What forex traders need to know about GDP

Forex trading
By :  ,  Financial Writer

What is GDP?

GDP is an acronym for gross domestic product and measures the productivity of a country’s economy, specifically the value of goods and services produced by the country. All goods and services produced are included in GDP, regardless of whether they are used domestically or exported to other countries.

GDP is most commonly expressed as a percentage of change on a quarterly or yearly rate. This percentage is known as the growth rate. Most economists agree a strong GDP growth rate is 2-3%.

Example: UK GDP in 2021

The United Kingdom’s GDP in 2021 was 2.2 trillion pounds* and featured a 7.4% growth rate from the year before. This high growth rate was caused by the country’s economy resuming normal operations after the Covid pandemic, which caused GDP to drop drastically in 2020. On average, the UK’s GDP is the sixth largest in the world.

*according to Statista

What are the four components of GDP?

The four components of GDP are consumption, investment, government and net exports. These categories make up the different channels through which all goods and services are sold. Let’s look at each in more depth.

  • Consumption includes all purchases by individuals for their own use. This covers nondurable goods like food and clothing, durable goods such as cars and appliances and services provided by workers like mechanics or lawyers
  • Investment describes purchases made by a business entity. They are divided into fixed goods and inventory. Fixed goods are anything bought by a company such as real estate, patent rights, machinery and even employee salaries. All fixed goods are assumed to depreciate or amortise except for land. Inventory, on the other hand, is all goods produced by a company which have not been sold. It is still counted in a business’s value because it is considered to eventually produce income
  • Government in GDP describes expenditures made by governments such as paying civil workers, military spending and infrastructure costs. These components of government GDP are considered to be goods and services produced in the country, so their costs are included when calculating GDP. Infrastructure costs are sometimes referred to as government investment
  • Net exports include all goods and services produced within the country but sold to foreigners. Net imports are calculated by subtracting the costs of imports from the profit of exports. Imports are not produced domestically, so the costs of those international goods and services actually subtract from a country’s GDP as the money paid is flowing out of the economy

How is GDP calculated?

GDP is calculated by combining the four components of GDP listed above: consumption, investment, government and net exports. GDP is usually calculated by each country’s national statistics agency, but independent organisations also publish national GDP reports.

What isn’t included in GDP?

There are a number of significant transactions that are not included in GDP, such as imports, some taxes and government subsidies. These transactions, though, are analysed in other techniques of fundamental analysis.

Imports, for example, are not included in GDP because the transactions involve money flowing out of the country and products created outside of the country. Goods and services produced by foreigners inside the country are also excluded from GDP, but they are included in Gross National Product (GNP) – a value of the goods and services produced by a nation. Typically, there is not much difference between the two figures.

Taxes collected by businesses such as sales tax are also not included in GDP because they are not considered income for businesses. Rather, these taxes are expected to be accounted for in government expenditures later on.

Transfer payments like social security and welfare are represented in the UK by monthly Claimant Count reports and are used by forex traders to gauge unemployment rates in the country.

How to use GDP in fundamental analysis for forex

You can use GDP when conducting fundamental analysis to analyse historical trends, make projections about a country’s economic future and compare one economy with another. Now that you know what GDP is and the economic activity it represents, let’s see how forex markets react to GDP announcements.

How high GDP impacts currencies in the long term

High GDP impacts currencies in the long term by increasing demand for the currency, both domestically and internationally. These high-GDP countries are considered growing economies, because the size of their economy is literally growing in monetary value.

For example, if a country has a GDP of $3.53 trillion and maintains a stable annual growth rate of 7% for an entire year, its economy will grow to $3.78 trillion. That’s a growth of $247 billion.

This growth also increases the demand for the economy’s currency. You can remember this by remembering high GDP is caused by increasing production rates, which itself means there is growing demand for the country’s products. In this case supply is driven by demand. A high demand for a country’s products also usually means there is a high demand for the country’s currency in order to buy its products.

When a country’s economic growth, and with it demand for its currency, increases above that of another country, the value of the two currencies’ exchange rate shifts.

Example of long-term effects of GDP growth in forex

For an example of how GDP can be used when trading forex, let’s review long-term GDP growth rates between the Eurozone and the US and the value of EUR/USD. The chart below shows the annual GDP for the US and EU from 2004 to 2017.

CI GDP rate reference

Immediately before the global financial crisis of 2008, the Eurozone had risen above the US in economic performance. Once the crisis hit, both economies entered a recession in 2009. A recession is commonly defined by two consecutive periods of negative GDP growth.

After the crisis, the US annual GDP rate was consistently higher than the Eurozone’s. This suggests the Eurozone’s economy suffered worse than the US’s and took longer to recover. From 2010 to 2011 subsequent economic troubles like the Greek debt crisis rocked Europe.

Now let’s compare the GDP growth rates depicted above to the value of EUR/USD, the forex pair representing both economies. The euro was steadily rising against the dollar from mid-2005 to early 2008. Checking the chart above, this correlates to when the Eurozone’s GDP rate held higher than the United States’.

CI EUR-USD Monthly Chart 2004-2017

Soon though, the financial crisis hit Europe just as hard as it has the US. USD had already experienced a loss in value due to the crisis, so when the euro followed suit, its value fell hard and fast against the dollar.

Then the dollar recovered while the Greek debt crisis and other issues hit Europe, as reflected in the country’s GDP rate. This discrepancy between the two economies prompted a selloff of the euro in 2014 and lowered the value of EUR/USD.

How GDP affects currencies in the short term

GDP can affect currencies quickly, if a GDP report is significantly less or more than what economists and traders expected. A GDP reading that is as expected may also move forex markets, but likely not as much. In these cases, you will want to compare the current reading to previous quarters and years as well as new reports from other countries.

How lower-than-expected GDP affects forex

Lower-than-expected GDP reports can trigger volatility in related forex pairs.

This is because a lower-than-expected reading means the economy is not growing as quickly as expected, or it’s growing even slower than expected depending on how you look at it. This news might trigger a loss in the confidence of traders and investors and influence them to sell the currency in expectation of a further slowdown.

Traders with a long position in EUR/USD when a lower-than-expected GDP rate is reported for the EU may sell back the euro and close their positions. Some may even place short positions on EUR/USD and buy the dollar in expectation that it rises against the euro.

How higher-than-expected GDP affects forex

A higher-than-expected GDP report may strengthen a currency’s value in the forex market. If no other factors exert a stronger influence on the currency, its value can rise in relation to a currency with a lower GDP rate.

A higher-than expected reading might suggests the economy is growing faster than expected or not slowing down as abruptly. This could increase trader confidence in the currency. However, if the rate is too high it might spark fears of inflation and erode trust in the currency. Thus, larger higher GDP rates can be more difficult to decipher.

For example, if the UK GDP rate was announced to be 3% when it was expected to be 2.5%, traders may read it as a sign the pound is thriving more than they assumed. If a counter currency like the US dollar does not increase at a similar rate, traders may sell dollars for pounds, opening a long position in GBP/USD.

If the rate was instead reported at 4% when 2.5% was expected, the growth may be seen as too extreme. In response traders may avoid opening positions or even short GBP/USD if they suspect hyperinflation is to follow.

Interested in using GDP data in your forex trades?

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When does GDP not affect forex?

GDP reports may not affect forex if the rate is as expected, at an average rate, overshadowed by another economic event, or cancelled out by inflation.

  • GDP rates that match predicted figures, especially when they are in the 2-3% range, may not be newsworthy enough to influence trader sentiment
  • Additionally, the markets may be overwhelmed by more severe economic news
  • Lastly, inflation often cancels out GDP growth as well, and inflation is its own economic phenomenon to study in forex

A GDP report can still be useful even when it doesn’t create trading opportunities. Fundamental analysis of the report can point you towards other trading signals. From this data you can look at what economic activity affected the GDP rate and how it compares to other countries. Information you find there can still be valuable when trading forex using fundamental analysis.

GDP and inflation

Often GDP growth can be cancelled out by inflation. If gross GDP is 7% and inflation for the same period is at 4%, the growth rate will be announced at 3%. Inflation can eat up progress that would be made by a high GDP growth if it is high enough to match or outpace GDP. This is why central banks sometimes influence to adjust inflation as a way to move GDP.

This is also why most economist settled on the 2-3% range mentioned earlier as the best GDP rate. A higher percentage might send inflation skyrocketing, but any lower and GDP growth will not rise fast enough to increase currency demand.

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