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TRADER'S NOTEBOOK


Interdependent Economic Factors And Forex

10/04/11 10:15:19 AM PST
by Rudy Teseo

Business cycles, asset allocation, economic indicators, and forex are intertwined in ways you can only begin to imagine.

What kind of effect do business cycles, asset allocation, and economic indicators have on forex? Understanding such relationships may determine your success in trading the foreign exchange market. In my July 2005 STOCKS & COMMODITIES article "Forex, Anyone?" I mentioned the immediate impact that changing economic indicators had on forex: more so, it turned out, than on common stocks. In recent years, the global economic picture has never been worse. So I decided to explore the topic, using personal trading experiences and notes gleaned from books, articles, and seminars. I have also found that exploring the content found in the websites listed in the sidebar "Economic Indicator Calendar" was an invaluable aid in understanding economic indicators.

ENTERING THE FOREX TRENCHES
This is for those market participants who have been successful in trading the stock market with parabolic indicators, directional movement indicators (DMIs), moving average convergence/divergence (MACD), and so on, and are thinking of exploring the foreign exchange arena. You've studied enough to know you will be trading currency pairs but have observed that a chart of the euro/dollar (EUR/USD) could look exactly like that of IBM or AAPL (and likewise, have profit/loss curves that look just like option strategies). Why is that?

The reason is simple. Although you are trading a currency pair (buying one currency and selling the other), you are only charting the tick-by-tick changes in the ratio of the two currencies. So if the EUR/USD is pegged at 1.95, it would take $1.95 to buy one euro. It is this ratio you are trading, and thus, it charts as a single entity just like a stock does (for example, up to $1.97, down to $1.94, and so on).

This ratio is determined by the respective differences in the interest rate of each country. Remember you always trade the base currency and never the secondary currency. You don't have to remember the formal names. Just think of a pair as a fraction: you always trade the numerator (the top number).

Can you trade these currencies the way you have been trading your stocks? From your preliminary studies, you have observed that as long as the dollar continues its long slide, there should be a good chance to make a few bucks trading the euro/dollar. Then again, nothing is certain.

ECONOMIC INDICATORS
What pushes the dollar down? What pushes it up? What tools do we need to anticipate these swings? Our first response may be to answer "world events." After all, currency markets react to real-time news. A catastrophe in Japan may not have an immediate effect on IBM stock, but if we were trading the US dollar/yen, in one minute you could get wiped out or have the means to retire. And if we can equate Greece's debt crisis to the bad apple in the barrel, then the rest of Europe can be likened to the rest of the barrel. Will the Greek debt crisis weaken the euro? If we see a third round of quantitative easing, the Standard & Poor's 500 will undoubtedly increase along with a falling dollar. Long story short: we need to know about business cycles, asset allocations, and economic indicators.

Whether we're in a bull market of early recovery or a bear market of early recession, the phase of the business cycle we are in plays a role. As far as your asset allocation is concerned (the mix of stocks, bonds, cash, and gold), financial managers recommend you should reexamine your portfolio at least once a year and make whatever changes are dictated by the changing times. Are you currently converting everything to cash, or are you going long on stocks? Your current personal situation is also a deciding factor for trading forex.

While these two major factors are beyond the scope of this article, economic indicators are not. These indicators are more easily identified, the positive and negative effects are well known, the information is released regularly on a known schedule, and it is available on the Internet. And when the market opens at 0930 am Eastern time (ET), every financial station will lead off with that day's economic data. Here are the most market-sensitive indicators:

Employment Report
This eagerly awaited report contains data on the latest changes to nonfarm employment and income. At 0800 am ET on the first Friday of each month, selected print, radio, and TV news financial reporters are given the latest data. They have a half hour to write up their text and submit it to their respective media. At 0830 am, the data is released to the public. No other indicator affects the stock and bond markets as much as this report does. A pessimistic outlook does not augur well for the dollar. Traders may be set up to buy the euro in anticipation of a down dollar.

Market reaction: Report up = bonds down, stocks up, dollar up

Unemployment Report
This report is released every Thursday at 0900 am ET. The weekly claims for unemployment insurance are another report that indirectly affects other statistics, such as consumer confidence. If the report is unfavorable, it is a psychological blow to the consumer. It is a sign that the economy is weakening and is going to get worse. On September 15, 2011, at 0900 am, the EUR/USD jumped 84 pips in one minute after the release of the report that day.

Market reaction: Unemployment up = bonds up, stocks down, dollar down

Institute for Supply Management (ISM) Report
This report on the state of the economy is heavily influenced by the manufacturing industry. It is released at 1000 am on the first business day of the month; thus, it may precede or coincide with the employment report. This report has been produced since 1931. At that time, the ISM was known as the National Association of Purchasing Agents. Purchasing managers across the country are engaged in the procurement of all the supplies that are needed by the manufacturing industry. The industries that produce these goods make up a good part of our economy's output. This data is important enough that the Federal Reserve is briefed before its release to the public. The Purchasing Managers Index (PMI) is regarded as a barometer of the economy's health. An index above 50 is a sign that manufacturing is growing, while below 50 is a sign of weakening manufacturing. An index of 50 indicates no change.

Market reaction: Report up = bonds flat, stocks up, dollar up

As fate would have it, I was in the process of writing this paragraph at 0945 am on September 1, 2011. At precisely 1000 am, the index was announced at 50.6. We would have expected the dollar to jump along with stocks with this news. Actually, The EUR/USD jumped 22 pips at 1000 am, and then from 1004 am through 1015 am, it fell 92 pips. The Dow Jones Industrial Average (DJIA), which was trending down from 0930 am to 0959 am, jumped 90 points at 1000 am and then fell more than 200 points that day. From this, we can conclude that nothing is certain.

Consumer Price Index (CPI)
This report measures price inflation of goods and services. It is released at 0830 am in the second or third week of the month, reporting on the preceding month. The CPI measures the change in a basket of approximately 200 goods and services. The index determines how much consumers are paying for goods and whether they will be buying more or less. To retirees, an increase in inflation equates to a decrease in fixed-income buying power. Inflation raises the costs of the providers of goods and services, and these increases are passed on to the consumer. Since consumer spending accounts for 65% to 70% of the money spent, this is an important number to the economy.

Market reaction: CPI up = bonds down, stocks down, dollar down

Producer Price Index (PPI)
Similar to the CPI, this report measures the price inflation of goods bought by businesses. It is released at 0830 am in the second or third week of the month. It is one of our oldest measures of inflation dating back to 1902. The impact here is the cost to the final user, whether that is the business itself or the consumer who ultimately suffers from the cost increase. It is not one index but three: an index of crude goods, an index of intermediate goods (in various stages of production), and an index of finished goods. It is this last index that gets the most attention, as it consists of big-ticket items such as furniture, cars, gasoline, and fuel oil.

Market reaction: PPI up = bonds down, stocks down, dollar down

Retail Sales
This report is released at 0830 am the second or third week of the month. As stated previously, consumer spending accounts for 65% to 70% of the economy's action and approximately one-third is provided by retail sales. This report only concerns itself with sales of goods like those found in restaurants and department stores. It does not include items such as travel and theater. It also has the disadvantage of quoting nominal prices (that is, not adjusted for inflation). If there is an increase, there is no way of telling whether it is due to increased spending or increased prices at the cash register. Despite these shortcomings, the currency market is very sensitive to this report.

Market reaction: Retail sales up = bonds down, stocks up, dollar up

Consumer Confidence and Sentiment Surveys
Happy consumers spend more. They buy more goods and services, which is good for the economy. This is one of those self-fulfilling prophecies in which a depressed economy sours the individual who then spends less, deepening the depression. The report is released on the last Tuesday of the month at 1000 am. If unemployment is high and future income expectations are low, then spending will slacken. So this report indirectly measures other factors affecting the economy.

Market reaction: Confidence up = bonds down, stocks up, dollar up

Personal Income and Spending
This report is released at 0830 am in the fourth week of the month. It is closely tied to the consumer confidence and sentiment surveys report. Personal income in this report considers gross income before taxes. What is really important is what spendable money is available. If consumers don't have it, they can't spend it. Not only do purchases satisfy the consumers' needs, they also support all the people who provide the goods and services that the consumer is buying.

Market reaction: Spending up = bonds down, stocks up, dollar up

These are by no means all the economic indicators affecting the currency market, but they are the major factors. The sidebar lists several more indicators, which you might want to research. Your results can be measured in dollars and cents.

IN CONCLUSION
I admit I question all these statistics. That is because most of them have lost their meaning when compared with their original concepts. As far back as the 1990s, the government redefined the terms "unemployment" and "inflation." And between them, then-President Bill Clinton and then-Fed chairman Alan Greenspan redefined the way the CPI was calculated. Consider that in 2010, the government declared no increase in the cost of living for retired seniors because there had been no increase in the cost of living the previous year, despite the spiraling increases in food and energy costs. In addition, cotton has hit an all-time high. Most people don't think much about items like that, but clothing is a major item in anyone's budget! It hurts eventually - and it's all intertwined.

SIDEBAR: ECONOMIC INDICATOR CALENDAR

INDICATOR
 
RELEASE TIME
(ET)
FREQUENCY
(Monthly)
PRIMARY WEBSITE
 
Employment report 0830 First Friday www.bls.gov
Weekly claims for
unemployment
0830 Every Thursday www.census.gov
ISM Report 1000 First business day www.ism.com
Consumer price index 0830 Second or third week www.bls.gov
Producer price index 0830 Second or third week www.bls.gov
Retail sales 0830 Second week www.census.gov
Consumer confidence 1000 Last Tuesday www.bls.gov
Personal income 0830 Fourth week www.bls.gov
GDP 0830 Last week of Jan,
Apr, Jul, Oct
www.bea.gov
Housing starts 0830 Second or third week www.census.gov

SUGGESTED READING

  • Baumohl, Bernard [2008]. The Secrets Of Economic Indicators, Wharton School of Publishing.
  • Galant, M. and B. Dolan [2007]. Currency Trading For Dummies, John Wiley & Sons.
  • Mendelsohn, Louis [2006]. Forex Trading Using Intermarket Analysis, Market Technologies.
  • Teseo, Rudy [2006]. "Beat The Business Cycle," Working-Money.com, June 28.
  • _____ [2005]. "Forex, Anyone?" Technical Analysis of STOCKS & COMMODITIES, Volume 25: July.





Rudy Teseo

Rudy Teseo is a private investor who trades stocks, options, and currencies. He has taught classes in technical analysis and option trading. He may be reached at rftess@optonline.net.

E-mail address: rftess@optonline.net


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