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• Glossary

Economic Indicators and their Affect on Forex Prices

Economic indicators are important to forex traders, as they represent vital data in evaluating the underlying strength or weakness of a currency’s economy. While their use short-term is highly subjective, using them as a gauge for long-term trends can be very effective.
 
These indicators usually fall into two categories: Trade Indicators and Capital (cash) flow indicators. From an economic perspective this should make sense. Trade and capital flows are two sides of the balance of payments for an economy. The balance of payments for any economy tracks all the money moving in or out of an economy. An increase of money moving out of an economy will be bad for the currency while an increase in the money coming into the economy will be good for a currency.

Trade indicators tell us what is going on with the current account or first half of the balance of payments. Capital flows report what is going on in the capital account or the second half of the balance of payments. All economic indicators will provide information about one side of the balance of payments or the other and sometimes both.
 
 
Trade Indicators
 
There are a few indicators that offer insight into a country’s trade activities, but the most useful is Trade Balance. If an economy is exporting more than it is importing, demand for that economy's currency will increase, which will increase that currency's value.

If an economy is importing more than it is exporting, demand for that economy's currency will likely decrease, which will decrease that currency's value. This indicator is usually released monthly by each economy, and it basically tells you the difference in value between a country’s imports and exports.
 
 
Capital Flow Indicators
 
Consumer Price Index:
 
The Consumer Price Index measures the average price of goods and services purchased by consumers in the United States. It is used as a primary measure of inflation.
 
CPI can lead to price changes in the forex in a couple of ways. First, like all announcements, if CPI misses or exceeds expectations the market for the currency will respond to it immediately. But it can be volatile during announcement days, leading to "whipsaws" or a lot of big price moves up and down.
 
CPI's long term predictability partially rests on the normal cycle of economic growth. In most market conditions, economic growth leads to higher wages, employment and spending which leads to higher interest rates and yields and a more valuable USD.

But CPI is subjective. The CPI measure looks at a number of different consumer items and calculates their price changes within a basket with different weightings attached to each item. That sounds simple but it is completely subjective and therefore often can be very misleading.

Additionally, comparison to another currency’s underlying economy is difficult.  CPI in the U.S. is not the same as CPI in the Euro-zone, China or any other economy. This makes comparison very difficult which is problematic for forex traders who trade currency pairs.
 
Non-farm Payrolls:
 
The NFP report tells us how many jobs were added or lost from the U.S. labor force. Obviously, a decline in jobs is a bad thing for the economy and a string of negative reports month after month is indicative of a recessionary environment.
 
The report comes out twice each month; the official government source (BLS) releases their version on the first Friday of each month and a private analysis from ADP (an outsourced payroll processing firm) appears on the Wednesday before the first Friday. These reports are developed from independent data sets but with a similar methodology.
 
The reports are not statistically very sound and are subject to major revisions, however the capital markets will often experience significant volatility each report date. The long term effects on trend can be more reliable and are easily seen in equities and other "high risk" positions like the short JPY based carry trade.
 
Other economies have versions of employment or labor reports that are similar to the Non-farm payrolls report in the US. You should treat them the same way but they may have a subtler impact on the forex market.
 
Interest Rates:
 
Each economy has a Central Bank which manages its monetary policy. Typically this involves targeting or setting interest rates. In the United States the central bank is the Federal Reserve.
 
Central banks also control rates by injecting cash into their economies. The more cash an economy has available, the more likely they are to lend. Banks don't make money by sitting on cash. They make money by deploying that cash and charging interest and fees. When the Fed, or any other central bank injects huge amounts of cash into the banking system, banks begin lending that money.
 
A lower effective Federal Funds Rate means businesses can borrow money at a lower rate, merger and acquisition deals can find capital, and hedge funds can borrow money to leverage their accounts. The hope is that lower rates in the long run will help keep the economy growing.
 
But in the short term, this has a negative impact on the currency. If one country’s rates are much lower than another, cash will move out of the economy with lower rates and into one with higher rates, which means higher returns from bonds and like-instruments.

Think in terms of the trend
 
More than anything, it’s important to take these indicators as factors in your analysis, but not trading signals. Placing trades to take advantage of an economic announcement is very difficult and very risky.
Instead, use these indicators to identify longer-term trends. If the USD has been declining steadily and labor reports have been bad, another bad labor report likely means a weak USD. But a positive labor report might mean you should pay more attention to your risk exposure in short USD postions. 

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