Interest rates may be most critical to traders when dealing with economic indicators for forex trading
Interest rates has often been put together with various other economic indicators to perform economic analysis on an economy. Many economic indicators are described as important. These include but not limited to Gross Domestic Production (GDP), Consumer Price Index (CPI), Producer Price Index (PPI), Employment, Retail Sales, Trade Balance, Current Account etc. However these are not equally important to all economies. Each economy has its unique structure that requires emphasis from different measures. Interest rates has features that make it easiest to master for an individual, whether he is involved in short term forex trading or making a long term investment in currencies.
Economic indicators each possess different qualities; each economy should be measured differently
Economic indicators are measurements of growth and inflation in an economy, demand for its currency as well as political and other stability. A strong booming economy leads to higher demand for its currency due to investment purposes. There could be higher speculative demand in anticipation of further currency appreciation. A weak declining or outright contracting economy leads to lower demand for its currency because of outflows. Money shifts to other regions. This outflow leads to currency depreciation. As mentioned earlier, different economies may be measured effectively with different economic indicators.
United States of America
USA is a technology leader but its manufacturing has moved overseas. The economy is largely consumption driven. With such an economy, economic indicators that are important are employment, retail sales, housing sales, CPI etc. These are indicators that measure the health of the US consumer. Even though the US retains a car manufacturing base, it can be said that the car production indicators are a measure of the health of the US consumer and not its export ability.
People’s Republic of China
China on the other hand relies on foreign investments, low cost manufacturing to power its economy. Despite a growing middle class, the economic indicators that matter to China are balance of trade, investment flows. Because of uneven growth and income distribution because of a huge rural population, the consumer price index has often been associated with China’s political stability more than the economic health it is supposed to measure.
Challenges that forex traders face when dealing with economic indicators
Individual forex traders will be challenged to process many different economic indicators. Difficulties come from availability, price and timeliness of data, as well as the ability and acumen to interpret them correctly. In fact, individual traders who claim that they trade forex with fundamental analysis are most likely speculating the short term technical movement of a currency following the release of a economic indicator.
Interest rates as an important ‘glue’ that pulls together fundamental analysis
Because it is such an important indicator, secondary analysis and information are very easy to find.
Because an interest rate is a policy action, it can be said that the best experts in central banks have processed all the other economic indicators to arrive at a decision.
Although point 3 above makes interest rates a kind of lagging indicator but they are excellent for confirming trend. By the time central bankers agree, signals from other economic indicators are already there.
Because no sane central banker would move interest rates in abrupt up-down fashion because of political and investment reasons, interest rates tend to move in gradual fashion albeit with pauses in between.
Stages of interest rates and the economy; some simple guidelines
These are guidelines because besides the numbers, financial markets also react according to market sentiment that are emotion driven. That is why economic models are usually based on ‘ceteris paribus’ that is ‘all other things being equal or held constant’.
Low to zero interest rates/ contracting, bottoming economy
Low interest rates are applied as a stimulus when an economy is needs to be revitalized. Economic health is poor so all the other economic indicators are poor. There are investment outflows because of poor economic development. Low interest rates can drive exchange rates lower.
Zero rates usually are usually associated with the bottom of an economy. Some times poor economic health can persist despite zero rates. A good example is the Japanese economy, one that persists to be perform poorly despite zero rates since the 90s.
Zero to rising interest rates / bottomed, recovering economy
At zero interest rates, money does not earn returns from deposits. Money that is seeking returns might be driven to make capital investments. These drive ecnonomic growth. Other economic indicators start to do well as economic activity improves. As a result exchange rates might start to rise because foreign investment inflows create demand for currency. There is also speculative demand in anticipation for higher interest rates.
Increasing to high interest rates / booming economy
High interest rates are applied to arrest an overheating economy and inflation. Other economic indicators are red hot and exchange rates are very strong. Increasing interest rates are good signs to forex traders as they confirm the uptrend. But high interest rates at historical high levels can be worrying because central banks can overshoot interest rates when an economy is starting to decline.
Singapore one exception
Although interest rates are the single most useful and easy to use economic indicator, again not all economies play by the same rules. Singapore is an example. It has a small economy despite very high GDP per capita. It is still export driven and depends on raw material imports as well as import of energy, food and building material. Therefore Singapore experiences imported inflation. Unlike other central banks that rely on interest rate as a policy action, the Monetary Authority of Singapore (MAS) adjusts the exchange rate of the Singapore Dollar instead. The Singapore Dollar is floated in a controlled band against a basket of other currencies.