Macroeconomics and Forex: Harnessing the Connection for Profit
September 12, 2019
Macroeconomics and Forex share a strong bond. Moreover, it's a bond that traders can exploit to generate profits. In fact, it's a bond that must be exploited. It's very risky to engage in Forex trading (or any other type of trading) without considering the economy.
It's not simple, though. Beginners, in fact, often don't even know where to start. In this article, we provide an overview of the relationship between macroeconomics and Forex, offering precise tips and guidance on integrating its study into your trading activity.
What is Macroeconomics?
The term macroeconomics is technical. Many have heard about it for the first time at university, where (in economics degree courses) it represents one of the most feared subjects. The concept, however, is more concrete than it might seem. In fact, for traders, it's so concrete that it requires thorough and regular analysis.
Macroeconomics is the study of the economic system at an aggregate level, i.e., considering broad population groups and equally broad classes of actions, both governmental and private. In short, it's the analysis of the most general parameters of the economy. It contrasts with microeconomics, which instead studies the behavior of individual economic operators.
Doing macroeconomics means studying certain indicators. Here are the main types of macroeconomic indicators.
Income. Income indicators consider the set of products made and the set of services provided by both public and private entities. The main indicator is the Gross Domestic Product. This parameter, as evidenced by frequent mentions even on generalist platforms, assumes fundamental importance. In fact, it's considered, perhaps a bit arbitrarily, as the indicator capable of summarizing a country's economic strength.
The labor market. This class of indicators takes into account the employed, the unemployed, and the inactive, both from a qualitative and quantitative point of view. The most important labor indicators are the unemployment rate, the employment rate, and the change in the number of employed. In some economic systems, parameters related to unemployment benefits (e.g., in the United States) or payslips (e.g., in the United Kingdom) also assume some importance.
Consumption. The most important indicator in this category is represented by sales, which is in fact the change in the value of goods sold. This is an important parameter as it provides a snapshot of the strength and sustainability of the economic system. The economic system can only grow if commerce generates good performance, if people are buying, etc.
Prices. The reference indicator is inflation, i.e., the change in retail prices. The importance is not only "macroeconomic," i.e., capable of affecting the health of the economic system, but also concerns monetary policy, which is determined precisely on the basis of inflation. A certain role, especially in a predictive function, is played by the producer price index, which is simply inflation detected at an earlier point in the supply chain.
Exports and Imports. Trade relations with foreign countries can impact the health of the economic system and, above all, the balance it manages to express. The main indicators are exports, imports, and the trade balance.
Currency. The stability of the currency or, more often, fluctuations against other national currencies affect the health of the economic system, the general characteristics of the economy, and the ability to attract investments.
The Relationship Between Macroeconomics and Forex
The link between macroeconomics and Forex is a fact that proceeds from empirical evidence, from technical issues (very complex), and even psychological ones.
First, it should be noted that today (but this was also true in the past), markets cannot be considered as watertight compartments. Everything is connected; all asset classes, certainly in the most varied ways and measures, influence each other. This relationship also extends to extra-trading dimensions, such as those of macroeconomics. It happens in bonds and stocks; it obviously happens in Forex.
In some cases, the link is more direct and decidedly more technical. For example, price changes push the central bank to act on the cost of money, and actions of this type directly impact the value of the currency. From here, a domino effect also hits the sphere of psychology. We're talking about inflation expectations, monetary policy expectations. All elements capable of moving investors in one direction or another.
Macroeconomics and Forex: Indications and Advice
How to exploit the relationship between macroeconomics and Forex to your advantage? Simple, with fundamental analysis. Well, simple up to a certain point, since this activity, which does not oppose but rather integrates technical analysis, is very complicated to analyze.
It's still a matter of studying market movers, i.e., macroeconomic indicators that are issued with a certain regularity, to grasp their outcome in advance and, consequently, their impact on currencies.
To do this, you need to know what to analyze and how to analyze it. Let's start with how.
How to Analyze
The issue of correlations. Obviously, it's not possible to analyze all macroeconomic indicators; you need to make a selection. Specifically, you need to choose only those that have a close relationship with the currency, which therefore generate a strong impact on it. The issue of correlation develops on two tracks: belonging and influence. Belonging, because it's the indicators of the economy to which the currency belongs that generate the greatest impact (e.g., US GDP for the dollar); Influence, because some economies impact Forex, or certain currencies, regardless of the currency's "technical" belonging to the economic system. For example, Chinese GDP is important for the Australian dollar, since Australia exports a lot to China.
History as a resource. The secret of fundamental analysis is to predict the outcome of indicators, in order to predict price movements. Prediction, however, is intended as the result of study and estimates. How to predict the outcome of market movers? The only way is to study historical data and policymakers' statements.
Studying context as a resource. However, it's also necessary to study the market context. That is, to draw an imaginary thread that links the market context to the economic and political context, or reveal the existing thread. The reason is simple: if these two vessels "communicate," and policymakers have not been sparing in their statements, it's possible that investors may discount macroeconomic changes in advance. So a terrible GDP figure, but widely announced, will not move the waters at the time of its publication, as investors have already taken action.
What to Analyze
GDP. Gross Domestic Product affects Forex in a somewhat linear manner. Also because it's considered by everyone (traders, investors, analysts, politicians) as the indicator that best offers an overview of a country's economic health. The correlation is very simple: when GDP rises, and especially rises beyond expectations, the impact is bullish; when GDP disappoints or even stagnates/decreases, the impact is bearish.
Unemployment rate and employment rate. The impact, in this case, is very strong. The reason is simple: the labor market reacts slowly to macroeconomic changes. This is evidenced by the unemployment rates of some countries like Germany and the United States, which have been stuck at the same numbers for several months. In any case, the correlation is very simple to understand: when the labor market improves (employment rises or unemployment falls), the impact is bullish. Otherwise, the impact is bearish.
Inflation. It's probably the single most important macroeconomic indicator. In fact, it not only provides an overview of a country's economic health but even guides monetary policy choices. Specifically, when inflation moves away from the 2% annual target (judged to be the best possible increase in terms of growth), the impact on the currency is bearish. If it gets closer, the impact is bullish.
Trade balance. Although often overlooked, it's an important impact in terms of Forex. In fact, changes in balances correspond to changes in the money supply, which in turn (by the law of supply and demand) generate changes in the relationships between currencies.
Monetary policy. It's the single most important indicator of all. When the central bank changes interest rates or directly injects money into the system, the impact on currencies is visible and significant. Specifically, a rate cut or an increase in Quantitative Easing (if any) corresponds to a weakening of the currency; a rate hike or a decrease/interruption of QE corresponds to a strengthening of the currency. The impact is also psychological. In general, central bank policymakers only need to give a hint about monetary policy to trigger reactions. This phenomenon, not by chance, is called forward guidance and is used by central banks to intervene in the market with a view to balance.
