Chapter 3-1 Macroeconomic Forex Investing
Although traders and investors influence foreign exchange rates, macroeconomic factors have the greatest effect on supply and demand in the Forex market. There are a number of macroeconomic factors in play and most of these can be grouped into two categories- Economic and Political. Investors analyze a nation’s economic policies and political stability in an effort to determine which currencies are inherently more valuable than the others. This section will cover the variety of macroeconomic factors that influence a currency’s value in this most global of marketplaces.
A nation’s internal economic policy is made up of two main components- fiscal policy and monetary policy. Fiscal policy represents the government’s policies on spending and collecting money. Governments can influence their own economies by varying the amount of money they spend and the amount of taxes they collect. If spending exceeds taxing the fiscal policy is said to be expansionary. If the opposite is true and taxing exceeds spending then the fiscal policy is said to be contractionary. Monetary policy is the method by which a government controls its money supply. Governments vary key interest rates to control the money supply in attempts to either stimulate growth or create stability. A high money supply that is easily accessible stimulates the local economy, but also decreases demand due to excess availability. As a result, the currency depreciates on the global market making it less attractive to investors.
Budget and trade deficits and surpluses influence a nation’s currency by revealing to the global marketplace how under control a nation’s financial situation is. Budget deficits, when spending exceeds intake, generally is frowned upon by investors. Conversely, budget surpluses signal strength and stability and make a currency more attractive to investors. Similarly, a nation’s trade balance influences its currency value by representing how competitive it is in the world economy and how much clout it has on a global scale. Furthermore, strong demand for a nation’s goods and services inherently increases demand for its currency as other nations will need to purchase the currency in order to conduct their business. As a result, an increasing balance of trade (towards surplus) positively impacts a nation’s currency. Conversely, a deteriorating balance of trade (towards deficit) makes a nation’s currency less attractive to investors.
A nation’s inflation rate has a profound effect on the value of its currency in the global marketplace. Inflation is a measurement of the general rise in prices of goods sold in a nation over a given period of time. This is often measured through the consumer price index, or CPI. The Bureau of Labor Statistics defines the CPI as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services”. A good way of thinking of this is tracking how the cost of a family’s grocery list changes from year to year. Rising inflation occurs when goods are getting more expensive. Another way of looking at this is a decline in purchasing power. If a nations currency loses purchasing power it becomes less desirable in the global marketplace. As a result, demand decreases and the currency loses value. Conversely, falling inflation, known as deflation, signals an increase in purchasing power. A currency that can purchase more is inherently more valuable, and this is reflected by a rise in the value in the global marketplace.
When considering the influence inflation has on a nation’s currency it is important to note that governments carefully monitor inflation, and often take action to control rising and falling inflation. A government or central bank may raise short-term interest rates in an effort to combat rapidly rising inflation. Raising interest rates is generally met positively in the world market and a currency’s value appreciates. The opposite is true in times of deflation; if prices get too low central banks may lower interest rates. Lower interest rates are frowned upon in the global marketplace and the currency may lose value. For these reasons, it is imperative for currency investors to pay attention to the interaction of these two indicators in order to know whether to buy or sell rising inflation.
There are a number of economic reports that influence currencies on a short term basis and thus merit the attention of all currency investors. Of these, the most widely followed is the gross domestic product, or GDP. The GDP is the measure of a country’s overall economic production produced within its borders. In essence, the GDP measures any individual nation’s contribution to the global economy. The larger a nations GDP is the bigger its influence on the global economy, which in turn translates to higher demand for a nation’s currency. Currently, the top 5 GDP’s based on currency zones are the United States, the European Union, Japan, China, and the United Kingdom. It is no coincidence that these five economies correlate to the five most heavily exchanged currencies- other nations need to convert their currency in order to do business in these economies. Closely related to the GDP is the GNP, or gross national product. GNP differs from GDP by including all production by a nation’s citizens that occurs on foreign soil. Although GDP and GNP are highly correlated, investors need to consider both when making currency investment decisions. Investors should pay special attention to nations with similar GDP’s but differing GNP’s in an effort to decide between which currencies to invest in.
Consider the following example of a GDP report:
There are several additional reports and indicators that help investors analyze the overall strength of a nation’s economy. A nation’s employment situation is key indicator to the health of an economy. Employment levels, the unemployment rate, and jobless claims are all quantifiable measurements of an economy. The US Bureau of Labor Statistics releases reports on a monthly, quarterly, and annual basis in an effort to inform the investing community, as well as the general public, on the employment situation in the United States. Other world economies release similar reports on the same time frames allowing investors to compare the employment levels across the board.
In addition to employment numbers, investors often look at consumer spending as an indicator of economic health. The most common measures of spending are the retail sales reports and housing market reports. The US Census Bureau and the US Department of Commerce release monthly, quarterly, and annual reports outlining the health of the US retail markets. Strong retail numbers indicate that people are spending their money, often viewed as a sure sign of a strong economy. There are a handful of housing market indicators that investors consider when analyzing the strength of an economy. Housing starts, new home sales, and existing home sales are the most common three indicators. In the United States, the National Association of Home Builders releases a monthly Housing Market Index based on a survey of the general economy and housing market conditions. In general, positive economic data reports on housing and retail correlate to a strong economy and an appreciating currency value.
Forex trading is done on a macroeconomic scale to purchase items abroad that are not sold in your home currency. As a result, many of the world’s commodities and most heavily traded government bonds trade in direct relationships with the US dollar. The most common application of this is the US dollar/gold trade. This makes sense as many of the worlds currencies are, or at some point in time were, backed by gold. Generally speaking, when the dollar appreciates gold depreciates and vice versa- the correlation is negative. Because currencies are traded in pairs, foreign currencies appreciate vs. the US dollar when gold is rising, particularly those of gold exporting nations. Of the major currencies, the Aussie dollar trade exhibits this phenomenon the best as it is among the world’s top 3 gold producers. Compare the AUD/USD and gold charts and you will notice a nearly perfect positive correlation.
The United States is the world’s largest consumer of oil, most of which comes from abroad. Consequently, the price of oil has a significant impact on the US dollar and major oil exporting countries currency values. Of the world’s oil exporters, Canada is the United State’s main supplier and therefore the CAD/USD pairing is most impacted by fluctuations in the price of oil. As US demand for oil increases, imports will increase, demand for Canadian dollars to purchase more oil will increase, and the CAD/USD will appreciate. The same holds true in times of decreasing demand. Canada is heavily reliant on exports and decreasing demand, particularly US demand for oil, often results in the depreciation of the Canadian dollar.
The government debt market is one of the most global securities markets and therefore ties in closely with the Forex market. Governments are constantly selling debt securities to investors, often other governments themselves, around the world to finance projects at home. The interest rate, or yield, is the main determining factor for how strong the global demand for a government’s bonds will be. The more stable a nation’s financial situation is the lower yield has to be to compensate debt-holders for lending money. Conversely, the more risky a nation’s financial policy is the higher the yield has to be to compensate debt-holders for assuming more risk. As a result, changes in yield drive the supply and demand for a nation’s bonds. Demand for a nation’s bonds has a direct impact on the value of its currency as foreign investors will need to buy the currency in which the bond is denominated in order to purchase the bond. Consider US Treasury bonds that normally yield 1%. If the yield were to increase to 1.5% demand for US treasuries would increase, foreign investors will buy more US dollars, and the US dollar will appreciate relative to the rest of the world.
Similar to the government debt market, Forex traders often look at equity markets around the world when making investment decisions. This makes sense as most of the fluctuations in Forex prices are based upon international supply and demand. When an equity market in one part of the world begins outperforming the rest investors take notice and will want to get a piece of the action. As a result, they will have to convert their Dollars, Euros, and Pounds Sterling into the local currency to participate in that market. Demand for the local currency will strengthen and as a result money will flow out of the underperforming markets in into the outperforming markets. Conversely, if international investors see weakness in an international equity market abroad they will quickly look to remove their funds, creating an excess supply of the local currency and thus devaluing it against the rest of the world.
The following indexes should be considered when looking for Forex trading opportunities: