank of England. Regarding a potential future rise in interest rates set by the bank, the article said:

Markets have factored in a rate increase for 2015, a year sooner than when the central bank expects to raise them.

How do markets factor in a future event, and how can you tell that an event has been factored in?

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At the most fundamental level, every market is comprised of buyers and selling trading securities. These buyers and sellers decide what and how to trade based on the probability of future events, as they see it.

That's a simple statement, but an example demonstrates how complicated it can be. Picture a company that's about to announce earnings. Some investors/traders (from here on, "agents") will have purchased the company's stock a while ago, with the expectation that the company will have strong earnings and grow going forward. Other agents will have sold the stock short, bought put options, etc. with the expectation that the company won't do as well in the future. Still others may be unsure about the future of the company, but still expecting a lot of volatility around the earnings announcement, so they'll have bought/sold the stock, options, futures, etc. to take advantage of that volatility.

All of these various predictions, expectations, etc. factor into what agents are bidding and asking for the stock, its associated derivatives, and other securities, which in turn determines its price (along with overall economic factors, like the sector's performance, interest rates, etc.)

It can be very difficult to determine exactly how markets are factoring in information about an event, though. Take the example in your question. The article states that

if market expectations of higher interest rates tightened credit conditions...

In this case, lenders could expect higher interest rates in the future, so they may be less willing to lend money now because they expect to earn a higher interest rate in the future. You could also see this reflected in bond prices, because since interest rates are inversely related to bond prices, higher interest rates could decrease the value of bond portfolios. This could lead agents to sell bonds now in order to lock in their profits, while other agents could wait to buy bonds because they expect to be able to purchase bonds with a higher rate in the future.

Furthermore, higher interest rates make taking out loans more expensive for individuals and businesses. This potential decline in investment could lead to decreased revenue/profits for businesses, which could in turn cause declines in the stock market. Agents expecting these declines could sell now in order to lock in their profits, buy derivatives to hedge against or ride out possible declines, etc. However, the current low interest rate environment makes it cheaper for businesses to obtain loans, which can in turn drive investment and lead to increases in the stock market. This is one criticism of the easy money/quantitative easing policies of the US Federal Reserve, i.e. the low interest rates are driving a bubble in the stock market.

One quick example of how tricky this can be. The usual assumption is that positive economic news, e.g. low unemployment numbers, strong business/residential investment, etc. will lead to price increases in the stock market as more agents see growth in the future and buy accordingly. However, in the US, positive economic news has recently led to declines in the market because agents are worried that positive news will lead the Federal Reserve to taper/stop quantitative easing sooner rather than later, thus ending the low interest rate environment and possibly tampering growth.


Summary: In short, markets incorporate information about an event because the buyers and sellers trade securities based on the likelihood of that event, its possible effects, and the behavior of other buyers and sellers as they react to the same information. Information may lead agents to buy and sell in multiple markets, e.g. equity and fixed-income, different types of derivatives, etc. which can in turn affect prices and yields throughout numerous markets.

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