Forex Trading and Economic Indicators

The publication of economic data is the be-all and end-all of fundamental data in trading. However, not all indicators are equally important. In this article, we will discuss the most important indicators. Important in this context means market moving.

Check the economic calendar of IC Markets in our review

What are economic indicators?

Economic indicators are statistics on economic activity. They are regularly published by government agencies and private organisations and are crucial drivers in the financial markets.

Research has shown that specific economic indicators have a significant impact on currency fluctuations and the direction of trading.

Hundreds of these data points are published each month. There are three types of indicators: leading, lagging and coincident.

  • Leading indicators typically signal possible future economic changes. These statistics will often change before an economy does.
  • Lagging indicators have a drather elayed response to changes in an economy.
  • Coincident indicators alter at the same time as the economy changes. It shows the current state of an economy.

Not all economic indicators are equally important. Some are much more important than others.

Let’s look at the most relevant indicators for us traders.

Statements of Central Banks

The monetary policy statements of the central bank are one of the most critical indicators. So why are central banks so important?

Central banks are responsible for a country’s monetary policy. This means that they control the money supply in the economy. So the central bank can take money out of the economy or lead it there. It can also control the attractiveness of investments and borrowing via key interest rates, depending on whether the economy is doing well or badly.

Monetary policy can be both restrictive and expansionary.

During a restrictive policy, interest rates are raised to counter rising inflation. In contrast, an expansionary policy aims to promote economic growth through low interest rates.

The central bankers try to inform the markets about future changes in monetary policy. According to the ECB, this is commonly referred to as “forward guidance”.

The Federal Reserve began using forward guidance in the early 2000s. In Europe, the ECB started using it in July 2013.

Why is transparency so important? Retailers can react illogically if there are surprises in the markets.

One example was the surprising decision of the Swiss central bank to remove a coupling for the EURCHF pair. This decision lead to sharp market volatility, where the currency pair dropped over 30% as a consequence. Many investors had their account balances wiped out as a direct effect of the heavy drop.

The tone and general sentiment given by central bankers is also important. The markets are trying to determine whether policymakers are taking a positive or negative view of future interest rates.

When central bankers argue for higher interest rates, they are referred to as “hawks”. When they ask for lower interest rates, they are called “doves”. “Hawkish” statements usually cause currency appreciation. However, if monetary policy is “dovish”, a currency devaluation occurs.

Interest rate decisions

Interest rates and key rates, in particular, are a big deal and any trader should understand the impact of key rates on the equity, bond, currency and commodity markets. Interest rate adjustments are probably the most critical indicator in Forex trading as they can have an enormous impact on currencies.

Investors are always looking for a better return on their investments. When a country raises its interest rates, it attracts foreign investment. If interest rates are low, this usually leads to an increase in economic growth. As the economy expands, it should generate capital inflows into the local currency. This means that the timing of interest rate changes is critical.

If interest rates rise early in an economic cycle, this is positive for the currency. Late interest rate hikes in a business cycle do not have the same effect.

Consumer Price Index (CPI)

The CPI is the most often used measure of inflation. The CPI tracks the price change of a shopping basket between two periods. One of the most relevant CPI figures is the year on year figure. As an example, a CPI year-on-year (YoY) of 1% means that prices have increased by 1% compared to the same time in the previous year.

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The basket measured in the CPI covers a wide range of goods and services. These include items such as food, clothing, transport, education, energy, health and housing.

The CPI is seen as a lagging indicator. However, this doesn’t mean that it is not as important as other leading indicators.

Price stability is a common mandate of most central banks, and they also have specific inflation targets. An inflation rate of 2% is an ideal target for industrialised countries. As inflation rises, so do expectations for interest rates. With weak inflation well below 2%, the opposite happens. Inflation is one of the essential metrics for deciding on monetary policy. Interest rates are the most common instrument used by central banks to control inflation.

If inflation is too high, central banks usually raise interest rates. If inflation falls too far below its target, they typically lower interest rates.

We already know that currencies fluctuate with interest rate expectations. Due to the inflation targets, the publication of the CPI can lead to large movements in the markets. This makes inflation one of the most powerful indicators for Forex traders.

Gross domestic product (GDP)

Gross domestic product is the total value of all goods and services produced within an economy. Some consider the GDP to be a delayed indicator while others classify the GDP as a coincident indicator.

According to Reuters, the delay in some GDP components does not diminish its importance or impact on the markets. The CME Group explains that the GDP is “the scorecard of a country’s economic performance”. As a pro-cyclical indicator, GDP moves in the same direction as the economy. This means that if the economy is doing well, it should grow. If the economy slows down, it should decline.

The most common method of measuring the GDP is the rate of change in per cent. A GDP QQ growth rate of 2% means that an economy has grown by 2% from quarter to quarter.

Besides inflation, the central banks are paying more attention to the growth rate of an economy. Too little growth could require a more expansionary policy. If growth is too high, a restrictive policy (rising interest rates) may be necessary.

Labour market data

Two employment indicators are significant. The first indicator is the unemployment rate and the second the change in employment.

Governments usually monitor changes in employment monthly, while some central banks track changes only once a quarter. The unemployment rate signifies the percentage of unemployed workers in an economy. Typically, the unemployment rate is published together with the changes in employment.

Employment indicators are considered as lagging indicators. They usually take longer to show the impact of changes in an economy.

Employment figures can lead to very high volatility in the markets. The US Non-Farm Payrolls (NFP) is a perfect example. NFP measures the total number of employees in US companies, excluding workers such as government employees, farmworkers and NGO employees.

The NFP can drastically affect volume, volatility and price direction. The USD moves mainly when the data is published, but we also see regular swings in gold and stock markets.

The reason why these data create such volatility in the markets is that central banks attach great importance to employment figures. Employment is also part of the mandate of many central banks including the ECB, the Federal Reserve, RBNZ and the RBA.

These reports are essential economic publications to keep track of every month.

Purchasing Manager Index – Manufacturing and Services

The Purchasing Managers Index (PMI) is an important leading indicator. The PMI is a survey compiled from questionnaires sent to hundreds of purchasing managers where they evaluate the business situation in their respective industries. They are asked to comment on employment, production, inventories and order intake.

When companies start to worry about an economy, it appears in the PMIs. The PMI’s can provide a leading indicator of economic activity and often lead to direct intraday market movements.

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There are two things we need to bear in mind when evaluating PMI data:

PMI publications need to be assessed in line with the business cycle of the economy. If an economy is in an expansion cycle, a high PMI might not mean much because it is typical for expansionary periods having higher PMI numbers.

Highly relevant are PMI data that deviate from current cycle expectations. The 50 level is crucial for PMI data. A measured value above 50 indicates the extent and below 50 the contraction.

Retail Sales

Retail sales are a measure of all retail sales in a given period and are considered an early indicator.

Retail trade tracks the rate in change of turnover as a percentage. Retails Sales year-on-year (YoY) of 2% means that retail sales have increased by 2 per cent from year to year.

Why are retail sales considered an important indicator? The answer is consumption. According to the World Bank, around 60% of the total GDP comes from consumption. However, the figures vary from country to country. In the US, consumer spending accounts for about 70% of GDP. In the EU it is only about 57%.

The retail sector can show us when the general economic conditions will change. It also tells us when interest rates or inflation are too high or too low.

When interest rates rise, people pay more for their mortgages and debts, and this affects their disposable income. If inflation increases, consumers will be able to buy fewer things at the same income, and this also affects disposable income. If consumers start spending less, we can expect a decline in economic growth.

Average Earnings

The average income corresponds to the change in wage growth in an economy.

Why is wage growth so important? It is due to the impact that wages can have on growth and inflation expectations. Consumer spending is a key growth driver in developed economies. If people earn more money, they can spend and invest more.

An interesting point is the influence of average earnings on wage inflation. Many economists believe that wages often lead to inflationary pressures. Both the ECB and the RBA see wage growth as a prime cause of higher core inflation.

However, according to a Riksbank study, this is not the case. The study found no empirical evidence that wage growth leads to inflationary pressures. So why should we focus on average earnings then? The reason for this is expectations and speculation. The only thing that is important in trading is to know how the market sees or anticipates things. If central banks focus on wage increases, we should do the same.

That can give us great trading opportunities. If wage growth rises or falls, it will have a direct impact on inflation expectations.

In February 2018, global equity markets fell by more than 10% in a matter of days. A surprising rise in average wages raised fears of higher, future interest rates. In the Forex market, the currencies concerned rose accordingly.

Confidence and Sentiment Indicators

There are many confidence and sentiment indicators for consumers and businesses. There are different indicators for different countries. Here are a few of them:

  • Business Climate Index (compiled by the OECD for most countries)
  • Consumer Confidence Index (compiled by OECD for most countries)
  • Consumer Confidence Survey (prepared by the Conference Board for the USA)
  • Consumer survey (compiled by the University of Michigan for the USA)
  • New economic assessment & framework conditions (surveyed by Zew Finanzmarktstudien für Deutschland und die EU)
  • IFO Business Climate Index (prepared by the IFO Group for Germany)
  • ANZ Business Outlook (created by ANZ Investment Bank for New Zealand)
  • Westpac Consumer Sentiment (compiled by Westpac Investment Bank for Australia).

The surveys serve as a mood barometer. Consumers and companies are asked about their future economic expectations. Confidence and sentiment are key early indicators since sentiment is a key driver of an economy.

These indicators are useful for estimating possible changes in the economic cycle. Higher interest rates and inflation at an economic peak should be reflected in sentiment.

Therefore, significant deviations in sentiment indicators can provide excellent trading opportunities.

Stock Markets

The stock market is regarded as one of the most important leading indicators. As a rule, stock markets begin to rise before an economic recovery. Vice versa, they also start to fall before an economy goes into recession.

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However, fluctuations in the stock markets are not always in line with the economy. There are regular exaggerations in terms of price performance. Stocks are very useful for traders as an indicator of risk sentiment. When news or events cause uncertainty, many investors become nervous and shift capital.

As a result, they move their capital away from risky assets and prefer safe investments (such as gold for example). This is known as a risk-off sentiment.

When news or events lead to optimism in the markets, traders want to take more risk. This means that they are moving capital away from security and towards riskier investments. This is then referred to as risk-on sentiment.

Since stocks are considered risky assets, equities are one of the first asset classes to respond to risk.

Below is an overview of typical safe-haven investments that are in demand for risk-off sentiment:

  • The Japanese Yen and the Swiss Franc
  • Government bonds from developed economies
  • Gold

And in return, here are the most common assets that typically rise during the risk-on markets:

  • Equity markets (mostly global equities)
  • High beta currencies such as AUD, NZD and CAD
  • Raw materials such as oil

Reactions in global equities can precede movements in risk-correlated currencies. This makes equity markets an essential indicator for Forex traders.

Commodity Prices

What do commodities have to do with foreign exchange trading? Commodity data can have volatile effects on currencies. Certain countries are important producers of specific commodities. As a result, fluctuating commodity prices can affect individual economies.

Let’s look take oil as an example. When a country is a large oil producer, its economy is largely affected by oil prices. This also applies to other commodities. Canada is a major oil producer, and very often, if the price of oil fluctuates, it affects the Canadian economy. So when we discover news about the oil market and see a reaction in WTI, Brent, etc., it often has an impact on the development of the Canadian dollar (CAD).

Commitment of Traders Data

The CFTC report shows the overall positioning of the futures contracts and it contains data for a large number of markets.

The report is published every Friday by the Commodity Futures Trading Commission (CFTC). The report covers futures positions for three different market participants:

  • Non-Commercial Traders (Hedge Funds, Professional Traders)
  • Commercial dealers (banks, institutions, companies)
  • speculators (retailers)

It is important to note that the CFTC data published on a Friday contains only data from the previous Tuesday. This means that the data has a delay of three days!

The main advantage of the report is to see the net position. This means that you need to understand when there are net short or net long positions on currencies. If the markets are building record net positions on a currency, then we have to be careful. Extreme net short or long positions usually don’t last long. At some point, extreme positions will either reverse or take a breather, and this gives traders a market edge.

In order to be able to trade the economic data and react to the market successfully, we recommend that you have an economic calendar in mind (or better on the screen) at all times. Be sure to know when important data is being released and keep an eye on the overall market situation. As said, countless intra-day trading opportunities are available with these indicators, and you can make decent profits if you’re able to react to the release of such data. There are various ways how to trade the news. Be sure to select one that suits your style and that you’re comfortable with.

In the end, it doesn’t matter if you’re swing trading short-term market volatility or if you’re going with the trend. What matters is, that you are aware of factors that are likely to cause volatility and that can trigger massive reactions in the markets or that can even change a primary trend. The worst thing you can do as a trader is entering the markets unprepared and unaware of economic events.

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