Currencies always trade in pairs, while metals and commodities usually trade against the Dollar. For example, asking about the value of the Euro today is meaningless, it only makes sense to ask about the value of the Euro with respect to the Dollar or the Sterling. In contrast, a barrel of Oil or an ounce of Gold are measured in Dollars.
The main currency quotes are:
EUR – Euro Area, Euro
USD – United States, Dollar
GBP – United Kingdom, Pound (or Sterling)
JPY – Japan, Yen
CAD – Canadian Dollar (or Loonie)
AUD – Australian Dollar (or Aussie)
NZD – New Zealand Dollar (or Kiwi)
Thus, the EURUSD currency quote, means that it looks at the value of one Euro against the Dollar, while the AUDCAD means that it observes the value of one Aussie Dollar against the Loonie. Thus, if EURUSD stands at 1.12 it means that one Euro buys 1.12 Dollars at this point in time.
Long and Short
Long means that the trader is betting that the first part of the currency pair (see previous question) will appreciate in value, while Short means that the trader bets that the first part of the pair will depreciate.
Bid, Ask, and Spread
When a trader seeks to buy a currency he uses the Ask price, while when the trader seeks to sell a currency he uses the Bid price.
An easy way to think about this is that when a trader want to buy he has to ask about the price others are willing to sell the currency to him; when wishing to sell he has to get the price other are bidding for the currency.
At times, the Bid and Ask prices differ significantly something that may make it more difficult for a trade to reach its target.
The difference between the Bid and Ask prices is called the spread
What Are Lots?
Forex trading is usually conducted sizes specified as standard lots.
A standard lot refers to 100,000 units of the currency the trader seeks to buy or sell.
For example, if the Euro – Australian Dollar exchange rate is at 2, meaning that one Euro can purchase 2 Australian Dollars, a trader seeking to purchase a standard lot of Aussie Dollars whilst holding Euros would have to pay 100,000/2=€50,000.
Similarly, if the EURUSD exchange rate is at 1.15, meaning that one Euro can purchase 1.15 US Dollars, if someone holds Dollars and wants to buy a standard lot of Euros he would have to pay 100,000*1.15=$115,000.
There are also smaller denominations of standard lots, namely mini lots, which refer to 10,000 units of currency, micro lots, which refer to 1,000 units of currency and nano lots which refer to 100 units of currency.
It is the trader’s job to select the appropriate lot size for his investment, taking into consideration the size of his position and the overall balance of his account.
Pips and Ticks
A pip (identical to a tick) is referred to as the fourth number, after the decimal, in a currency pair. For example, if the EURUSD pair is trading at 1.2345, a one-pip movement would mean that the pair would move to 1.2346.
Similarly, a 10-pip move from the AUDCAD 0.9569 level would mean that the pair would now trade at 0.9579. Some brokers show more decimal places, e.g. 1.23456, where the last decimal is just a tenth of a pip.
The only currency which does not abide by this rule is the Yen, where a pip refers to the second decimal place. For example, if the USDJPY pair trades at 111.91, a one-pip move would mean the pair is now trading at 111.92.
Pips are significant when it comes to calculating profits and losses. In the case a trader creates a short position using a standard lot in the EURUSD pair, which stands at 1.2345 it means that a 1-pip move up, i.e. to 1.2346 would cost him $10. In contrast, a 1-pip move down, i.e. to 1.2344 would gain $10 for the trader. In a similar manner, a one-pip move would cost $1 per mini lot, or $0.1 per micro lot.
Unfortunately, this standardization of Pip impact holds just for the EURUSD pair. In other cases, the impact of a pip on a trader’s position change is highly dependent on the current market price. For example, if the USDJPY pair is at 119.80, a one-pip movement would amount to approximately $8.34. If the USDJPY pair is at 115.00, a one-pip move would amount to about $8.70. For the interested reader, the formula is:
Effect=Pip(0.01 or 0.0001 depending on pair)/Price×100,000
Fortunately, almost all brokers provide this information to their clients so that they do not need to go through this on their own. Still, traders need to know the potential impact from a one-pip movement to their position, given that it can greatly affect their balance, or, in the case the move is large enough, wipe them out.
Think of leverage as a short-term loan. In essence, if a trader deposits $1,000 with a broker and wishes to trade a standard lot of the EURUSD pair, the broker needs to effectively “lend” this money to the trader. The $1,000 deposit is called the margin and it is viewed as the security the broker requires to lend you the additional $99,000.
In this scenario, for every Dollar deposited, the trader can trade in a multiple of 100. Thus, if he deposited $10,000 he could have placed an order of $1,000,000 (10,000 multiplied by 100) or 10 standard lots. In this case, we say that the leverage is 1:100. If leverage was 1:50 it would mean that if the trader deposited $500 as margin, he would be able to place order of $25,000 or 2.5 mini lots.
Account Equity and Account Balance
Equity is simply the current value of the trading account and it shows how much more money we have available for other trades. This means that if the trader has any open positions (trades), equity will fluctuate with every movement of the pair he or she is trading.
When the trader does not have any open positions, Account Balance and Equity are the same. Once a position is opened then Account Balance does not change, as it only reflects closed positions.
For example, if our starting Account Balance is $10,000 and we have one micro lot open with a gain of $10, then our Equity is current Account Balance is still $10,000 but our Equity would be $9,010. Once we close the trade, both Equity and the Account Balance would stand at $10,010.
What is the Swap?
A swap rate is simply the money one pays or receives when holding a specific currency. These pre-specified rates change on various instances across different brokers and essentially reflect the difference between the interest rates of the two countries which make up the pair.
What is Account Free Margin?
Suppose that we have deposited $1,000 in our account and want to go long GBPUSD by opening a mini lot. If the GBPUSD pair trades at 1.40 then we would need $14,000 to open a mini lot. If our leverage is 1:100 then the maximum we would be able to trade would be $100,000 with our existing funds, thus we have more than enough (including leverage) to do that trade.
If we proceed to do it then we do not have to commit all of our funds, but just a percentage. In this case, for a 1:100 leverage we would only have to commit $140 of our total deposits. This means that we need to commit $140 as Margin, but still have $860 of Free Margin.
This Free Margin money can be used to open other positions, so long as the positions do not exceed the maximum amount of levered lots we can buy (here $100,000 or one standard lot).
Stop Loss and Take Profit Orders
Stop Loss and Take Profit are pre-specified orders which specify when a specific trade should close.
For example, if we are long EURUSD, currently at 1.1205, we may set the Stop Loss at 1.1225, so that we earn 20 pips, and the Stop Loss at 1.1195 so as not allow the losses to eat much of our balance.
Stop Loss and Take Profit orders are important to protect the trader’s capital as well as to specify exit points and not let the position run. Proper risk management techniques require the use of at least the Stop Loss order so that traders are not wiped out from losses arising from a single trade gone wrong.
What Volatility is and Why it Matters
Volatility, simply put, measures how much a series (whatever series that may be) fluctuates. More particularly, by fluctuating we mean how much it deviates from its average and is measured through what is known as the standard deviation. Without going into the mathematics of the issue, let's have a look at how averages and volatility affect investment decisions.
The average is simply used as a benchmark for what we can expect from the asset. For example, if Asset A increases by 1% on Day 1, 1.5% on Day 2, and 1.7% on Day 3, then we can say the average growth of the asset is simply (1%+1.5%+1.7%)/3, resulting to 1.4%. This 1.4% suggests the average daily return one could obtain from holding the asset for three days.
Volatility serves as a proxy for risk. In this example, volatility would be just 0.36 (interested readers can refer to a book on statistics for the calculation), indicating relatively low movement around the average.
Now, imagine that we have Asset B, which has registered returns of 2% on Day 1, -11.3% on Day 2, and 13.5% on Day 3. The average daily return is still 1.4%, but few traders would have been happy with the huge drop on Day 2. This is where volatility is useful: in this case, volatility is 12.4 which suggests a relatively high movement around the average.
As such, volatility could be interpreted as a measure of the riskiness of an asset, even though this should not be looked at independently from the average return. The table above provides an example of just how deceptive focusing on just one of the two can be.
Asset 1 appears to be the most volatile and hence should be interpreted as the riskier one. Is this justifiable? Not particularly, as the chart on the following page suggests. Asset 1 (orange line) has been constantly increasing over time, and thus there would much less risk for our capital compared to Asset 3 (yellow line), which registers negative daily returns.
Looking purely at volatility, one could incorrectly assess that Asset 3 would be a safer investment than Asset 1, while this would be far from truth. As the chart suggests, holding Asset 3 would result in losses, despite its lower volatility. Asset 5 suggests what would happen if one held an asset with zero volatility: this would mean that the average return on that asset would have been fixed, never fluctuating.
An example of such an asset are bank deposits where we the interest rate is fixed in advance and the investor runs zero risk of losing the invested funds. Still, zero volatility excludes the possibility of higher returns, as in the case of Assets 1 and 2. Naturally, there are times when higher volatility is associated with losses, such as in Asset 4.
Thus, what the trader should remember from the above is that volatility, on its own, is neither good nor bad. Depending on how traders act on it, volatility can either provide opportunities or pitfalls, while it should be remembered that it should be viewed in line with the average return on an asset and not individually. Finally, past volatility of an asset should be viewed as a signpost and not a projector of the future, given that the world of trading is dynamic and asset fundamentals can change dramatically in a short period of time.
Forecasting and Discounting
When it comes to exchange rates, or any other financial instrument that is traded in an exchange, we should expect a reaction to any sort of data surprise, whether positive or negative. If no surprises are recorded, then we would expect no change in the exchange rate. The idea is that experts aim to provide a forecast on the future values of important variables such as inflation, and other important determinants of exchange rates.
Usually, more than one expert is asked to provide his or her opinion about the future value of an economic variable. Opinions from many experts are then grouped, and a “Consensus Forecast” is produced, which indicates the average of multiple forecasters’ estimations. Given that such data are usually available in most economic calendars, traders observe them and tend to discount this information: if the forecast suggests that a country will be better off in the future this is factored in the exchange rate as soon as traders view it.
This is simply an anticipation effect: if many traders believe that the improvement in the country’s prospects should appreciate the exchange rate in the future, then they will go long on the currency now, when the exchange rate is lower, in order to hold it until the price increases in the future. Naturally, as many traders seek to do this, the exchange rate will appreciate from higher demand.
Still, given the fact that this is just a forecast, most traders would not be willing to factor in the whole effect. In essence, if the trader estimates that the forecast would suggest an overall appreciation of the currency by 2.5%, he may not be willing to place his money on a 2% appreciation given that this is simply a forecast which could be wrong.
The trader would more likely be willing to go long on the exchange rate until it had increased by, say 1.5%, leaving the extra 1% as a margin of safety given that the forecast could go wrong. This well-justified unwillingness of the traders to go all out, means that the exchange rate would not increase by the expected 2.5%, but by a lower percentage. This can be viewed as a “discount” in the “correct” value of the exchange rate and hence the term “discounting”.
Unconventional Monetary Policy
In recent days, Central Banks have actually aimed at signalling how many interest rate changes will take place in the coming year or quarters. Such tactics, often called "unconventional monetary policy" and this section will provide more information on what this is and how it is conducted.
In the past, Central Banks had been more secretive of the indicators they observe as well as their intentions regarding the future path of interest rates. As such, policy rate changes usually came as a surprise to the markets, both with regards to their magnitude as well as their timing. In recent times, Central Banks have opted for a different type of communication, i.e. they choose to hint the timing and extent of future monetary policy actions in order to make the markets discount the impact from rising interest rates in advance and, in theory, reduce the shock.
In practice the idea works as follows: the Central Banks makes a statement about its future monetary policy intentions, e.g. that interest rates will not be changed in the near future. Given that no monetary policy action is expected, banks are more likely to set their long-term interest rates at a lower level, given that they know that they can borrow funds from the Central Bank at low rates, which are not expected to increase in the future.
As such, businesses can get cheaper loans and are in a better position to plan their future steps. By communicating their future plans, Central Banks allow businesses and people to better prepare themselves for the future and make longer-term investments easier to assess.
For example, ECB’s Governing Council said that it expected interest rates to remain "at present or lower levels for an extended period of time".
The exact specification of ECB forward guidance has been adapted in many occasions, including its intentions with regards to the horizon of its asset purchase programme. Naturally, the whole success of forward guidance lies on the Central Bank's credibility. Consequently, the content of any forward guidance regarding policy intentions must always be consistent with the assessment of the current economic situation and the outlook for the future, in particular for inflation. Further to this, the Central Bank should also abide its own agenda, as in the case of the recent US rate hikes.
Forward guidance does not only include the Central Bank's attitude with regards to interest rate changes but also about its plans regarding its asset purchase programme. In particular, the asset purchase programme is another form of unconventional monetary policy, which aims at injecting liquidity into the financial system via exchanging government, or at times corporate, bonds with cash generated by the Central Bank.
The transmission channel in this case has to be similar, i.e. this will pass through the financial sector: owners of bonds are usually banks and other investment funds which receive cash in exchange for their bond holdings. The private sector is left with more cash and less bonds and is, as a result, more liquid.
This added liquidity is expected to be channelled to the economy in the form of productive investments, i.e. banks are expected to increase their lending while investment funds are expected to invest their liquidity in investments such as the stock market or other, perhaps riskier ones, such as start-ups etc. Through this expansion in liquidity, the economy is expected to grow faster.
Fundamentals - Inflation
Inflation refers to the change in the price level of a country. In more detail, inflation is calculated on the basis of a weighted basket of the most commonly bought goods and services in an economy whose price is tracked across time, usually on a monthly basis.
The collective basket values are converted into an index, which is usually referred to as the Consumer Price Index (CPI). Given that inflation refers to price changes in the basket of goods, it should not be viewed as a rate of growth specific to one good (or service) but should be interpreted as the average growth of prices in the whole economy.
That is, if we observe an inflation rate of, say 3% in Japan, this means that prices have, on average, increased by 3% in the specific month, across all goods and services, compared to last year. As usual, an average suggests that some goods (or services) have increased by more than others and some by much less.
For example, it could be the case that the price of oil rises by 10% during a specific month. If this happens, then even if all other constituents are stable, then the sheer magnitude of the change, as well as the fact that oil prices constitute a large part of household spending, the CPI will increase, albeit to a smaller extent.
Inflation is usually considered a relatively bad thing, with the reason being that an increase in the monetary value of goods and services would mean that people’s purchasing power would be lower.
In simple terms, suppose that to purchase all your basic goods and services you have to pay EUR500. If inflation on this month stands at 10%, then it means that, on average, you would have to spend EUR50 more to obtain the same goods and services. This means that people’s purchasing power has decreased, as it takes more money to purchase the same amount of goods and services, leaving you with less savings.
The basic tenet of demand-pull effects is that higher demand for goods leads to higher prices. To put the word pull in perspective, think of it as consumers pulling the price up due to increased spending. However, spending needs to increase in the majority of the CPI goods in order to have an economy-wide and not just a specific-good effect. Let us now examine the determinants of higher demand in an economy.
To start with, a person working in a closed economy would, after some time at his job, wish to get a raise. If he gets the raise then this essentially means is that this person will have more spending power, whilst the spending power of his boss will be reduced, as his profit will be decline, all things equal.
A higher wage cannot be counteracted with a higher price given that, as the purchasing power of the general populace remains the same, an increase in price would decrease the quantity sold. In such an economy, for one person to earn more money, it would necessarily mean that someone else would have to earn less, given that everything else is constant.
To illustrate this, suppose that two bakeries exist in the country. If bakery 1 makes terrible bread then it will lose all of its customers, who will start buying from bakery 2. If total spending was, say, $100 per bakery, then after the deterioration in quality total spending would still be $200, only this time baker 2 will get it all.
Even in the case where bakery 2 decides to increase its prices, then this would mean that while its profit will increase, available spending of all bread-buyers would decrease, leaving aggregate income stable. While baker 2 may have different preferences to baker 1 (e.g. he may like chocolates vs candy), the shift in preferences would have only a small effect on the price level, given that chocolate prices will increase by candy prices will decrease.
As the above demonstrates, in order for demand to have an impact on prices (i.e. inflation) it would have to change consumer purchasing power as a whole. In other words, for this to happen, money in the economy needs to change. How is that possible? See below for the four major ways this could happen.
More on Demand-Pull Inflation
1. People Collectively Increase/Decrease Savings.
Most people, after getting their wages, put aside a percentage to save up for a rainy day. These savings percentage is, however, not stable across time, for reasons having to do with perceptions, availability of money and goods and so on. The graph below illustrates the US experience, with the savings rate (blue line) being as high as 12% in 1955, reaching lows of 2.5% in 2005.
As expected, if a higher percentage of income is spent, then money in the economy rises, with a subsequent increase in inflation (red line). Naturally, given that the US was not a closed economy at the time and that, as we will shortly demonstrate, other factors also play a role, the relationship is not clear-cut, even though they move together at an impressive 80%.. Note that availability of savings also has important indirect effects on money, which will be elaborated in the next point.
2. The Government Decides to Increase/Decrease Spending.
Suppose that the government decides that the construction of a new road would increase the citizens' well-being. Note that the construction would come in addition to the usual expenses observed in the country's budget. As such, construction company A will have more profits that year compared to previous years, without any other companies being adversely affected. As such, overall money circulating in the economy will increase. The government, in order to finance this project needs to borrow some money.
This is usually done through the issuance on bonds, which are most often purchased by commercial banks, using customer deposits (i.e. people's savings) to fund this purchase. As such, savings can also be indirectly used to increase money in the economy.
However, note that this increase in money will likely not be permanent given that the government will have to repay the bond and hence either increase taxation or decrease spending. Nonetheless, if money in the economy is growing for other reasons, an increase in taxation or a decrease in public spending will not have a large impact on inflation.
3. Commercial Banks Increase/Decrease Lending.
Banks can create money by simply increasing the amount of lending they provide to the economy. Put simply, if someone wishes to purchase a house which costs $400,000 and does not currently have that money then he can borrow and thus increase his purchasing power by that amount. Similar to the case of the government, the individual would have to repay the loan hence a reduction in his future spending will take place.
4. The Central Bank Issues More Money.
This cause of inflation is the one which has caused most debate among economists over the past century. The idea is that, for some reason, the Central Bank decides that the economy needs some additional cash. What it could do then is simply "print" the money and spend it in a way that reaches the broader public.
For example, it could finance government spending, meaning that the government would not have to borrow from commercial banks to fund its expenses. This is similar to what quantitative easing (QE) aimed at doing, i.e. the issuance of money to purchase government bonds.
Supply, in the case of inflation, relates mostly to producers increasing prices due to shocks which increase production costs, usually occurring for goods or services for which no close alternative exists at that point in time.
The wage example we have seen before can also be partially used to illustrate a supply-driven effect on inflation. If the quantity of money is increasing due to demand factors, workers may request higher wages.
If demand is increasing, firms can accommodate the workers' requests and pass, at least some part of this cost increase, on to consumers by raising the price of their goods. The increase in the price will be counteracted with the overall increase in the quantity of money and hence the quantity sold will not decrease by much, or even at all, depending on the respective growth rates of the two variables.
Given that wages cannot always make a difference on their own, we do not expect them to be as directly related to the inflation rate as the savings rate.
In a closed economy, we assume that all the materials required for the production of goods are produced/mined within the country. In the case of an open economy, goods can also come from abroad.
As such, the price of goods abroad will have an impact on the price these goods are sold domestically. If a computer is sold for $500 abroad in January and then the price increases to $550 in February, due to worldwide demand surging, it would mean that the inflation rate for that particular category of goods would increase by 10%.
This, naturally, depends on how important that good is for the domestic economy. As in the 1970s, if the price of oil increases internationally and our country is a net importer (i.e. imports more than it exports) of oil then we can expect a higher inflation rate.
Note that in many countries, goods are imported so that they can be re-exported and as such the effect from inflation does not stay within the country. Similarly, the amount of goods imported vs all goods changes over time and hence a constant relationship should not be expected.
Capital Flows and Inflation
Remember that increases in money supply tend to increase inflation? Well, suppose that the government decides to issue new bonds because it wants to spend some money on infrastructure.
Even though domestic banks may not be willing to lend to the government, mainly because they are lending their money to individual borrowers and obtain higher yields, foreigners can perform such an action. The chart below indicates the percentage of US bonds held by foreigners which, has increased over the time, raising overall funding in the economy.
Naturally, capital inflows is not only related to public bonds. Foreign direct investment, related to large investments in the country (e.g. purchasing a house or building a factory), portfolio investment, related to smaller-scale investment (e.g. bonds or stocks), as well as deposits and loans by foreigners, can also have an impact, given that foreigners offer to exchange their currencies for the domestic one.
This means that more money is channelled into the domestic economy, raising corporate profits (especially in the foreign direct investment case) and leading to higher wages and spending.
The opposite can also hold: US residents can also invest in bonds and stocks abroad, raising inflation in those countries to some extent. As in everything, capital flows, mostly related to portfolio investment and deposits and loans can easily be reversed hence causing a drop in prices and tightening monetary conditions in the country.
Inflation and Forex in Major Pairs
Standard economic theory postulates that positive inflation surprises should have a negative effect on the exchange rate. Nonetheless, currencies appear to move in tandem with inflation surprises. In particular, it appears that exchange rates are positively related to inflation surprises, as we will demonstrate with four, illustrative, examples:
- August 10, 2018, GMT 12:30. US Core consumer price index comes out at 2.4%, against expectations of 2.3%. The USD appreciates approximately 20 pips against the Euro upon this announcement, and continued to move upwards for the rest of the day (column 1, row 1).
- August 30, 2018, GMT 23:30. The Tokyo Consumer Price Index, a proxy for the overall price level in Japan, registered a 0.4% increase – 1.2% compared to expectations of 0.8%. The fact that the index is only related to one city had its impact, as the USDJPY pair declined by 12 pips upon the announcement, continuing to drop until noon next day (column 2, row 1).
- August 31, 2018, GMT 09:00. Euro area core and overall CPI come out 0.1% less than what was expected. The EURUSD pair declines 3 pips on the announcement but continues to drop over the following hours, with a full decline of approximately 70 pips (column 1, row 2).
- August 17, 2018, GMT 12:30. Bank of Canada Core and overall CPI measures show an inflation rate of 1.6% and 3% respectively. The numbers are 0.5% and 0.3% higher than consensus expectations. The CAD appreciates approximately 75 pips with respect to the Dollar and maintains its gains until Monday (column 2, row 2).
Why this happens? Remember the inflation determinants we discussed earlier. In particular, remember that inflation is governed by supply and demand forces, which move to set the inflation rate. However, there have not been many supply shocks, at least in the last few years, given that the price of Oil has more or less fluctuated more or less around $70 since 2006.
This suggests that supply shocks to inflation are strictly domestic to the US economy and hence are evened out by the subsequent increase in consumer spending. As such, any change in prices, even from the supply side, will be related to the growth of the real economy.
Consequently, higher inflation in developed economies, i.e. the major currency pairs, should be associated with currency appreciation. While this relationship could change in the coming years, perhaps due to unexpected supply-side changes, at the moment, it appears that the relationship is the opposite of what traditional economic models would suggest. To this end, the following section provides an example of such a behaviour.
What About Developing Countries?
In July 2018, inflation in Turkey stood at 24.5% y/y, compared to "just" 17.9% y/y in June. This prompted a well-justified, 500-pip depreciation of the Turkish Lira with respect to the Dollar. It also provides us with a perfect example to illustrate the important distinction between supply-side and demand-side inflation, and how this affects our interpretation of inflation results.
Nonetheless, there also exists the dark side of inflation, which is driven by supply-side factors. As you may recall, supply-side inflation is affected by factors which increase the cost of production. These include wages and the cost of raw materials, with the latter being a stronger predictor of supply-side inflationary pressures.
In the case of Turkey, inflation was not caused by the economy's growth but came as a result of the 25% depreciation in the Lira, stemming from uncertainty about the country’s growth potential, and US sanctions. Simple mathematics show that a 25% increase in the 17.9% July inflation rate would result in approximately 22.5%, close to what has been reported.
The Lira's depreciation is likely to have caused a severe increase in the cost of imported goods, with the blow to consumer spending becoming even harder as oil prices surged during the last few months. Given the increase in prices consumer spending power has most likely decreased as demand factors cannot adjust that fast to changes in the cost prices. Hence, this increase in inflation is likely to be bad for the economy of Turkey and thus should justify a depreciation of the currency. In addition, the increase in inflation is expected to continue if the Lira does not return to its previous levels.
An important question is how one can determine whether changes in inflation have been caused by supply or demand factors. The answer lies in examining the causes of inflation shocks: for example, if inflation changes by more or less in accordance to the change in bank lending and/or government spending, then we can gauge that this is caused by demand factors.
However, if inflation increases by much more than these indicator would have implied and, in addition, the exchange rate is declining or wages are increasing by much more than justified by previous inflation rates, then the cause likely lies on the supply side and should be a cause for worry.
Another important point to be made here is that higher inflation tends to also be in a feedback loop with exchange rates. In other words, higher inflation could cause an exchange rate depreciation, potentially leading to higher import prices (especially if we refer to energy imports) which could also lead to even higher inflation, even more depreciation in the exchange rate and so on.
Naturally, the opposite would also hold, i.e. an exchange rate depreciation could cause higher inflation, which would further depreciate the exchange rate, and so on. While this is a relatively rare situation and should not be often observed, given that periods with high inflation are usually met with increases in domestic interest rates (something which we will deal with in the next chapter) the case of Turkey clearly shows that such a situation could take place.
Another Example? Sure
On August 3, 2018 the Swiss CPI inflation numbers came out, suggesting that inflation stood at 1.2%, the same as the consensus forecast. Hence, there was no change in the investors’ perceptions about the demand or supply for Swiss Francs and thus no change was recorded in the exchange rate.
On the other hand, on August 17, 2018 the Canadian CPI came out standing at 3.0% versus a forecast of 2.5%. The CAD appreciated on the announcement and also managed to maintain the appreciation at the day’s closing. This behaviour provides an illustration of how demand-side inflation can be beneficial with regards to the exchange rate prospects.
Traders should, however, also keep an eye out for other events which could take place at the same time which could either amplify or decrease the impact of the inflation announcement on the exchange rate. For example, on that particular day, another positive announcement took place for the CAD, namely that Foreign Portfolio Investment (FPI) in Canadian securities was higher. FPI was more than double of what was expected, sending positive messages about the Canadian economy.
Overall, the FPI suggests foreigners’ willingness to invest in the securities of a country, thus increasing demand for its currency, given that have to exchange their currency with Loonies in order to purchase securities. This willingness to invest in Canada sends positive signs about the state of the Canadian economy and is thus expected to benefit the exchange rate.
On the other hand, a worse than expected FPI result could blunt the reaction and thus one would observe a much smaller positive candle, or even a negative one. As such, while inflation may be important, there could also be other news coming out on the same day which could have the same (as in this case) or even the opposite effect on a currency.
Fundamentals - Interest Rates
Before we start our exploration of interest rates, we need to differentiate between the two main sectors of the economy: the real and the financial one. The real economy refers to businesses which produce goods and services which are used by the public.
The financial sector refers to all activities which are related to financing, mainly referring to commercial banks (i.e. banks which deal with offering loans and deposits to consumers), investment banks (i.e. banks which focus on providing services to other firms), and the stock market. The financial sector is also referred to, especially in the past, as the monetary sector.
In the past, the monetary sector was just a fraction of the real sector. This started to change in the 20th century when economists realized that the financial sector was growing in importance. Furthermore, they also understood that as this happened its importance on determining the amount of money in the economy was also growing.
Note that money is determined by the amount of outstanding deposits, with an increase in loans suggesting an increase in the overall amount of deposits in an economy. To put this in perspective, imagine that you are obtaining a loan for whichever reason (the reason is really not important). Usually, this money is obtained to be spent, i.e. it will end up in someone else's account.
Hence, banks can generate money through their loan-creation process. In a similar manner, if a stock market is continuously rising, new money is expected to be created. As we discussed in the previous chapter, an increase in the supply of money in the economy will cause higher inflation, which could hurt consumers' purchasing power.
What Are Central Banks?
A Central Bank can be generally defined as an institution whose main objectives lie in managing a state's currency, money supply, and interest rates. Central Banks are also known as Reserve Banks, Monetary Authorities or, in the case of the US, the Federal Reserve (aka "Fed").
The Central Bank usually also prints the national currency, which usually serves as the state's legal tender. In the early 20th century, a state's legal tender meant that money could be exchanged for precious metals in some fixed amount, but this does not hold since the abandonment of the Gold Standard in the 1930s.
Currently, most currencies are fiat money, meaning that the "promise to pay" consists of the promise to accept that currency to pay for taxes in that country. In the broader sense, the Central Bank enforces the use of that specific currency within its jurisdiction, making sure that at all commercial banks accept the currency when the public presents them with it.
For example, commercial banks in the Euro Area should accept any euros brought to them by any of their customers, provided of course that they meet some criteria (not counterfeit, not stolen, etc.). This also indirectly ensures that all citizens within that state would be happy to receive the specific currency for the work and services they provide.
The first Central Bank to be established with on-going operations was the Swedish Riksbank, which was set up in 1668. However, the bank did not have a monopoly over the issuance of bank notes until the early 20th century. Bank of England, which was established in 1694 defined the model on which most modern central banks have been based.
Motives for the establishment were not so pure though: the Kingdom of England wanted to obtain a loan to finance the ongoing Nine Years' War with France, but its credit position was too low to be able to borrow.
In order to agree to the provision of the loan, the lenders proposed that they were incorporated as The Governor and Company of the Bank of England with long-term banking privileges including the issue of notes. The lenders would give the cash to the government and also issue notes against the government bonds, which could be lent again.
Consequently, the Central Bank's first functions were to act as the government's banker and trustee, in particular when it came to raising money. In their function as a trustee, Central Banks have often, bought government bonds themselves, an action also known as monetary financing, and still used by some countries.
Still, the Bank of England did not have many of the objectives and powers modern Central Banks do. Power over the value of the national currency and monopoly over the distribution of banknotes, evolved slowly through the 18th and 19th centuries. The most important benefit of having a monopoly over the supply of money essentially means that a Central Bank cannot run out of money as it can, theoretically, issue (print prior to the digital era) any amount of money to satisfy its needs.
Naturally, an uncontrollable increase in the amount of money would come at the cost of higher inflation, hence cancelling out any benefit from more money in the economy. Following the British example, Central Banks were established in many European countries during the 19th century.
A result of its unlimited ability to create money is that the Central Bank cannot, at least in theory, run out of liquidity. This was not always the case, as when the Gold Standard presided over the world, Central Banks had to obey a law stating that a specific percentage of the existing money had to be backed with Gold.
This was very impractical given that in times of distress either the percentage would have to be lowered in order to issue more money, or the Central Bank would see its reserves depleted if enough citizens requested an exchange of their money for Gold. As a result, the Central Bank's ability to affect the money supply could be severely diminished, given that runs to get gold in return for money usually happened during recessions, when the economy needed the money the most.
This led to higher unemployment and a severe and persistent decrease in prices (deflation) which can be very harmful if it persists for a long period of time. As such, the Gold Standard was abandoned, allowing the Central Bank to potentially create unlimited liquidity and use it when it sees fit.
This leads to another important role the Central Bank function which is to act as the 'lender of last resort'. The term was popularized by journalist Walter Bagehot and suggests that during periods of distress Central Banks should lend early and without limit, against good collateral, and at high rates, to firms which are solvent, in order to avert panics.
To understand why this is required, we need to have a glimpse of how commercial banks operate. In general, commercial banks provide loans and obtain deposits from the public, and also provide other sorts of financial services. Given that the money is lent out, banks only have a limited availability of cash to cover for potential deposit withdrawals.
In times when many withdrawal requests could come at the same time, but the commercial bank does not have the available funds to satisfy all of these needs, it usually borrows either from other banks, the Central Bank itself, or from other financial institutions (e.g. investment funds, etc.) for short periods of time, so as not to cease withdrawals and enter a state of default. This is why the Central Bank is also usually referred to as the "Bank of Banks".
However, during periods of financial crises, it could be the case that withdrawal requests increase while the interbank market dries up. During these periods of time, the Central Bank assumes the role of a liquidity provider to financial institutions which are unable to obtain sufficient liquidity to maintain their operations, but are judged to be in a position to be able to continue with their operations.
This allows the Central Bank to prevent economic disruption as a result of financial panics and bank runs spreading from one bank to the next as a result of bank illiquidity. Central Banks also use an additional tool to avoid panics, by providing what is known as deposit insurance, i.e. guarantee an amount of deposits in the case that the commercial bank fails. As such, depositors should not feel the rash to withdraw their funds in the case when a commercial bank faces problems. The lender of last resort role and the deposit insurance tool assisted the US Fed to avoid a systemic crash of the economy during the 2008-2009 crisis.
Central Banks also have the ability to control the supply of money (and indirectly other macroeconomic developments such as inflation and GDP growth) through the manipulation of interest rates, something which is called Monetary Policy, a theme we will deal with in the next section.
Prior to abandoning the Gold Standard, where any increase in the amount of currency needed to be met with an increase in the level of gold reserves according to a predetermined percentage, Central Banks had a stronger grip over a country's money supply. Nowadays, the power of monetary policy is affected by the strength of the transmission channels through which it affects the economy.
Finally, in a theme which re-surfaced since the 1990s, Central Banks are the official licensors and supervisors of commercial banks. While this does not refer to the micro-managing of commercial banks, i.e. in interfering regarding whether Mr and Mrs X obtain a loan, the Central Bank monitors the overall lending behaviour of commercial banks, as well as their capital buffers and requirements. The reason behind this monitoring is to ensure financial stability, since financial crises can be much more harmful to the economy compared to economic downturns.
Notice that in order to proceed as they see fit, Central Banks need to be independent from political developments so that their interference in the economy is objective and not driven by any political agenda.
The idea is that if Central Banks are affected by politics then they may not act in the best interest of the economy but could take steps to assist the agenda of politicians which could hurt the economy in the long-run. As such, independence is highly valued by investors and is indeed the case in the majority of developed countries, with the recent examples of BoE and Fed acting against what the UK Prime Minister and the US President would prefer.
In a nutshell, Central Banks have the following functions:
- Banker and Trustee to the government
- Issues and controls the quantity of banknotes
- Bank for commercial banks
- Controls the money supply through monetary policy
- Lender of last resort
- Financial oversight
What's Monetary Policy
Commercial banks, i.e. the institutions where citizens deposit and withdraw money form, in any usual operating day, could end up with a small money deficit or surplus as people may choose to withdraw or deposit more money with them for whichever reason. To meet this change in their position, they tend to borrow either from the Central Bank or from each other, for often as small a horizon as a night.
The policy rate not only defines the overnight lending rate banks would pay the Central Bank but also serves to define the overnight inter-bank interest rate. The mechanism is simple: if a bank seeks to borrow from another bank it would be to its benefit only if the interest rate charged was less than the Central Bank rate. Hence, the policy rate serves as a ceiling for all inter-bank lending activities.
Given that banks can borrow at the policy rate or lower than that in the inter-bank market, this means that the policy rate would serve as a floor for their lending to consumers or businesses. For example, if the policy rate stands at 2%, then the minimum a bank would charge would be that, plus its operating costs; that is, if the bank wants to avoid losses.
If, for example, the policy rate increases by 1% then the bank would mean that it would have to borrow from the Central Bank at a higher rate and thus if it want to maintain its profit margin it would have to increase its interest rate on loans by that amount; otherwise, it will experience a reduction in its profits.
The same holds for the interest rate offered on bank deposits: as the Central Bank increases policy rates then banks need to increase their deposit rates. Suppose the policy rate is increased by 1% but commercial banks do not raise their interest rates by a similar extent.
Then, it could be the case that a single bank could actually raise its rate by, say 0.25%, and receive an influx of deposits which it could actually lend back to Central Bank and enjoy a hefty profit from the 0.75% difference (the 1% increase minus the 0.25% increase in deposit rates). However, another bank can do the same by increasing its deposit rates by 0.30%, another could do it by 0.35% and so on.
This arbitrage (i.e. certain profit with zero risk) opportunity would be zeroed out only if banks raised their deposit rates by 1%. This chain of events hence confirms that any change in the policy rate will subsequently be passed on to consumers and businesses.
Through this, Central Banks affect the public's inclination to borrow: as interest rates increase, less people will find it profitable to borrow. For example, in the case the total cost of lending is 3%, then an investment with a return of 4% would be profitable. However, if the lending rate is raised to 4.5% then an investment offering the same return will no longer that appealing.
As such, people would be less willing to borrow for investments which would yield lower returns and will also be less willing to borrow for those yielding higher returns as these are, by definition, riskier. Reducing the amount of lending is expected to stabilize the amount of money in the economy and hence ease inflationary pressures and cool down the demand side of the economy.
In a similar manner, higher policy rates would result in higher deposit rates which would in turn also substitute riskier investments. In other words, an increase of the deposit rate to 3% would make a potential investment yielding the same return less attractive given that the risk for the former is almost zero, while in the latter it is much higher.
This would mean that less money will go for investment purposes and more money will remain at the bank, again cooling off the economy.
Why Do Banks Change Interest Rates
First and foremost priority, controlling the inflation rate is the main reason for the existence of monetary policy. As we know, inflation increases when the money supply is increased, with regards to the demand side, and due to changes in production costs, with regards to the supply side.
If inflation rises because of demand side pressures, then monetary authorities tend to increase policy rates to cool down the economy and hence control inflation, through the transmission channels elaborated in the first part of this series. The same rationale holds when the economy enters a recession: inflation drops as demand falls and Central Banks cut interest rates to boost the economy and the price level.
In a similar manner but in an opposite way of operation, Central Banks raise policy rates when higher inflation due to supply-side factors is observed. By raising policy rates fast, the Central Bank effectively creates a recession, aiming to counter the inflationary supply side with a deflationary demand side.
As overall demand in the economy decreases then prices will decrease. Then supply will also decrease to meet this reduction in demand, with a subsequent reduction in the demand for production goods and a lowering of their price which should contain inflation. Naturally, as the 1970s experience has shown, the economy can take up to a couple of years to adjust to abrupt changes to supply-side costs.
Consequently, policy rates will be adjusted in times when inflation is either lower or higher than the Central Bank's target, which is usually at 2% per year.
The second potential priority for the Central Bank to move interest rates is in an effort to boost the labour market. This incentive moves usually in conjunction with the first, given that, usually, wages increase and unemployment decreases when inflation increases. However, there could be times when unemployment is higher than expected or wage growth is slow while inflation is stable.
During those periods, the Central Bank may choose not to raise policy rates until the increase in wages or the decrease in unemployment catches up with the inflation rate. A notable example of such behaviour is Australia, in which RBA continues to maintain low interest rates despite inflation being close to 2%, precisely because wage growth is very slow.
Central Banks Official Reasons
Firstly, note that Central Bank priorities can shift over time. For example, the Fed's priority in the 1970s was to tame inflation. In the early 2000s, attention shifted to boosting the economy following the dot-com bubble, for which Alan Greenspan got the credit for maintaining a stable economy. SNB focused on inflation stability prior to the financial crisis but moved on to include exchange rate manipulation to its duties. As such, investors need to remain ahead of the curve and pay attention to what drives Central Bank behaviour.
The critical point for the change in SNB behaviour was that the Swiss Franc was seen as a safe haven currency after the financial crisis. This led to an increase in its value, given that a large number of investors sought to exchange their currencies with the CHF. To avoid this hurting the economy at a time when exports provided (and still provide) the boost for growth, SNB also included the exchange rate in its priorities.
Any Indicators to Watch?
Most Central Banks are inflation-targeters. This means that they will tend to increase policy rates in the case where inflation persistently steps out of hand. Hence a persistent increase in the inflation rate would often signify that policy rates are also likely to rise. Note that the increase in inflation needs to be persistent, as one-off hikes due to e.g. a spike in energy prices or perhaps even due to base effects as prices may have been lower last time are usually ignored by policymakers.
Further to the inflation rate, central banks also closely monitor the wage growth rate. Remember that wages are important in understanding both the supply side as well as the demand side of inflation. If prices increase due to higher demand then workers will demand higher wages to compensate for their loss in spending power.
This will put some cost pressure on the firms which may in turn try to further increase prices in the future to compensate for that. Hence, in order to pace themselves for future bouts of higher inflation, wage developments need to be closely observed.
Another important indicator refers to the main transmission channel of monetary policy, namely growth in the provision of loans to the public. In particular, remember that monetary policy is transmitted mostly via the banking sector. To this end, if the stock of loans (and subsequently money) in the economy is growing fast, then monetary policy is considered to be loose; otherwise, a slow, or overall average growth rate of money and lending indicates that monetary policy is tight.
This definition, although at times not closely followed, goes back to the influential economist Milton Friedman in 1968 and provides a much better understanding of whether monetary policy has been doing its best to cool down the economy or not.
Central banks also tend to keep an eye on labour market developments, which is also one of their priorities. For example, the Federal Reserve itself notes that it monitors developments in the unemployment rate, which measures how many people are able, willing, and actively seeking employment but have failed to obtain a job.
The unemployment rate is also usually observed in conjunction with the natural rate of unemployment, which is calculated by Central Bank staff, but is not usually published in countries other than the US. The unemployment rate is not the only important labour market indicator: employed persons as a percentage of labour force, also known as the labour force participation rate, is also closely monitored by Central Banks.
One of the most important numbers is of course that of real GDP. No Central Bank would feel comfortable in increasing policy rates when GDP has been growing very slowly given that it could hamper the economy's prospects. Finally, labour productivity, popularised by Fed Chairman Alan Greenspan in 1990s, is also closely watched before a change in the policy rates.
Higher productivity could provide a justification for higher production and hence explain why, for example, GDP may be growing by much faster than the inflation rate. In contrast, if productivity is stale, then inflationary pressures may accumulate in the economy. Naturally, for Central Banks which also take exchange rates into consideration, the currency place would also fare as an indicator of future policy rate changes.
A Recent Example
The Federal Reserve did not begin to raise interest rates until December 2016, when average earnings (blue line) were growing a stable rate, higher than the price level (green line). During that period, the unemployment rate was below 5%, continuing to remain so until September 2018.
Furthermore, the bank lending was growing fast, at more than 8% monthly. Hence, the Fed reaction was to tighten the leash on the economy, and increase policy rates. Note that the gradual increase in the policy rates does not halt the economy, as the path of inflation, unemployment and wages shows, but gradually reduces the growth rate of loans.
Nonetheless, notice that despite the gradual increases in the interest rates, from 1.25% to 2.25% presently, loans appear to still increase by more, reaching 5% on an annual basis. As such, monetary policy, while pursuing a tightening strategy, still has room to go if it really want to slow down the growth in lending, and this could perhaps indicate that more rate hikes can be expected in the future.
Fundamentals - Trade Balance
What's the Trade Balance
According to economic theory, trade is an important determinant of exchange rate behaviour. The rationale is simple: by buying local products, foreigners are essentially offering their currency. For example, a European would need to offer Euros for the purchase of a Japanese car. Let’s assume that the car is worth EUR 15,000.
This means that the quantity of Euros in the international market, i.e. the supply of Euros, would increase by exactly EUR 15,000. As per standard economic thinking, an increase in supply means that there will be a corresponding decrease in the price. Price, in this example, is the EURJPY exchange rate. Hence, the increase in the quantity of Euros would mean that there is more supply for the existing demand and the Euro should depreciate with respect to the Yen.
A country’s trade balance shows exactly this: how much the country has sold abroad and how much it has purchased from abroad. If it is positive, then this suggests that the country has sold more goods and services than it has purchased, meaning that there is more demand for its currency than there is supply.
In FX terms, a positive trade balance (surplus) signals a potential strengthening of the country’s currency. The opposite also holds: a negative trade balance (deficit) suggests that there is more supply of the currency than there is demand, and this signals a potential weakening of the currency. As expected, the larger the deficit or surplus, the larger the move in the exchange rate due to the larger change in supply.
While forecasts are offered for the trade balance, there are times when these are imprecise. Despite expecting, say, a USD20 billion trade deficit for the US, actual numbers may show a USD10 billion deficit or a USD30 billion deficit. In this case, traders usually adjust their view of the currency when the announcement is made public.
If the trade deficit was less negative than expected (e.g. USD10 billion) then the USD would most likely see an appreciation given that supply of currency was less than anticipated. In contrast, if the trade deficit was more negative than expected (e.g. USD30 billion) then the USD would most likely depreciate since the supply of Dollars was more than anticipated.
Let’s put the above into context: traders and experts anticipated a smaller trade deficit in the Japanese July 2018 data (YEN50 billion) than the actual (YEN231 billion). This is also reflected in the path of exports which increased by much less (3.9%) than expected (6.3%). Imports also increased slightly more than expected. This means that the supply of Yen in the market is higher than expected and this should depreciate the currency’s value.
This is exactly what happened in the USDJPY (column 1, row 2), EURJPY (column 2, row 1), and GBPJPY (column 2, row 2) pairs which recorded a depreciation in the Yen. In particular, EURJPY recorded the largest increase, at 0.41%, GBPEUR increased by 0.31%, while USDJPY increased by 0.19%, all within an hour of the announcement. The shift in the price appears to be rather persistent in all pairs.
A question which may arise relates to the reason the reaction is smaller or larger according to the pair. As you may have guessed, the magnitude is mostly based on the other currency’s trade balance. Given that the Euro area’s trade balance records a surplus, it means that the supply of Euros was already lower and hence a larger reaction could be expected.
The UK, in contrast, has been dealing with increasing trade deficits in the past years, also a result of the depreciation of the Pound following the Brexit decision in June 2016, while the US, which records probably the highest trade deficits in the world, registers the smallest reaction.
A Trade Deficit is Bad For Everyone?
No, not in every occasion. A trade deficit could also mean that the domestic economy is growing enough to consume more than it produces or, in other words, it needs to import goods for consumption. Higher imports mean higher consumption and higher consumption leads (eventually, albeit with some lag) to improved firm profitability.
This suggests that the value of companies will increase and as a result stock prices would also rise. This is evident in the behaviour of the JP225 in the previous question (column 1, row 1) which rose by 0.73% within an hour of the announcement. Note that a continued, long-term, trade deficit can lead to some trouble but we will leave this for another analysis.
So let’s sum up what this article is all about in a couple of sentences: a worse-than-expected trade deficit is usually bad for the currency and usually good for the stock market. The extent of the effect depends on the extent of the difference between the actual and the forecasted values, as well as to the other currency’s trade balance.
Why Is it Not Bad Again?
One of the most important questions in economics, is whether a trade deficit is bad or good. For example, US President Donald Trump suggested that the trade deficit is bad as it means that the US is producing less than it could and hence people are left without jobs. Most economists, on the other hand do not agree with this point, their arguments being that trade is beneficial to all countries, regardless of whether a particular country registers a surplus or a deficit.
To begin with, it is easy to see the validity of the economists’ arguments: how many countries would have access to technological goods they had not developed themselves if no trade existed? People would probably not have been able to click on their PCs or smartphones and we would have no way to communicate what we are writing if it wasn’t for imported technology.
Then comes what economists have dubbed as comparative advantage, i.e. someone’s ability to do something much more efficiently than ourselves. This can be due to a number of reasons: not all countries can cultivate coffee beans, while not all countries can become financial or shipping hubs or have huge factories all over their territories. Consequently, geographical restrictions and benefits, as well as weather and country size can play an important role as to what goods and services a country can offer. This was well understood centuries ago (90 millennia according to some), as Egyptians travelled to India to obtain spices.
In recent years, this was just rephrased to mean outsourcing: instead of purchasing goods and services from abroad to transform them into different products in our own country (e.g. silicon to create computer chips), businesses have found that it is more profitable to actually construct most of the products they need abroad and then assemble them back home. This makes the whole production more efficient and thus allows firms to be more competitive across the world.
Naturally, business tactics are not the only reason for a trade deficit. Another, more important role for a trade deficit is because a country is rich and can afford to consume more than it produces. I guess the same would hold for the ancient Kingdom of Egypt and for the US: they consume because they like to and, most importantly, because they can. In fact, trade also has some interesting geopolitical implications: if country X is importing heavily from country Y then the latter is dependent on the former, thus giving country X more power.
Moving from trade to trade deficits, a usual argument in favour of trade deficits is the following: if someone is willing to give you goods in exchange for pieces of paper (which is what money really is) then wouldn’t you be very happy in that scenario? It costs nothing to print pieces of paper and, so long you are prudent in printing, the pieces will more or less maintain their value. In this case, it should not matter if your deficit is 2% or 15% of GDP.
In real life though, it does. A higher trade deficit would usually mean a depreciation of the currency, while, at the same time, it would mean an improvement in domestic consumption. The question which matters is how this trade deficit is supported. Despite the apparent complexity in the economy, there are really not many reasons on why this could happen: government spending, bank lending, central banks issuing money and less savings.
Usually, the first three are the “culprits” for the increase in spending, all of which can lead to unsustainable trade deficits. For example, rapid credit expansion, uncontrollable increases in government deficit and debt, as well as excessive money printing, can all be blamed for trade deficits going bad.
Still, this is not absolute: a large trade deficit can also be indicative of a growing economy, as consumption and investment are increasing. A stable, but not excessive, credit expansion, a government deficit which is not in greater than GDP growth, and money printing in regular quantities can be viewed as contributors to higher growth than warning signals.
What’s the conclusion: a trade balance is not bad on its own, unless it is associated with credit booms, unsustainable government policies, or reductions in the savings rate. While in developed countries these events are less frequent than in developing ones, they can still occur. Still, it’s far more often the case that a banking or a sovereign debt crisis will erupt rather than to experience trade balance problems
Fundamentals - Economic Growth
So What's GDP?
GDP stands for Gross Domestic Product, which measures that value of all goods and services produced in a country during a specific period of time. Given that the value of all these goods and services is measured through their market prices, GDP can also be viewed as a measure of total expenditure in the economy.
Furthermore, since expenditure means essentially that goods are exchanged with money then GDP can also be viewed as a measure of income received for the production of goods. As such, GDP has the triple ability to serve as a proxy for production, expenditure, and income. In addition, as it encapsulates the whole of economic sectors, it provides us with an informed view on the total performance of the economy.
To calculate GDP we need to sum its four constituents: private sector consumption, government consumption, investment, and net trade (exports minus imports). The first two are straightforward as they basically measure the amount of money spent by each of the two sectors of the economy.
Distinguishing between them is important because investors and economic observers need to observe how much of GDP can be attributed to each. The reason is that GDP growth fuelled by increases in government spending can only be sustainable for so long, as government debt and deficit will increase and make its repayment much more difficult, unless the private sector picks up and starts consuming again.
The reason investment is important is also straightforward given that it shows the potential of the economy in the longer term. The more investment in the economy the more trust exists in its future prospects as investment projects may be used to produce various consumer goods and services. Nonetheless, given that the nature of investment is volatile, large ups and down can occasionally be observed and is the category most affected by recessions (red line).
Net trade (exports minus imports) essentially measure the extent of international trade and how this has affected the country over the period under study. For example, if imports and higher than exports then it means that the country has consumed more than it has produced. This suggests that it spends more money than it receives from abroad and this can harm its currency prospects.
However, higher imports mean higher consumption which also suggests that the economy is growing. In essence, deducting the amount of imports allows us to separate between the total production which was domestically produced and consumed from the consumption of imported goods. The same holds for exports which allow us to measure total domestic production and not the one just consumed within the country.
The major difficulty with interpreting GDP results has to do with prices. If inflation increases by 2% annually but production does not increase, then GDP will register a 2% fictional increase. To this end, economists and investors have been using real GDP which accounts for the change in inflation. As such, examining real GDP (including real private consumption, real government consumption and real investment) provides a better understanding of the economic fundamentals of the economy.
Real GDP results are usually assessed at a y/y growth rate or a q/q growth rate if they are seasonally adjusted. Both have their merits: a y/y growth rate allows for an overview as to how the economy is doing compared to last year, while a q/q rate allows us to observe the short-term trend in the economy.
Naturally, there have been times where positive y/y growth and negative q/q growth is observed, suggesting either a large one-off event in the previous quarter or the beginning of a slowdown. In the opposite case (negative y/y growth and positive q/q) one could expect either the beginning of a recovery period or the base effect from a better than expected quarter last year.
In most times though, q/q and y/y growth rates have the same sign. Other than these growth rates, the US specifically reports annualised growth rates which suggest what the growth rate for the whole year would have been if the same quarterly growth persisted. This is a rather fictional number, only useful when compared to past releases of itself and not to any other growth rate.
In an example of what happens during unexpected positive real GDP data releases, on August 29, 2018 12:30 GMT, US real GDP came out at 4.2% (annualised) compared to expectations for 4%. A positive reading for the US economy did not have a large effect on the currency but it did push the stock market up 3 points at the time of announcement and led to a three-hour surge in the index value, with a total gain of 16 points
Fiscal Policy refers to the collective actions a government takes with regards to its spending and income levels aiming to influence a nation's economy. Government spending includes investment in important projects such as building and maintaining schools and roads, in addition to government employees wages, while government income is usually derived in the form of income and value added taxation.
Fiscal policy works best when being proactive and not engaging in policy actions to satisfy voters at the expense of economic stability. This suggests that fiscal policy needs to be expansionary, i.e. increasing spending and/or lowering taxes when the economy is in a recession, and contractionary when the economy is booming. One policy usually necessitates the other: if a government carelessly spends funds during expansionary periods then its debt will increase by so much that it will not be able to borrow in order to spend in periods of contraction.
The main difference between fiscal and monetary policy is that the former's effects are direct and do not rely on any channels of transmission to reach the consumer. For example, if the government decides to decrease taxation, this means that the public will have more money to spend which should increase private spending and assist in reviving the economy. This will also assist the inflation rate to remain close to the 2% level and not slide below it.
Similarly, if the government decides to increase spending, the additional money will enter the pockets of the people and businesses who worked on the projects the government sought to undertake. Interestingly, higher government spending will actually aid government finances, at least to an extent, as it will mean more consumer spending, which suggests higher proceeds from value added and income taxes.
Overall, fiscal policy is more direct compared to monetary policy, given that its effects reach consumers and businesses much faster and do not rely on other institutions. However, fiscal policy usually takes longer to materialize its plans given its large dependency on long, usually bureaucratic, procedures for undertaking projects as well as because changes in tax rates have to pass through the Parliament and hence require much more time.
The effects of any fiscal policy are not the same for everyone, since a tax cut could affect only the middle or upper class. For example, the tax cuts proposed by the Trump administration were expected to be beneficial for the upper class but not so much for everyone else. Similarly, when the government decides to adjust its spending, such a policy may affect just a specific group of people: while building a school will benefit construction workers and improve the well-being of the community, spending more money on defence systems will only benefit particular companies and a specialized pool of experts and not do much for overall employment.
As expected, if fiscal policy is expansionary for longer than required, i.e. long after an economy is out of a recession, then inflationary pressures are likely to occur in the country. Note that increased government spending will increase demand for goods and services and hence place upwards pressure on the inflation rate. Thus, a looser fiscal stance may provide incentives for the Central Bank to raise interest rates faster than it would have otherwise.
Such actions mark the interplay between fiscal and monetary policy. While, ideally, the two should be moving in tandem, there are times when governments, moved by the incentive to satisfy voters, may choose to spend more than they should, given that the economy is booming. At such times, monetary policy can choose whether to move to dominate fiscal policy or whether it should choose a more accommodative stance.
Fiscal and Monetary Policy Interactions
The US fiscal deficit for the fiscal year 2018 increased to $779 billion, or approximately 4% of GDP for the period. As Reuters notes, the deficit has been the largest reported since 2012, during a time when elections were coming up and the economy was still at a low interest rate environment and perhaps also in need for more government spending.
It is known that bond traders keep a close eye on fiscal and monetary developments. Following from the previous section on Fiscal Policy, we now examine how fiscal deficits can affect bond yields.
Overall, recall that higher interest rates, or even expectations of higher interest rates, cause bond yields to rise, given that investors demand higher compensation for their money as interest rates increase. This leads to raising the cost of borrowing for the government, which in turn leads to higher deficits, all else equal. Naturally, it could most likely be the case that interest rates have increased because of improved economic conditions and hence more taxes will be flowing in to cover for the raise in the bond yield.
Another important point is that fiscal deficits tend to also increase bond yields simply because there is more debt running for the same amount of investor funds. As such, investors can potentially gain higher compensation as demand for their funds has increased. Furthermore, the higher the deficit, the more unlikely it is that the state will remain able to meet its repayments.
Consequently, higher, persistent deficits are indicative of higher risk in the economy as potential fiscal actions would need to be taken in the future, i.e. increases in taxation or spending cuts. This increase in non-payment risk is bound to increase yields as well.
In the US, approximately 68% of overall GDP can be attributed to Personal Consumption Expenditure (PCE), with similar percentages registered for other countries as well. Note that since overall GDP measures the amount of goods and services produced via the expenditure method (among other methods), having one variable accounting for that much surely underlines its importance.
In general, PCE measures the amount of money that consumers have spent on goods and services in the previous quarter and hence provides an overview of how people feel about the state of the economy. If the PCE growth rate is negative, then consumers have either decided to spend less on a whim, or they are able to purchase less.
The latter could be due to either higher supply-side inflation or because of higher unemployment or because wages have been cut. In the first case, if this is just a short-lived reaction, we can expect that negative growth will not persist for long. However, in the other three cases, we can expect the negative pressures on GDP to be more persistent.
Unfortunately for investors, there is a significant lag between each PCE data release, given that they are published only once per quarter. To avoid this lag, a monthly publication called Retail Sales is released, aiming to capture shorter-term developments in consumption expenditure. Retail Sales collect total retail turnover from retailers to gauge how personal consumption has changed.
Given its monthly frequency, Retail Sales data tend to be noisier and more prone to seasonal patterns. To this end, my personal preference is to look at both m/m and y/y growth rates to gauge both the short-term and the long-term trend in the data. In addition, due to the increase in noise, one-off negative effects should be overlooked.
Retail Sales data are widely used by financial markets as well as policymakers, as Central Banks use retail sales to analyse trends in consumer purchases and overall demand-side inflationary pressures as part of their overall analysis of the economy. Since Retail Sales are measured across all sectors of the economy, all industries are directly impacted by these data, hence stock markets are also directly affected.
To this end, the release of the Retail Sales Report can cause volatility surges both in the FX and the stock market. Retail Sales, serving as a proxy for private consumption, can also provide signals regarding recessions.
As the chart on the previous page suggests, retail sales started to drop in December 2007, stabilizing at a lower level and then moving on to deteriorate further from July 2008 onward. By the time the US economy was officially declared as being in a recession on December 1, 2008, retail sales had already declined almost 11% since June 2008, and about 12% since their peak in December 2007. Similar to this, Retail Sales started to increase in April 2009 and continued their upward trend, despite the occasional down month, way before the September 2010 data officially declared that the recession had ended.
It is especially because of its importance as a forward-looking variable that Retail Sales can cause volatility surges, even if this proves to be a false alarm given the large amount of noise in the series. Remember again that expectations matter and hence what we should observe is how far off the reported chart is from the consensus forecast.
Retail Sales - An Example
Remember that the main idea was that worse-than-expected Retail Sales releases are bad because they imply less consumption spending. This would be bad both for the stock market, given that less spending means less profits, and the currency market given that it would suggest that the economy is growing more slowly than expected.
Now, in 2018, US Retail Sales release showed that the numbers for September were much worse than anticipated. How did the market react?
Industrial Production and Capacity Utilization
The Index of Industrial Production measures the volume of goods produced by various industrial firms such as factories, mines, utilities, and publishing. In the US, the Index is set to be 100 in 2012 and hence Industrial Production is essentially compared not only to last period (via the growth rate) but with the 2012 level.
The Index assists Central Banks understand how industrial production has fared over the previous period, while it also allows us to observe whether the increase in inflation is also coupled with an increase in industrial production and hence can be attributed to demand or supply sources. If prices are increasing without industrial production moving then we can expect that price changes are not due to demand factors. On the other hand, if industrial production increases we can expect that demand-side inflation will also be increased in the future.
Capacity Utilization refers to how much of available production ability has been used in the past month as a percentage of total production ability. Naturally, the higher the Capacity Utilization rate used, the better for the economy given that it is reaching better levels of production and is producing more goods. In essence, the closer to 100% Capacity Utilization is, the more the economy is producing and does not leave economic resources sitting idly.
Durable goods orders are widely considered to bear much importance for the economy and the FX markets and this is why the majority of economic calendar providers include it in the list of the most important events on the day they are announced.
How big is the effect? Just in the first ten minutes into the October 25, 2018 durable goods release, the Euro gained 13 pips against the US Dollar (chart above), while a move of 33 pips took place in the first five minutes after the announcement. At the same time, the S&P500 (chart below) rose by 8 points within five minutes of the announcement.
The question then is why this particular indicator is of such importance. To put things in perspective, think of all the categories of goods this includes: automobiles, furniture, jewellery, electronics, and so on. These goods are, by definition, durable, because they are expected to be used for a long period of time. As such, durable goods are usually more expensive than non-durables and services, particularly for this reason.
Their high value necessitates that, in order to purchase them, interested consumers first need to have the available money. This, from the consumer's perspective, would either mean that they have saved up this amount of money and they are not afraid of using it or it would mean that they have found an alternative way to fund this purchase, most likely a loan.
Given that we are all consumers, it is easy to understand that we are more willing to part with a large amount of our money when the economy is growing and we are earning more in wages. In a similar manner, banks are more willing to extend credit to us when it observes that our income is steady and the economy's prospects are bright, as this maximizes the probability of getting its money back.
The transportation part of durable goods consumption is usually not employed given that in industries such as aviation, one large order is enough to severely distort our view of the market. Thus, while the interested investors keep an eye out for any unexpected developments in the transportation market, traders usually employ orders for durable goods excluding transportation. Durable goods orders usually move in a relatively cyclical manner, along with inventory and investment cycles, but only register large and persistent decreases during recessionary periods.
Given that new orders for durable goods usually go hand in hand with inventories (red line), and the latter are a key determinant of investment, it is thus not surprising that traders keep a close eye on them. Even in terms of measurement, purchases of durable goods are usually classified as investment demand, while non-durable purchases are usually considered as part of consumption demand.
As such, as employment and retail sales data proxy for the consumption part of GDP, durable goods measure the equally important investment part of the equation. Without investment there would be very little potential for future growth, given that all growth would necessarily have to come from consumption, something which is not very viable in the long run.
Given that the GDP report is only out once a quarter, durable goods orders are a very useful indicator when it comes to gauging the short-term developments in investment.
NonFarm Payrolls - NFP
Non-Farm Payrolls (NFPs) are probably the most important leading indicator in the US economy, in anticipation of CPI and GDP results. The predominant measure of economic performance, as elaborated in various previous posts, is consumption and investment. The more people are employed, the more a nation will spend and hence the higher economic growth will be, as measured by GDP.
In addition, the higher the employment in a country, the more likely it is for firms and entrepreneurs to invest, as demand for the goods and services they will produce will be higher, and hence the higher aggregate investment will be. In contrast, if less people are employed then spending will be much less, demand will drop, and investment will be much lower.
The NFPs provide exactly this type of information. The indicator measures the change in the number of employed people across all US sectors, excluding farming. The reason for excluding the farming sector is that it is, almost by definition, affected by factors which are not due to economic conditions, such as weather and seasonality in crops.
Furthermore, the agricultural sector only has a small contribution on the overall US GDP. With regards to its importance, it is not just that NFPs have a strong fundamental interpretation. In addition, the fact that it comes out just a few days into a new month allows us to use it as a leading indicator for the future of the US economy. To this end, volatility tends to be very high during the time when NFPs are out.
Let's have a look at what happened in the October 2018 NFP release. The above chart, using a 5-minute frequency, suggests that as NFPs came out worse than expected, at 134,000 compared to expectations of 185,000, due to the hurricane season.
The Dollar traders were caught by surprise and just focused at a better-than expected unemployment rate, after which the Dollar depreciated by of 24 pips just 10 minutes after the announcement. Following that rather unexpected reaction, markets realized that NFPs matter more than the unemployment rate and the Euro started to rally, by a total of 47 pips.
Unemployed people are defined as those who are eagerly active in looking for a job, able to obtain it, but have yet to find one. This definition excludes pensioners, students or underage people from it and thus assists in obtaining a better view regarding job destruction and creation in the economy. After obtaining the number of unemployed persons, this is divided by the total labour force. The latter is simply comprised of the number of employed and unemployed people.
Initial and Continuing Jobless Claims
The Unemployment Rate comes out once a month, but policymakers and traders want more frequent information. To this end, Initial Jobless Claims measure how many people have filed for unemployment benefits in the previous week after being separated from an employer. As such, Initial Claims can serve as a leading economic indicator once its volatility, due to its higher frequency, is also taken into consideration.
While Initial Jobless Claims measure emerging unemployment, Continued Jobless Claims measure the number of persons which have already filed an initial claim in the past and have experienced at least one week of unemployment since then. The number of persistently unemployed persons, while not serving as a leading indicator, provides an overview of labour market conditions and usually serves as confirming evidence of the state of the US economy.
In the case where a recession badly hits the economy, some people may become disappointed from the constant search for employment and decide they will stop actively looking for a new job. This, according to the unemployment definition, means that they will not be included either in the unemployed or the employed pool of citizens.
In other words, this means that these people will no longer be included in the labour force but will be part of the greater definition of the working age population, which just measures the number of people who belong in a certain age group and are able to work but choose not to.
Participation rate is an important indicator because it measures the willingness of people to participate in the workforce. If the economy is doing well then more people are willing to join the labour force, hence the participation rate is bound to increase. Overall, a higher participation rate is usually better for the economy and the currency.
After being employed, the most important thing is how much one is actually earning. Earnings, which also come under other names such as average hourly earnings (US), average earnings (UK), or wages (Australia) are important as they are a leading indicator of inflation and growth. Higher inflation would mean that prices would increase and hence a corresponding increase in the wage level should take place in order for workers not to lose any purchasing power.
However, this would mean that their purchasing power has been increased and thus they would be purchasing more, leading to an increase in inflation. As is well known, demand-side inflation is a side-effect of economic growth and hence higher labour earnings should signify that both inflation and the economy are growing, with the expected positive impact on the FX market.