If you hope to profit from currency trading, then you need a
solid understanding of the forces that move currency pair prices.
The price of a currency pair, like any other good, is fundamentally affected by supply and demand.
If demand of the GBP/USD pair is higher than supply, then more people are buying pounds and selling dollars than those who are buying dollars while selling pounds.
Therefore, GBP/USD goes up (you need more dollars to buy a pound).
Conversely, if supply of GBP/USD is higher than demand, then the pair goes down (you need fewer dollars for each pound).
In this case, there are more sellers than buyers: more people selling pounds for dollars than the other way around.
Ok, I understand, but how can I use this information to make money forex trading? Read on.
As a forex trader, you need information that’s both relevant and reliable.
Data must be useful now not 2 years ago (relevant). And data must be accurate enough for you to profit from (reliable).
With that said, is it possible to measure demand and supply for a currency? And if so, how relevant and reliable are those measurements?
As we’ll see by the end of this piece, knowledgeable traders focus on indicators that are most relevant while sufficiently reliable.
Let’s continue with the British pound (GBP).
Who demands it?
Every person, corporation, and government that purchases goods and services offered by the United Kingdom (U.K.)
If you want to invest in the U.K., you will also have to buy pounds.
So how can we approximate demand of pounds? Well, we can think of economic activity.
People and organizations in the U.K. consume goods and services produced in their country.
They also invest in U.K. assets.
The government spends pounds in their economy.
But people and organizations from the rest of the world also consume and invest in the U.K.
What we have here is:
Consumption (C), Investment (I), Government expenditure (G), and net exports (NX).
Where net exports are U.K. exports minus its imports.
When U.K. exports, whoever is buying those exports has to buy pounds and sell their own currency.
For imports, U.K. sells pounds and buy the foreign currency.
Economists have a name for what we just described:
Gross Domestic Product (GDP) = C + I + G + NX
Government Expenditure (G)
Net Exports (NX)
GDP is a measure of the total value of all goods and services produced over a period of time.
It is one of the most important economic indicators used to gauge the health of an economy.
Now, the GDP of a country is not the same as the demand of the country’s currency. But it can give us an idea.
If more goods and services were produced, then more currency must have been demanded.
Another popular indicator is a country’s Current Account (CA) balance. The current account measures the net exports (NX) we mentioned earlier.
Net exports include net investment income.
In this manner, we take into account not only the relationship of goods and services bought and sold between U.K. and the rest of the world, but also the amount of money earned from investing between U.K. and the rest of the world:
If I buy a bond issued in the U.K., all coupon payments represent money fleeing U.K. towards my country.
And the opposite is also true (an Englishman buying a bond from my country).
Thus, net exports (NX) accounts for the difference in money leaving and coming in this way.
We already covered the basics of GDP and current accounts, so let’s see if we can use them to make intelligent trading decisions:
How reliable and relevant are GDP and current account numbers?
The consensus is that these two are fairly reliable numbers.
It takes data compilers months to pull together a whole country’s transactions, evaluate their findings, and publish official statistics.
This is why GDP and current account statistics are usually released quarterly, and only for a previous period.
For this reason, these are called lagging indicators. Since they can’t predict a move, they only confirm what has already occurred.
By now you are probably thinking that GDP and current account indicators are reliable but not relevant (they inform the past), so traders can’t pay too much attention to these.
You are almost right.
By the time GDP numbers are released, exchange rates have long taken into account currency demand.
Exchange rates are adjusted many times a day with fluctuations in supply and demand.
If you tried to trade with this mindset, you would be like a baby dinosaur before the big extinction.
So why on earth did I teach you all about GDP?
Because GDP and current account numbers may signal big upcoming changes in the supply of a currency.
Due to relevance and reliability, currency supply tends to be much more useful to forex traders, and soon, you will find out why. Just scroll down!
In the U.K., everyone demands pounds. Heck, even people who don’t live there want pounds.
From the demand section, this much is clear: demand of currency comes from many, many places.
But what about supply? Can I start printing pounds with a cheap printer in my home?
Cops would throw me in jail. But why?
Because only one entity is allowed to produce a country’s currency: the Central Bank.
Everyone can demand, but only one can supply.
The mystery begins to unravel.
It’s hard to measure demand fast when there are so many sources of it. But supply comes from one single entity.
If I follow the Central Bank’s movements I’ll know where supply is going and thus, where exchange rates are going.
More importantly, if I can anticipate the Central Bank’s next move, I’ll be able to trade accordingly and profit. Perfect relevance, with sufficient reliability.
What do we call sufficient anyways? Read on.
Go on to part 2 of Forex economics. Where supply meets demand and you finally get some practical forex trading tips.
If you somehow missed it, click here.
Sep 12, 17 09:09 AM
Learn what you need to know about Forex audio squawk here.
Sep 11, 17 09:48 AM
GBP (pound) traders what can you expect from the Bank of England's MPC vote this Thursday, Sep 2017? Click to find out.
Aug 21, 17 04:41 PM
Three of the eight major currencies are commodity currency. But what is that? Which are those currencies, and how can we trade them? Click to find out.