Gross domestic product (GDP) is a fairly well-known indicator of the economy and is often mentioned in financial market news. It is also one of the most important fundamental analysis parameters. Let's try to figure out what GDP is. In this article, we will look at what gross domestic product is, how it is used in currency analysis, and how the difference between the GDP of two countries affects exchange rates.
What is gross domestic product (GDP)?
Gross domestic product is the total economic activity of private and public companies over a given period. Economic activity is broken down into:
- Consumption. Personal expenses, clothes, cars, fuel or rent.
- Investments. For example, businesses that invest in new plant equipment or private investment in real estate.
- Government spending, which includes spending on infrastructure, defense, or employee salaries.
The balance of trade is added to exports and counted in the gross domestic product data, while imports are subtracted.
Economic reports on GDP usually cover quarterly and annual periods. These data are revised periodically until the final annual GDP is released. GDP reports are usually published monthly in most countries, although some only publish data quarterly. The monthly release of these data allows for a more frequent assessment of the state of the economy.
The US GDP report is published by the Bureau of Economic Analysis towards the end of each month. An update of data for the previous month on quarterly activity is also published.
There are different types of measures of gross domestic product, such as gross domestic product per capita or GDP at constant prices. Most market traders see GDP growth, which is reflected as a percentage. This indicator of GDP is the most convenient in terms of comparing the state of the economies of two currencies.
On the contrary, a comparison in dollar terms or per capita would be particularly difficult, as many other factors would have to be taken into account. Therefore, for a more effective analysis, economic activity is compared as a percentage change over a certain period.
Analysis of GDP data
Economic reports on gross domestic product are an important and comprehensive indicator of economic activity and therefore should always be included in the fundamental analysis of each currency pair. It goes without saying that a fundamental trader uses GDP data as a key factor in determining the strength of a country's economy and therefore the strength of its currency.
Gross domestic product in the foreign exchange market involves comparing GDP data with previous reports. The first estimate involves comparing GDP data for currency A with GDP data for currency B.
This comparison helps determine which of the two currencies has the stronger economy. The next estimate is between the current data and the previous month's data. This data shows progress in expanding or contracting economic activity. Comparison can also be made with GDP data for the previous year.
GDP data must also be considered in the overall context of a country's economy, as each country is at a certain level of development and has a certain level of expectation when considering GDP growth. Therefore, it is necessary to compare similar economies on the same basis. An advanced economy cannot be expected to achieve annual growth rates above 4%.
For more developed countries, growth rates of 3% are considered relatively high. When we look at developing countries, we can expect annual growth rates that exceed this number and often even double it. This is especially true for emerging market economies, especially the BRIC countries (Brazil, Russia, India and China).
If you are trading EURUSD and comparing the growth rates for both currencies, you can simply look at the two GDP numbers to determine which one is growing faster. When both economies are well developed, a 0.5% increase in GDP growth, for example, in one currency can be seen as an important factor in the strength of that currency.
This comparison does not carry over when we look at currency pairs where one currency is an emerging market currency. Average annual US GDP growth between 2007 and 2017 was below 2%, with expansion phases showing growth peaks of 2.5%. If you look at China, its growth has been over 8%, and until 2012 it often hit double digits.
The 0.5% GDP growth for China cannot be viewed in the same way as the 0.5% growth in the Eurozone when looking at the EURUSD. Annual GDP growth in the eurozone at 0.5% will be a significant event. Keep in mind that the average annual GDP growth rate in the euro area from 1995 to 2017 was only 0.4%, while China averaged 9.7% over the same period.
When considering GDP growth rates between two currencies, the overall health of each currency's economy and historical average annual growth rates must also be taken into account.
The impact of GDP data on the currency
GDP data is one of the most closely monitored economic indicators, as it provides a fairly clear indication of the expansion or contraction of an economy. This data is easy to track over long periods of time and can show different stages of the business cycle. For example, in the case of a recession, which is defined as a period with two or more consecutive quarters of negative growth.
With this in mind, the rate of GDP growth is an important driving factor due to the impact of economic activity on the currency. A higher level of economic activity creates more demand for the currency. Companies and individuals will need large amounts of foreign currency to boost demand. An increase in economic activity also increases the overall value of the economy, since all currencies are fiat money, and the more value an economy has, the more value a currency will have.
Demand also creates the need for tighter monetary policy to prevent overheating of the economy. Monetary tightening means that interest rates on assets such as government bonds denominated in the target currency will also be higher.
Higher returns on these assets will stimulate investor interest and hence the currency will appreciate in the near future as money flows into the currency to buy new assets.
The illustration above shows that annual GDP growth in the euro area outpaced that of the US from 2006 to 2008, when both economies fell into recession due to the financial crisis. From 2009 to 2014, the US annual GDP growth rate exceeded that of the Eurozone.
Looking at the price chart below, we see that the euro continued to appreciate as the US dollar weakened during 2006-2008. EURUSD rises from around 1.1700 to reach its all-time high in July 2008 at 1.6038.
After overcoming the effects of the financial crisis, economic growth in the United States began to grow at a faster pace than in the euro area. EURUSD saw a slow downward price movement, with the price reaching a low of 1.1875 by June 2010.
Forex price movements are also based on expectations, not just the latest data. After the economic crisis of 2008, variable expectations of economic growth continued to have some influence on the price of the euro. However, the euro has also been subject to geopolitical and financial crises. The debt crises in Greece in 2010/2011 and the banking crisis in Italy, Spain, Ireland and Portugal (PIIGS) in 2011/2012 created a highly volatile market for the euro.
Gross domestic product in trading
Trading GDP numbers can be tricky. FX markets factor in expected data and real events, while data releases do not always match expectations. This means that if a particular country is expected to have a high GDP, and this event materializes, the market reaction will usually be subdued.
When the reaction is almost non-existent, since the release of the data occurs without incident, because the expectations were just met. In fact, if you expect a currency to rise relative to its peers in the event of strong GDP growth, you may actually see it decline.
This is because markets often anticipate significant news releases, so expected GDP growth may not be enough to drive up the price of a currency. When the GDP figures are released, it may even lead to a depreciation of the currency, despite the growth in GDP. GDP growth figures are certainly very important, but currency markets are more likely to overreact in prices ahead of the next GDP release, giving way to volatility.
Another scenario is that the published GDP figure is significantly lower or higher than expected. This will likely also create volatility as traders and investors react to this unexpected number. Much higher-than-expected GDP growth will generally lead to an appreciation of the target currency, at least for a short period of time. The continued trend after the initial appreciation of the currency will largely depend on the overall health of the economy.
Let's say the economy is struggling to show growth, and it's possible that the GDP data has been low for several months, and suddenly there is a jump in the latest GDP release.
The immediate reaction of the market will be the purchase of the target currency. Traders will feel that the currency may have been oversold and, given the new data, is currently undervalued. Traders will start buying the target currency in hopes of seeing it reach higher prices, at least in the short term.
But it shouldn't come as a surprise if prices ease after the initial rally and eventually return to pre-GDP levels. One release of GDP data may not be enough to change the overall fundamental picture of the economy.
GDP data releases are usually quarterly data and annual data. These releases are made monthly for most countries. The most important indicator, which will be more subject to volatility, is quarterly GDP growth. Quarterly data is more dependent on economists' forecasts. Analysts and economists publish their expectations, which are therefore well known, and deviations from these expectations can often steer markets in a certain direction.
GDP growth rate
Data on GDP differ from country to country and depend on the level of development of the economy. It is also worth taking into account other factors that determine the economic environment. We will look at the three largest economic zones - the US, the Eurozone and China.
In the US since the 2008 financial crisis, a healthy emerging economy is considered to have annual GDP growth of 2% or more, while lower numbers still show economic growth that is not sufficient.
The Eurozone has historically had slightly lower GDP growth rates than the US. This has usually been the case over the past two decades. From 1995 to 2017, the average annual GDP growth rate in the United States was 2.4%, while in the same period the euro area averaged 1.6%. For the euro area, the consensus for a healthy emerging economy is 2% or higher.
Over the past 40 years, China has had very high GDP growth rates. Since 1978, when economic reforms began in China, the average annual growth rate of the country's GDP has been 9.6%. After the 2008 crisis, the economy could only operate with double-digit growth between 2010 and 2011. The country is now critical of growth rates if they fall below 7%. GDP growth rates for China should be between 7% and 9%.
Another factor to consider is the current business cycle. Let's say the US has a GDP growth of 2.5%, and the current data shows a growth of 2.7%. The new data shows an increase in GDP, but may also leave analysts and economists in doubt as to how long this level can be sustained. The currency markets always set prices relative to future events and data, so you have to consider if the economy has peaked.