- Different Types Of Forward Guidance - July 11, 2020
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- Another Example Of Why Expectations Are So Important - July 10, 2020
Are you afraid of trading economic news events? Maybe you were taught that it’s best to avoid risk events in trading altogether.
If you relate to the above questions, then this article is for you.
Economic Indicators should not be avoided in trading. They can provide some of the best trading opportunities.
How can we learn to trade these events? With the help of Fundamental Analysis.
We believe Fundamental Analysis is an essential tool in Forex Trading. It allows traders to understand why markets are moving.
Economic data releases are the bread and butter of the Fundamentals.
Not all indicators are equally important though. In this article, we will discuss the 15 most influential indicators.
The points we will discuss in this article:
- Economic Indicators Explained
- Central Bank Policy Meetings
- Interest Rates
- Consumer Price Index
- Gross Domestic Product
- Employment Change and Unemployment Rate
- Average Earnings
- Manufacturing & Services Purchasing Managers Index
- Retail Sales
- Confidence and Sentiment Indicators
- Stock Markets
- Industrial Production
- Commitment of Traders Reports (CFTC) Data
- Commodity Data
- Bonds and Bond Yields
- The correct way to use Economic Indicators
Economic Indicators Explained
According to Wikipedia, Economic Indicators are statistics on economic activity.
They are released periodically by government agencies and private organisations.
They are critical drivers in the Financial Markets.
The CME group confirmed this in a study done in 2013. They found that specific economic indicators significantly affect currency volatility and trade direction.
Hundreds of these data points are released every month. There can be anything from 100 to 200 scheduled indicator releases every week.
There are three types of indicators namely; leading, lagging and coincident.
- Leading Indicators usually signal possible future economic changes. These stats will often turn before an economy does.
- Lagging Indicators typically have a delayed reaction to changes in an economy.
- Coincident indicators change at the same time as the economy. It shows the current health of an economy.
Not all economic indicators are equally important. Some have much greater importance than others.
We will discuss the 15 most essential ones in this article.
Central Bank Policy Statements
Central bank monetary policy statements are one of the most critical indicators. So, why exactly are central banks important?
They are responsible for a country’s monetary policy. This means they control the supply of money in the economy.
Monetary policy can be both contractionary or expansionary.
Central bankers try to guide markets about future monetary policy changes. According to the ECB, this is referred to as forward guidance.
The primary purpose for it is to make sure markets are not caught off guard. In a 2014 study, over 74% of surveyed central bankers said transparency was a vital part of monetary policy.
The Importance Of Central Bank Statements
Why is transparency so important? Traders can react illogically when there are surprises in the markets.
An example of this was the SNB’s surprise decision to remove a currency floor on the EURCHF pair. The surprise saw the pair drop over 30% and caused severe market volatility.
Despite this, some central bankers do not agree. Governor Poloz of the BOC advocates less guidance.
He explains economic models don’t account for the uncertainty in financial markets. The uncertainty warrants less guidance.
The tone that central bankers take is also important. Markets try to establish whether policymakers are positive or negative about future interest rates.
Below is an example of the impact of Central bank statements.
The EURUSD fell 240 pips in one session in June 2018. This happened when the ECB pushed back their future rate hike path.
Hawkish policy and statements usually cause currency appreciation. If policy and statements are dovish, they typically have the opposite reaction.
This makes central bank policy statements an essential indicator for forex traders.
This is a big one. Interest rate adjustments are probably the most important indicator in Forex Trading.
Changes in interest rates can have tremendous impact on currency values.
Investors are always looking for better returns on their investments. When a country raises interest rates, it attracts foreign investment.
Currency values usually appreciate when interest rates go up.
When interest rates are low, investors don’t want to invest. As a result, this causes less demand for the local currency.
The effect of interest rates should be evaluated with the business cycle. Rates can have different impacts on a currency depending on the business cycle.
If rates are low, it usually causes a boost to economic growth. As the economy expands, it should create capital inflows into the local currency.
This means the timing of interest rates are crucial.
When rates are increasing early in a business cycle, it is positive for the currency. Rate hikes very late in a hiking cycle will not have the same effect.
Consumer Price Index (CPI)
According to Investopedia, CPI is the most commonly used measure of inflation.
The CPI tracks the change in prices of a basket of goods between two periods. A CPI YY of 2% means prices increased 2% from the previous year to present.
The basket measured in the CPI includes a broad range of goods and services. It includes things like food, clothing, transportation, education, energy, healthcare and housing.
CPI is considered as a lagging indicator. However, this does not mean that it is less important!
Price stability is a common mandate shared by most central banks. Most of them also have specific targets for inflation.
Central banks will change monetary policy to keep inflation close to specific targets. An inflation rate of 2% is considered an ideal target for developed economies.
Inflation is one of the most important metrics used to decide monetary policy. Interest rates are the most common tool Central Banks use to adjust inflation.
When inflation is too high, central banks usually raises interest rates. If inflation falls too far below their target, they usually cut interest rates.
We know currency values fluctuate with interest rate expectations. Due to inflation targeting the CPI release can cause big moves in the markets.
Below is a recent example of the impact CPI releases can have.
The USDCAD pair jumped 85 pips in 30 minutes. This came due to a surprise fall in Canadian CPI numbers.
As inflation rises the expectations of interest rates rise as well. The opposite of this is also true.
This makes inflation one of the most influential indicators for traders.
Gross Domestic Product (GDP)
Gross Domestic Product is the total value of all the goods and services produced within an economy.
According to Focus Economics, it’s the most widely used measure to track economic activity.
It is most commonly measured using the expenditure method as seen below.
Some consider GDP to be a lagging indicator. Other classify GDP as a coincident indicator.
They further explain that GDP is “the scorecard of a country’s economic performance”. As a procyclical indicator GDP moves in the same direction as the economy.
This means when the economy is doing well it should increase. When the economy is slowing down, it should decrease.
The most common way of measuring GDP is by tracking its rate of change as a percentage. A GDP QQ growth rate of 3% means an economy grew 3% from one quarter to the next.
Central banks are very concerned with an economy’s growth rate.
Too low growth could require more expansionary policies. Where too high growth could require more contractionary policies.
Growth numbers can provide another essential consideration for future monetary policy.
Employment Change And Unemployment Rate
There are two employment indicators which are very important to know. The first is the Unemployment Rate and the second is the Employment change.
Governments usually track changes in employment on a monthly basis. Some Central banks only track changes once a quarter.
It measures the total amount of workers added to an economy.
The unemployment rate is the percentage of unemployed workers in an economy. Usually, the Unemployment rate is released with the employment change numbers.
Employment indicators are considered as lagging indicators. They usually take longer to show the effects of changes in an economy.
Employment numbers can be very volatile. The US Non-Farm Payrolls (NFP) is the perfect example of this.
The NFP measures the total number of workers employed by US businesses. This number excludes workers like government employees, farm workers and NGO employees.
According to the CME Group, the NFP is the most volatile of all economic indicators. They explain that the NFP can drastically effect volume, volatility and price direction.
Why are these events so volatile? Central banks place a lot of focus on employment numbers.
These monthly reports are crucial events to keep track of every month.
Average earnings track the change in wage growth in an economy.
Why is wage growth significant? It’s because of the impact wages can have on growth and inflation expectations.
A significant contributor to growth in developed economies is consumer spending. When people earn more money, they can spend more and invest more.
Contracting labour markets are often the cause of a slowdown in economic growth.
The impact of average earnings on wage inflation is an interesting point. Many economists believe that wages lead to inflationary pressures.
According to a Riksbank study, this is not the case. They found no empirical evidence that wage growth led to inflationary pressures.
The Federal Reserve bank of Cleveland came to the same conclusion. They explained that wage growth is not useful in predicting future inflation.
So, why should we focus on average earnings? The reason for this is expectations.
The only thing that is important in trading is knowing how the market sees things. When central banks focus on wage growth, we should too.
That can provide us with great trading opportunities. As wage growth rises or falls it will directly impact inflation expectations.
Below is an example of how Average Earnings releases can impact markets.
In February 2018 global Equity markets fell more than 10% in a couple of days. A surprise jump in Average Earnings caused fears of higher future interest rates.
This can provide us with great trading opportunities. Especially when the changes in wages affect the policy stance of central bankers.
Manufacturing & Services Purchasing Managers Index
The Purchasing Managers Index (PMI) is a significant leading indicator. The PMI is a survey put together from questionnaires sent to hundreds of purchasing managers.
Purchasing managers rate business conditions in their relevant sectors. They are asked to comment on employment, inventories, production and new orders.
Do not underestimate the PMI’s because they are only surveys. Businesses are the first to react to changing conditions.
When businesses start worrying about an economy, it shows up in the PMI’s. The PMI’s can provide a leading gauge of economic activity.
Manufacturing and Services sector PMI’s are the most important.
There are two things that we need to keep in mind when evaluating PMI data:
- PMI releases need to be assessed in line with the economy’s business cycle
When an economy is in an expansionary cycle a high PMI reading might not mean much. This is expansionary cycles usually have higher PMI numbers.
PMI data that deviates from the current cycle expectations are important.
- The 50 level is vital for PMI data. A reading above 50 indicates expansion and below 50 indicates contraction.
Below is an example that PMI releases can have on markets.
The EURJPY pair fell over 100 pips in one trading session. This came after a big miss in German PMI numbers.
Retail Sales are a measure of all the sales in the retail sector for a specific period. It is considered as a leading indicator.
Retail Sales tracks the rate of change of sales a percentage. Retails Sales YY of 3% means Retail Sales increased by 3% from one year to the next.
Why are retail sales an important indicator? The answer is due to consumer spending.
According to The World Bank, about 60% of total GDP comes from consumer spending. The numbers differ from country to country.
In the US consumer spending forms about 70% of GDP. While in the EU it only makes up about 57%.
Retail Sales can show us when economic conditions change. It gives us insight into when interest rates or inflation are too high or too low.
When interest rates go up, people pay more for their mortgages and debt. This affects their disposable income.
When inflation goes up consumer’s money can buy fewer things. This also affects disposable income.
When consumers start spending less, we can expect a contraction in economic growth.
Confidence And Sentiment Indicators
There are many confidence and sentiment indicators for consumers and businesses. There are various indicators for different countries:
- Business Confidence Index (compiled by OECD for the majority of countries)
- Consumer Confidence Index (compiled by OECD for the majority of countries)
- Consumer Confidence Survey (compiled by The Conference Board for the US)
- Survey of Consumers (compiled by the University of Michigan for the US)
- Zew Economic Sentiment & Business Conditions (collected by Zew Financial Market Surveys for Germany and the EU)
- IFO Business Climate Index (compiled by IFO Group for Germany)
- ANZ Business Outlook (compiled by ANZ Investment bank for New Zealand)
- Westpac Consumer Sentiment (compiled by Westpac investment bank for Australia)
Above are just a few examples of the confidence and sentiment indicators.
These indicators survey consumers and businesses. The surveys ask consumers and businesses about their future economic expectations.
Confidence and Sentiment are essential leading indicators. Sentiment is a key driver of an economy.
When consumer and businesses are confident, they tend to spend and invest more. If they are negative about the future economy, they save and refrain from borrowing.
Sentiment indicators are more and less critical in various business cycles. When an economy is expanding, we expect sentiment to be good.
These indicators are useful when gauging possible shifts in the business cycle. Higher rates and inflation at an economic peak should show up in the sentiment.
Consequently, significant deviations in sentiment indicators can provide excellent trading opportunities.
The Stock Market is considered one of the most significant leading indicators.
Usually, stock markets start to rise before an economic recovery. They also begin to decline before an economy goes into recession.
Another key driver for Equities is the future economic expectations. This is not always the case though.
According to Bloomberg, traders should not confuse the stock market with the economy. Furthermore, they explain that stock markets fall and rise for numerous reasons.
However, Stock market fluctuations are not always in sync with the health of the economy.
Equities are very useful for traders as a gauge of risk sentiment. When news or events cause uncertainty it can cause traders to worry.
This causes them to move their capital away from risky assets. During these times investors move money into safer assets.
This is called risk-off sentiment.
When news or events cause optimism in markets then traders want to take more risk. This means they move capital away from safety and into riskier assets.
This is called risk-on sentiment.
Equities are considered as risky assets. Stocks are one of the first asset classes that react to risk.
Below is a list of the most common safe-haven assets:
- The Japanese Yen and Swiss Franc
- Government Bonds from developed economies
Below is a list of the most common assets that appreciate during risk-on sentiment:
- Stock Markets (usually global Equities)
- High beta currencies like the AUD, NZD and CAD
Reactions in global equities can precede moves in risk-correlated currencies. This makes Stock Markets an essential indicator for Forex Traders.
Industrial Production is an essential measure of industry activity within an economy. In the US industrial production makes up 40% of total economic activity.
The components measured typically comprise of the following sectors:
As a result, changes in industrial production can affect employment.
Industrial production is a key input of GDP and economic performance. As a result, Central Banks closely watch these numbers.
This indicator can provide details about the current state and future direction of an economy.
The Commitment Of Traders Reports (CFTC) Data
The CFTC report shows the total positioning of futures contracts. It includes data for a broad range of markets.
- Non-Commercial Traders (Hedge funds, professional traders)
- Commercial Traders (Banks, institutions, corporations)
- Speculators (Retail traders)
It’s important to note that the CFTC data released on a Friday only includes data from that Tuesday. This means the data has a three-day delay.
The main benefit of the report is seeing the net positioning. This means seeing when there are net short or net long positions on currencies.
When markets have record net positions on a currency then we need to pay attention. Extreme net short or long positions usually do not stay that way for long.
Below is an example of a net short position on the Kiwi Dollar.
A few weeks after the net short positioning the Kiwi dollar started a short squeeze. It rallied over 530 pips against the Yen.
Eventually, extreme positions will either reverse or take a breather. This provides traders with an edge in the market.
Imaging that the market has an extreme net short position on a currency. The extreme positioning should be a warning sign to be careful with short trades.
This is because it can take weeks or months to unwind. Therefore make sure to use it as a rough gauge and not a crystal ball.
What do commodities have to do with forex trading? Commodity data can have volatile effects on currencies.
Certain countries are major producers of specific commodities. As a result, fluctuating commodity prices can impact certain economies.
Let us look at oil as an example. If a country is a major oil producer, it’s economy will be impacted by oil prices.
This is also true for other commodities as well. Canada is a major producer of Oil. When Oil prices fluctuate, it affects the Canadian economy.
Below is an example of the correlation between Oil and the CAD.
Another example is Australia and base metals. Australia is one of the world’s major base metal producers.
Iron ore alone accounts for 24% of Australia’s total exports. They are also the fourth largest exporter of copper ore.
As a result, any deviations in base metals prices can affect the Aussie Dollar.
New Zealand Is another excellent example. Over 41% of their exports are animal products.
The biggest of these are dairy products. This means dairy prices can have an impact on the Kiwi Dollar.
It is essential to keep track of commodity prices when planning trades. If oil prices are falling, it might not be a good idea to buy the Canadian dollar.
There are also a few commodity releases that are important to watch:
- Crude Oil Inventories (this indicator is released weekly)
- Global Dairy Trade Price Index (published twice a month)
Bonds And Bond Yields
The bond markets can be another important indicator.
Bond markets are used as a leading indicator. Many people use Bonds to predict economic conditions.
Bond markets usually have close relationships with their respective currencies. This is because bonds and currencies move with interest rates.
As a result, Bond yields can have a direct influence on its local currency.
When bond yields fall the currency usually fall as well. A rise in bond yields normally supports the respective currency.
The bond market can sometimes also indicate possible recessions.
This occurs when short-term yields surpass longer-term yields. It is referred to as an inverted yield curve.
According to Forbes, the 1998, 2000 and 2005 inverted yield curves are a good example. They explain that recessions occurred within 1 to 3 years in all three these examples.
As always there is nothing guaranteed in trading. Similarly, Inverted yield curves are not a magic eight ball.
But inverted yield curves do not necessarily always lead to recessions.
Therefore, they are just indicators letting us know that we need to pay attention.
Housing is an integral part of any economy. Data such as Housing Starts and New Home Sales are considered as leading indicators.
The housing industry accounts for approximately 5% of the overall US economy. Consequently, the demand for housing can tell us a lot about consumer sentiment.
When interest rates rise, the cost of borrowing goes up. This means mortgages become more expensive.
As interest rate rise consumers find it more difficult to invest in real estate. A decline in Housing Starts is often preceded by recessions.
A rise in the housing market during recessions often point to economic recoveries.
This makes it another indicator to keep track of for an economy.
The Correct Way To Use Economic Indicators
Never treat economic indicators like a crystal ball. In short, no indicator will give you guaranteed success.
These indicators are intended to be used as part of a Fundamental method. Therefore, traders need to look at these data points in the bigger picture.
Building a bias for a currency is like building a puzzle. All the pieces are necessary to see the big picture.
Evaluate economic indicators as part of the broader economy. Above all, don’t try to take one indicator out of context.
It’s possible for markets to completely ignore all 15 of these indicators. It all depends on whether they are expecting something or not.
In this article, we learned about the top 15 economic indicators. We also saw why each of them are important for currency traders.
Do not let all of this information discourage or overwhelm you. It will take time to get to know these indicators better.
There are a few ways that you can learn to incorporate these indicators in your trading.
- Find a reliable economic calendar and see when these indicators are released.
- Establish what the consensus is for the events before they are released.
- After the data is published see whether it deviated from the forecast.
- Watch the markets and see how they react to the data.
- Read up on trusted market analysts to hear their interpretation of the data.
- Start building a bigger picture view of each economy.
These steps will get you off to a good start. The important thing is to take your time.
In time the process of keeping track of these various indicators will become autonomous. In other words, it’s like riding a bike.
We wish you all the best with your Fundamental Analysis.
If you have any questions or comments, feel free to let us know in the comment box below.