PMI – A Vital Economic Indicator
Economic releases are closely watched by Forex traders, as they offer a clue about what the central bank is going to do at the next meeting. If the economic data is pointing towards a growing economy, then the likelihood is that the currency is going to be bought, and vice versa. So far we’ve treated inflation and jobs data as being crucial factors in any central bank’s decisions, because they are part of its mandate. In some cases, a central bank’s mandate includes the two of them, but most of the central banks have only inflation as part of their mandate. However, as mentioned in previous articles dedicated to this section on the Forex Trading Academy, central banks look at the whole economy to see the shape of it and how it may move in the foreseeable future. All the economic data is important, in the sense that central banks will change rates if the economy is improving or deteriorating. So how do we know when such a thing is happening? PMIs (Purchasing Managers’ Indexes) are useful in this case.
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Interpreting the PMIs
The Purchasing Managers Index (PMI) is a vital economic indicator for any economy. It is based on a survey in which purchasing managers of companies from different economic sectors in a country are asked several questions, such as, What is the inventories level if the company were to receive new orders? Is the company planning to hire/lay off people? What is the business perspective over a 6-month horizon? etc. All this data is compiled into a single indicator that refers to a specific sector: either services, manufacturing, or construction. Not all countries release all three sets of information, but services and manufacturing are always interpreted and calculated.
The Beauty of the 50 Level
The information mentioned above is compiled, and the result is the PMI indicator, which is interpreted based on the 50 level. Any value higher than the 50 level is considered to show expanding conditions, while a value below the 50 mark signals recession. Because the PMI is calculated for different sectors in an economy, if the PMI Manufacturing indicator, for example, shows the 48 value in a given month, it means that the manufacturing sector in that respective economy is shrinking, and most likely the overall economy will suffer soon. The natural reaction will be that the currency is going to be sold on expectations that the central bank is going to react next time it decides on interest rates. There are some other factors to be considered, though. Such a factor is the nature of the economy the PMI is referring to. Let’s take the United Kingdom’s economy. The Gross Domestic Product (GDP) largely consists of service-based activities, and thus the economy is a service-based one. This makes the PMI Services index more important than the PMI Manufacturing or Construction indexes, and much of the time the market will simply ignore the manufacturing data, and focus on the services index. Imagine if the PMI Manufacturing index shows a value of 49.5 and its Services counterpart a 54 value, the economy overall is still expanding since Services plays a bigger role in the overall GDP calculations. This is just a simple fundamental analysis trick market participants should be aware of. In the Eurozone, the PMI shows the data for the services and manufacturing sectors, while in the United Kingdom and Australia, the construction sector is considered as well. This is not to say that construction data is not important in Europe and the US, but there are other indicators to look for when it comes to interpreting this data.
ISM Manufacturing and Non-Manufacturing
In the United States, things are a bit different, but only from a semantic point of view. The PMI release is called ISM, which stands for Institute for Supply Management. This is the institution that carries out the surveys, but the overall indicator and the way it is calculated are basically the same; only the name is different. As in Europe, the ISM does not take the construction data into account, but there are plenty of indicators that do refer to the housing market: Existing Home Sales, Pending Home Sales, Building Permits, etc. Coming back to the ISM releases, the Services index is more important, as the US economy is a service-based economy, and this means that what happens with the services sector matters the most in the overall picture. The Fed is going to consider the services sector first, and the other ones second, when deciding on interest rates. Talking about interest rates, this is the ultimate target traders have in mind: to have an educated guess as to what the central bank is going to do with the rates. This is all that matters for the Forex market!
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Recommended further readings
- “Using the purchasing managers’ index to assess the economy’s strength and the likely direction of monetary policy.” Koenig, Evan F. Federal Reserve Bank of Dallas Economic and Financial Policy Review 1, no. 6 (2002): 1-14.
- “Stock return, consumer confidence, purchasing managers index and economic fluctuations.” Afshar, Tahmoures, Ghodratollah Arabian, and Reza Zomorrodian. Journal of Business & Economics Research (JBER) 5, no. 8 (2011).