Education > Forex - Step4

[SECTION 2.2]

Strong economy, strong currency

Strong economies and strong currencies tend to go hand in hand. When an economy performs well, corporations are making profits, most of the workforce is employed and, in most cases, interest rates are on the up. Each one of these characteristics of a strong economy benefit you as a forex trader.

You will remember from the first fundamental analysis section that rising interest rates are the best indicator of rising currency values. Central banks all over the world determine interest rates in their respective economies. These central banks typically raise interest rates when inflation?as measured by the consumer price index (CPI) and the producers' price index (PPI)?starts rising too quickly.

Economic growth spurs inflation. The stronger the economy is, the higher the demand for workers becomes. As demand for workers goes up, their wages go up accordingly. The more money workers take home, the more disposable income they have to spend at retail stores, on cars and on houses. As demand for goods and services increases, the price for those goods and services also increases. That, in a nutshell, is inflation.

Naturally, if central banks watch inflation indicators (like the CPI and PPI) in their decision-making process, you would assume they would also be interested in watching economic strength indicators to see how strong an economy is. The assumption would be right.

Central banks watch the following fundamental economic indicators to assess the strength of an economy. You should too:

1. Gross domestic product (GDP) [SECTION 2.2.1]
2. Payroll employment [SECTION 2.2.2]
3. Durable goods orders [SECTION 2.2.3]
4. Retail sales [SECTION 2.2.4]

[SECTION 2.2.1]

Gross domestic product

Gross domestic product (GDP) is the broadest measure of aggregate economic activity available. Reported quarterly, GDP growth is widely followed as the main indicator of economic performance.
GDP represents the total value of a country's production during the period. It is made up of the purchases of domestically produced goods and services by individuals, businesses, foreigners and the government.
As GDP reports are often subject to substantial quarter-to-quarter volatility and revisions, it is wiser to follow the indicator on a year-to-year basis. It can be valuable to follow the trend rate of growth in each of the major categories of GDP to determine the strengths and weaknesses in the economy.
A high GDP figure is often associated with expectations of higher interest rates. This is frequently positive, at least in the short term, for the currency involved. The exception would be when expectations of increased inflationary pressures concurrently undermine confidence in the currency.

Extra material / cut outs

The top five countries based on GDP are as follows (GDP levels are reported in U.S. dollars for comparison):

1. United States $12,455.83 billion
2. Japan $4,567.44 billion
3. Germany $2,791.74 billion
4. China (excluding Hong Kong) $2,234.13 billion
5. United Kingdom $2,229.47 billion

Source: The Economist
The GDP of the United States dwarfs those of the other large economies. It means you should keep a close eye on U.S. economic data as a forex trader.

[SECTION 2.2.2]

Payroll employment

Payroll employment measures the number of people being paid as employees by non-farm business establishments and units of government. Monthly changes in payroll employment reflect the net number of new jobs created or lost over the month. Changes are followed carefully as an important indicator of economic activity.
Payroll employment is one of the principal indicators of aggregate economic activity because it permeates every major sector of the economy. It is also useful to examine trends in job creation in several industry categories as significant deviations in underlying industry trends can get submerged in the overall data.
A big rise in payroll employment is seen as a sign of strong economic activity that could lead to higher interest rates. In the short term, these would be supportive of the currency. But if inflationary pressures are thought to be developing, this may undermine long term confidence in the currency.

[SECTION 2.2.3]

Durable goods orders

Durable goods orders measure the number of new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods. Monthly percentage changes reflect the rate of change of such orders.
The amount of durable goods ordered and significant changes in orders are widely followed as indicative of factory sector momentum.
Durable goods orders are a major indicator of manufacturing sector trends as industrial production is generally done to order. The indicator excludes defence and transportation orders, however. That is because these are generally much more volatile than other orders and can mask more critical underlying trends.
Durable goods orders are measured in nominal terms and therefore include the effects of inflation. Therefore, durable goods orders should be compared to the trend growth rate in PPI to arrive at the real, inflation-adjusted durable goods orders.
Rising durable goods orders are usually linked to stronger economic activity. It can therefore lead to higher short-term interest rates that are often supportive to a currency at least in the short term.

Peeking ahead

Durable goods orders are often affected by an economy's ability to export its goods abroad. If exports start to fall, a subsequent decline in durable goods orders will probably follow. You will learn more about an economy's trade balance (the difference between its exports and imports) later.

[SECTION 2.2.4]

Retail sales

Retail sales measure the total receipts of retail stores. Monthly percentage changes reflect the rate of change of such sales and deserve close scrutiny as an indicator of consumer spending.
Retails sales are a major indicator of consumer spending because they account for nearly half of overall consumer spending and approximately a third of aggregate economic activity.
Retail sales are, frequently, viewed as less important than auto sales as they are generally much more volatile. �More important underlying trends can get lost if you focus too heavily on them.
Retail sales are measured in nominal terms and therefore include the effects of inflation. Rising retail sales are often linked to a strong economy and therefore lead to the expectation of higher short-term interest rates that are often supportive to a currency at least in the short term.