Economic Indicators That Move Financial Markets

Economic indicators are the key drivers of financial markets. For a novice trader, currency market is always full of surprises. Price moves when you don’t want it to move. But for a professional trader there is no surprise as he keenly follows these economic indicators like professional market analysts. Gold prices are keenly watched by investors all over the world. India and China have become major consumers of gold. Gold price is intricately linked with US Dollar. Did you read this post on Gold prices reaching 3 month’s high? This increase in gold prices was the result of poor economic data. Whenever there is a risk of economic recession, investors rush to gold as safe haven. So you can well imagine how important economic data is for the global financial markets.

US Dollar (USD) is one of the major currencies in the market. If you are trader you know most pairs trade against USD. For example EURUSD, GBPUSD, USDJPY, NZDUSD, AUDUSD, USDCAD and USDCHF are some of the major currency pairs. But this doesn’t stop here. Most exotic pairs also get traded against USD like USDTRY, USDMXN, USDDKK, USDSEK, USDNOK, USDHUF and so many more pairs. TRY is the symbol for Turkish Lira while MXN is the symbol for Mexican Peso. So this is what I am going to do. I will discuss the economic indicators that move US Dollar (USD). Once you understand what are the economic indicators that move USD, I will also discuss what moves EURO (EUR) and British Pound (GBP). Actually if you look at the Forex Factory Economic News Calendar, you can see what are the daily economic news releases that effect the currency market.

Daily Economic News Calender

If you take a look at the above Forex Factory Daily Economic New Calendar, you can see different currencies with their respective economic news releases on a daily a basis. For example in the above screenshot, you can see New Zealand Dollar (NZD) at the top with RBNZ Rate Statement. Rate Statement is just like the FOMC Meeting that is held every month at Royal Bank of New Zealand. For the Federal Reserve FOMC Meeting a general overview of the US economy is taken and decision is taken by the Federal Open Market Committee on whether to increase/decrease Federal Fund Rate which than sets the short term and short term interest rates in the economy.

Royal Bank of New Zealand also has a monthly meeting where the rate decision is taken. Almost all central banks have such monthly meetings. Now if you look down you also see British Pound (GBP) MPC Official Bank Rate Votes and the Monetary Policy Summary plus Official Bank Rate. So on the same day every month we have the Bank of England having its MPC Meeting and the decision on the bank rate plus monetary policy. We also have Retail Sales M/M for GBP just 21/2 hours before the MPC Meeting. Many traders wonder whether EURO will reach parity with USD.  Read this post when market analysts predicted EURO DOLLAR parity.

So you can well imagine daily the economic news calendar is full of economic releases for different currencies that move those currencies. These economic news releases provide information about the different economic indicators that are considered important for an economy. Financial market analysts are a keen watchers of these economic indicators. Markers react differently to the good/bad readings of these economic indicators. If you want to understand why currency pairs suddenly change their directions, you should keep an eye on these economic indicators like the professional market analysts.

When we are trading for example GBPUSD, we should check what economic news releases GBP has for that day plus what economic news releases USD has for that day. Interest rates and money supply are very important for any economy. These are the monetary tools at the disposal of the central banks that make the decision every month what to do with the interest rates and the money supply to keep the economy on track. Central banks are tasked by law to keep inflation and unemployment low. Now this needs a trade off most of the time.  So central banks hold these monthly meetings and check the economy and take corrective action by adjusting interest rates and money supply.

Federal Reserve can increase and decrease money supply in the economy by buying/selling treasury notes. The whole economic system is intricately build and in times of crisis can act like a house of cards. The first card to fall is the financial markets. This is precisely what happened in the 1929 New York Stock Market crash that acted as a trigger for a global economic depression.If we want to understand how these economic news releases move the financial markets and what are the important economic indicators, we will need to discuss some macroeconomics and try to understand how these economic indicators effect the economy and as a result affect the currency of that economy. Read this post on why US Dollar is no longer the king.

Let’s focus on US Dollar and the US economy. This will help us understand what happens in the US economy and how it effects the US Dollar. Once you understand that you will easily understand rest of the economies in the world also. There are some 18 economic indicators that effect USD. Just keep this in mind. Currency market is the central hub of financial markets. What moves US Dollar also moves US Stock Markets and what moves GBP also moves the London Stock Exchange. What moves Yen (JPY) also moves the Tokyo Stock Exchange and what moves Aussie Dollar also moves the Australian Stock Exchange. All the the financial markets are intricately linked. I will make the link more clear below as you read. So let’s start with the most important. USDJPY is an important currency pair. Read this post on will USDJPY range between 100 and 105.

Gross Domestic Product GDP Q/Q

Gross Domestic Product is the most important economic indicator for any economy. Gross Domestic Product also known as GDP measure the total economic output in the economy on an annual basis. Since we will focus on the US economy. GDP measures the total economic output of the US economy on an annual basis. GDP was invented in US in the early part of 20th century and from there rest of the world also started measuring their annual economic output in terms of GDP. Gross means that we haven’t included the depreciation of capital goods that take place during a year into the calculation of GDP. GDP can be nominal as well as real. Nominal GDP is when we measure the economic output in terms of current prices without accounting for the inflation that took place during the year. Real GDP is when we calculate economic output in terms of inflation adjusted prices what we call constant prices. Size of GDP can be used to compare different economies. When we calculate Real GDP we fix a year as a base year and then calculate the prices in other years relative to that base year.

You should have the concept of circular flow in an economy. Whatever the consumers spend and the government spends in the economy goes into the pockets of the capital owners as profit and workers as income. When the workers get paid they go to the shops and buy good and services which are produced by that economy. Some part of the profit that goes to the capital owners gets reinvested in the economy as plant and machinery as well as R&D. So the economy is a circular flow. Capital leaks out of the economy in the shape of imports and capital flows into the economy in shape of exports. So when we import more, we will have more capital outflow which can result in strong pressure on the domestic currency to depreciate. This is what happens in most developing countries that do not export much but import a lot.

This is important. Since we are focusing on financial markets, we need to know how GDP effects the financial market. GDP figures are released on the quarterly basis. Financial markets focus on the seasonally adjusted annualized percentage change in the expenditure based GDP in the current quarter as compared to the previous quarter. Three reports on quarterly GDP figures are released by the US Department of Commerce.First we have the Advanced GDP Q/Q report released in the first month of the following quarter. Then we have the Preliminary GDP Q/Q report released in the second month of the quarter. After that in the third month we have the Final GDP Q/Q report. All these reports are released by the US Department of Commerce and you can find them listed in Economic News Calendar sites. Most of the time we traders are worried whether a given rally will last or not. Read this post on AUDUSD rally.

This is how the analysts at Wall Street look at these three GDP Q/Q reports. Q/Q stands for quarter by quarter. Wall street analysts look at the seasonally adjusted real expenditures based GDP of the last quarter as compared to the previous quarters. They breakdown the GDP Q/Q figures into the final sales and inventories to predict the future economy. Since GDP are already published and known to the market, reaction is most of the time mild. Reaction only comes when there is something unexpected. This is most of the time at the release of the Advance GDP Q/Q report as compared to the Preliminary and the Final GDP Q/Q report. GDP Q/Q figures are also important for GBP, JPY, NZD, AUD and other currencies. Central banks are very important players in financial markets especially the currency markets. Read this post on how central banks rule the currency market.

GDP Deflator

GDP Deflator is another important economic indicator that is a measure of the overall inflation in the economy as it takes into account changes in price levels in the overall economy that includes consumer products, capital goods, the government and the imports and exports. There are three types of GDP Deflators:

  1. The Implicit Price Deflator
  2. The Fixed Weight Deflator
  3. The Chain Price Index

The Implicit Price Deflator measures the changes in the general price level plus changes in the composition of output as some goods are less expensive than others. Since 1989, US Department of Commerce has been using the Fixed Weight Deflator. Year 1987 is taken as the base year. The Fixed Weight Price Deflator measure only the changes in price levels.The Chain Price Index measures a combination of fixed weight and variable baskets. Chain Price Index is seldom used. Rigging is an important issue in the financial markets especially the currency markets. Read this post on forex market rigging allegations being investigated by Bank of England.

US Bureau of Economic Analysis releases the figures for these three GDP Deflators four weeks after the end of each quarter meaning around 1 month after the start of the new quarter the GDP and GDP Deflator figures for the previous quarter are released which are seasonally adjusted and annualized before release. As said above, market analyst pay more attention to the Fixed Weight Deflator as compared to the Implicit Price Deflator. Fixed Weigth Deflator measures the general price level change so it is considered to be more relevant while Implicit Price Deflator measures changes in GDP composition as well as the general overall price levels in the economy.

When government increases the pay levels in the government sector it is usually done in the first quarter and can cause GDP Deflator to increase drastically. An increase in the GDP Deflator figures is not considered good by the financial markets and will most of the time lead the stock prices to fall alongwith the bond prices as well as fall in the value of US Dollar. A moderation in GDP Deflator figures will have an opposite effect with stock prices rising, bond prices rising and the US Dollar appreciating. GDP Deflator is an important economic indicator that you should not ignore.

Producer Price Index PPI

PPI is an important economic indicator and it measures the price that is charged by the manufacturers and the farmers to the shops. US PPI is measured in three different ways. First PPI is based on the type of commodity produced. The second type of PPI is based on the net output of the industries. Last type of PPI is based on the stage of industrial production. The third way of calculating the PPI is considered more relevant by the Wall Street market analysts. Watch this video on how to capture trends in the market.

The stage of industrial production PPI is divided further into three types. The first is the crude materials that require further processing like the crude oil and live stock both need further processing before they can be sold to the consumers. Second type of PPI is based on the intermediate materials, supplies and components. These intermediate goods require further processing before they can be sold in the market. The third type of PPI is based on finished goods that can be sold in the market directly.

You might be wondering what’s the use of separating PPI calculations into three different types. PPI calculations are separated into three different types as it helps in measuring inflation as it works its way through the production process. These three different PPI measures can show if inflation is low at the crude material stage and later increases at the intermediate level and then the final level. There is a fourth PPI measures also that combines the three PPI measures into one overall commodity index.

Financial market analysts are interested in the monthly changes in the finished goods PPI. Food prices are seasonal while energy prices can be highly volatile so they get stripped out of the core PPI which the market analyst watch every month. PPI figures are published by US Department of Labour in the middle of each month.  Market analysts focus on the seasonally adjusted PPI figures and look at the month to month changes as well as quarter to quarter changes and six month to six month and year to year changes. This gives them a rough idea of where the inflation is heading in a general trend.

It is important to not confuse noise with the general trend. As said above analysts look at the core PPI which is a headline PPI minus the food and energy. Now core PPI contains volatile auto component which accounts for roughly 5% of the finished good index. Financial analysts eagerly look for these PPII figures when they are released. Money market analysts want low inflation as compared to high inflation. So increase in PPI value will have a negative effect on the money market and the bond market. When inflation increases above a given threshold level, Federal  Reserve is forced to increased interest rates to cool down the heated economy.

Accelerating inflation is not viewed positively by the stock market and the currency market. If PPI values are increasing and accelerating meaning increasing month by month and quarter and quarter, stock market will react negatively alongwith the currency market until and unless there is a strong expectation that Federal Reserve is planning a rate hike to combat accelerating inflation. Psychology has a very important role of play in the financial markets. Watch these videos on how to master trading psychology.

The Index of Industrial Production

The Index of Industrial Production is an important economic indicator. Federal Reserve publishes on the 15th of each month, the preliminary estimate of the previous months industrial production. Industrial Index Production figures are divided into a number of indexes that measure the US industrial production in different sectors like US factories, mines, gas and electric utilities. The main index is broken down into number of indexes that measure production by the type of industry that is manufacturing, mining and utilities and by the type of markets that is consumers, equipment, intermediate and raw materials.

After the release of the first preliminary estimate on the 15th of each month, the second estimate along with the first preliminary estimate for the next month are published after 45 days. After that the second, third and the fourth estimate are published in the subsequent months. US Index of Industrial Production Report is based on the employment report published 2-3 weeks before by the US Bureau of Labor Statistics. Industrial production is a cyclic thing that rises during times of economic expansion and falls during times of economic recession. Since this index is published every month, analyst use it as a proxy for GDP even though industrial production only represents 20% of total GDP.

When this index rises it means rise in industrial production which means economic expansion is taking place. This is taken as a warning signal by the analyst as they think rise in the index of industrial production is a warning signal for inflationary pressure increasing in the economy. Inflationary pressures rising in the economy means a potential interest rate hike which is a bad signal for the money market and the fixed income bond market. Increase in interest rate means bond prices falling. On the other hand, decrease in the index of industrial production is a warning signal that the economy is contracting which means interest rates will need to be reduced. This is a good signal for the fixed income bond market. Decrease in interest rates means increase in bond prices.

Stock market analysts and the currency market analyst like rising index of industrial production together with the capacity utilization rate which is a signal for economic strength. Stock market analysts focus on increase in corporate earnings while forex market analyst focus on increase in interest rates. Higher interest rates means more demand for US stocks and as a consequence a higher US Dollar when foreign investors buy US Dollars to invest in the US stock market. But what is Capacity Utilization Rate? Let’s discuss it now!

Capacity Utilization Rate

Capacity Utilization Rate measures the percentage of capital stock in the economy that is being utilized for industrial production. In more technical terms, Capacity Utilization Rate of an industrial sector is measure is equal to the Output Index divided by Capacity Index. Output Index is the Index of Industrial Production that we have discussed above in detail. Capacity Index tries to measure the sustainable practical capacity which is based on work scheduled and the availability of inputs to operate machinery and equipment that is being used.

Capacity Utilization Rate is published by the Federal Reserve at the same time it publishes the Industrial Production which is 2 weeks after the end of each month. Capacity Utilization Rate tells us the capacity of the industry to fulfill aggregate demand. When aggregate demand increases beyond that threshold it results in inflationary pressures building in the economy. The threshold at which inflationary pressures start building up has risen over the years due to technological progress over the years.

In the past Capacity Utilization Rate has been used as a leading indicator of inflation. But in recent years, its value has become less important. This is due to the fact that the Capacity Utilization Rate is based on different industries that has different threshold levels. For example paper industry has a capacity level of 95%  whereas the non electric machinery level has a capacity level of 75%. So you can see there is a huge difference in capacity levels between the different industries. Watch this video tutorial on how to read forex charts.

Market analyst look at both Index of Industrial Production and the Capacity Utilization Rate when doing their analysis. A rise in Index of Industrial Production is good as it means economic strength. So a rise of 1.5% in the Index of Industrial Production is considered good but if it comes with 85% Capacity Utilization Rate whereas the threshold is 75% means rise in inflationary pressures which is not good for financial markets. Inflationary pressures mean the economy is overheating and the Federal Reserve will be forced at some point to hike the interest rates. Food and energy prices are also keenly watched by market analysts. Increase in crude oil prices in the global market result in inflation building up in the domestic economy. In the same manner increase in food prices also mean inflationary pressures building up.

Crude Oil Prices

Crude oil price is considered to be an important economic indicator. Crude Oil prices are watched keenly by financial markets. Rising crude oil prices means rising inflation and a global economic slowdown. China has recently opened its commodity futures exchange. Till now New York Mercantile Exchange (NYMEX) was the place where crude oil prices primarily used to get determined. China has become the biggest importer of crude oil in the crude oil and as said China has recently launched crude oil futures contracts in Shanghai Exchange. It might take a few years for the Shanghai Exchange Crude Oil Futures contract to replace NYMEX.

NYMEX right now determines both the spot and the futures price of crude oil in the global market. Spot and futures price of crude oil is quoted continually in real time on the NYMEX screen based information system. US is also a major importer of crude oil. As said market analyst view rising crude oil prices as a signal for inflation. But its not easy to determine the long term trend and predict crude oil prices months ahead based on hourly changes in the crude oil prices. Crude oil is highly prone to react wildly to rumors. So it is difficult to predict sustainable increase in crude oil prices.

The sudden increase in crude oil prices in 1973 resulted in a global recession with the US economy hit hard. So whenever there is a rumor that crude oil prices can increase due to political uncertainty in Middle East which is the major exporter of crude oil, stock market and the currency markets react wildly. If the rumor is found to be not true after a while stock market and the financial markets in general return to calm but we can see short term volatility in the financial markets. In coming years, crude oil may not be as important for US economy as US is expected to increase shale oil production and become a major exporter of crude oil instead of a major importer.

Food Prices

Food prices are very important for any economy and can be considered to be an important economic indicator. Food prices are very important for the stability of an economy. Food prices effect the lower income and middle income groups more than the rich people. Since majority of the people in any economy belong to the lower and middle income groups, food prices are closely monitored  by economists and market analysts. In US, market analysts keenly watch the Index of Prices Received by Farmers. This index is also known as the Ag Price Index.

Index of Prices Received by Farmers consists of crop prices and livestock and dairy product prices. These are average prices in each sector with crops giving 44% composition to this index while livestock and dairy products giving 56%. US Department of Agriculture is responsible for publishing the Index of Prices Received by Farmers at the end of the month based on figures till the middle of the month. No seasonal variations are included in the index calculations.

Now this in important for you to understand. Index of Prices Received by Farmers is a price index which measure prices at the first point of sale at the farmer level and the prices are aggregated. If you compare it to Consumer Price Index and the Producer Price Index both of them are seasonally adjusted and measured at the finished product stage that means it is adjusted for quality and grades of food products. Since Index of Prices Received by Farmers is not seasonally adjusted, the index declines somewhat at the harvest stage when the supply of food and livestock items increases in the market and increases off season when the demand is high and supply is low.

Ag Price Index is released late afternoon at the end of each month. As said, market only reacts when there is a surprise large rise in the index which can result in bond prices going down if the market is already feeling bearish. On the other hand, if the index gives a surprise large drop, bond prices can increase.

I will continue with the economic indicators that are keenly watched by the market analysts in the next post in which I will discuss in depth how Commodity Price Indicators  affect the financial market sentiments. The gist is these economic indicators affect market sentiment by making the participants bearish or bullish on the economy. Just keep this in mind, financial markets don’t hang in the air with no relevance to the economic ground realities. In the short run, we can find financial markets highly sentimental and irrational but in the long run, financial markets have the capacity to rationally analyze the situation and adjust accordingly.

As I had said, currency markets are the spinal cord of the financial markets. Whatever happens in the currency markets gets transmitted to other markets and whatever happens in other financial markets gets transmitted to the currency markets. Now if you have been trading for a while, you must have noticed chart patterns failing repeatedly. Why is this so? Did you ever try to know the reason? The reason is simple! It is the fundamentals that move the markets. Whatever you see on the charts is just the reflection of the fundamentals at that point of time. When fundamentals change, you will see chart patterns immediately reversing themselves. So if you are a trader, it is always a good idea to daily check the economic news calendar.

Important question! Can we use fundamental analysis in our trading? Technical traders question the value of fundamental analysis. They argue that at any point of time, price reflects all the publicly available information. So all we need is to look at the charts. This is true fundamental analysis is not precise and so is technical analysis. These economic indicators don’t tell you how much the market will move as a reaction. But knowing the time when these economic indicators are released can surely help in improving the performance of your trading system. Asian market hours are the most passive. During Asian market hours, there is no important economic news release especially for USD, EURO and GBP so most of the time GBPUSD, EURUSD etc don’t move much during asian hours. However currencies like JPY, AUD and NZD have important news releases during Asian market hours, so you can see AUDUSD, NZDUSD and USDJPY move a lot during Asian market hours. This is how you can incorporate these economic indicators  into your trading by looking at the time these economic news releases are made. At the time of these economic news releases anticipate high volatility.