Macroeconomics – A Guide for Forex Trading Beginners
Macroeconomics plays an important role in Forex trading. This is essentially what fundamental analysis means: interpreting economic events, news, and releases with the purpose of speculating on the future moves a currency will make as a result. The currency trader should look at the Forex dashboard and see those currencies as economies. They are effectively representing an economy, country or region in the world. It means that understanding how a respective economy is performing entails having an idea about the direction the currency is going to move in. This makes it a powerful tool for trading Forex in general.
Expanding on the above, a currency pair effectively represents two economies, and it moves based on the economic differences between those economies. In other words, comparing the two economies should result either in them being the same, or in one performing better than the other. This, in turn, results in the currency pair staying flat, or in a range, in the first situation, or moving to the upside or to the downside in the second case. Interpreting two economies means considering macroeconomics.
What is Macroeconomics?
As the prefix “macro” in the name suggests, macroeconomics deals with the bigger picture. It is not only one specific economy that traders consider, but the implications in the overall global picture. Macroeconomics reflects these implications as traders anticipate future currency moves. When the macro-environment is shifting, this is due to specific events that have the effect of changing the way the markets move compared to how they did before.
Factors That Matter
Macroeconomics and monetary policy go hand in hand; and understanding monetary policy is therefore key. Monetary policy, on the other hand, refers not only to the interest rates the central bank sets, but also to how the central bank addresses a given situation. The best recent example comes from the United States of America, and how the biggest and most influential central bank in the world dealt with the 2008 financial crisis.
As mentioned here on the Forex Trading Academy in different articles, central banks meet on a regular basis to evaluate the status of the economy, and to set the interest rates and monetary policy. In the case of the Federal Reserve of the United States (the Fed), the meeting takes place every 6 weeks; so between every two Fed meetings, there is a time span of 6 weeks. However, this doesn’t mean that the Fed is not going to communicate with markets all through this time. Three weeks after a Fed meeting, the minutes of the meeting are released. These are snippets showing what the Fed members discussed – whether they were dovish, hawkish, etc.– and markets react aggressively to this. Some say that the minutes are lagging, in the sense that they refer to something that happened 3 weeks ago, and that they do not consider the economic news that was released in the meantime. While this is true to some extent, markets still react to them.
The way in which the Fed communicates its monetary policy serves to highlight the impact and importance of the 2008 events. At the peak of the financial crisis, the Fed slashed interest rates to zero in an overnight move! This means that the central bank didn’t have time to wait until the next meeting was due, as macroeconomic events were unravelling with the speed of light. A decision needed to be made, and it was made in the blink of an eye, at least from a central bank’s standard. Such a decision was taken because macroeconomic stability was otherwise threatened, and this is translated as a risk-off sentiment. (For more about a risk-off trading environment, please refer to the previous article here on the Forex Trading Academy.)
Another great example was the way the European Central Bank (ECB) reacted to the Greek situation in the 2012–2014 period. As a quick reminder, the Greeks reported fake economic numbers, and the Greek economy was in a worse shape that it had been believed. By the time the situation became clearer and clearer, markets around the world started to unravel, and the Euro currency has been sold aggressively. Related macroeconomic factors started to affect economies far away in other parts of the world. The central bank needed to react fast. And it did, not only with classical monetary policy tools, but also with new ones, such as providing loans to the Greek economy at extremely low interest rates, as well as giving Greek banks access to liquidity in order for the population not to be affected. Some moves were not so popular, and set dangerous precedents, such as was the case in Cyprus, where deposits above 100,000 euro were confiscated over the weekend. Some other moves were bold and new, in the sense that there was no existing precedent to compare them with. In both cases, this is true macroeconomics, which essentially means looking at the bigger picture, and the implications for the markets around the world.
When trading is based on macroeconomic news/events, then the time horizon for those trades should be considered. This means that traders consider a longer period of time when planning their trades, and this is typically what investing means. When investing, traders do not consider the day-to-day economic releases, but the shifts in the macroeconomic picture. For these shifts to come into play requires time. All costs associated with such a trading style are considered here, one good example being the swap that is paid. If the swap is a negative one, then keeping a position open for a long period of time is a costly process. These costs should be considered, as they will affect the balance in the trading account.
To sum up, macroeconomics plays an important role in helping to understand what is happening around the world from an economic point of view, and how the Forex market is affected. It is a vital tool that helps traders make the right decisions, and is a must when trading is being carried out with a long-term perspective.
Other educational materials
- Geopolitical Risks That Influence Markets
- Different Trading Styles
- Trading with the Cloud – Use Ichimoku Cloud to Spot Reversals
- Forex Market Terminology
- What is Elliott Waves Theory?
- Defining Impulsive Waves
Recommended further readings
- “Currency traders and exchange rate dynamics: a survey of the US market.” Cheung, Yin-Wong, and Menzie David Chinn. Journal of international money and finance 20, no. 4 (2001): 439-471.
- Macroeconomics and reality. Sims, C.A., 1980. Econometrica: Journal of the Econometric Society, pp.1-48.