Hello traders! Yes, this week’s article focuses on economics, but hopefully in a way that can help you make a few more pips in your trading, and therefore, is fun! First we’ll define what GDP is, then look to see what role commodities play in GDP, and then which currency pairs to focus on when GDP is growing quickly or slowly.
Investopedia defines Gross Domestic Product as:
The monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
GDP = C + G + I + NX
“C” is equal to all private consumption, or consumer spending, in a nation’s economy
“G” is the sum of government spending
“I” is the sum of all the country’s businesses spending on capital
“NX” is the nation’s total net exports, calculated as total exports minus total imports. (NX = Exports – Imports)
This is quite a definition! In fact, the very definition of GDP shows you it’s obvious weakness – check out the “G” which is the sum of government spending. A country could certainly “manipulate” their own GDP by paying people to dig holes, and then paying others to fill in those same holes. Ta da, GDP is growing because of increased government spending! Ha! Economics is funny!
The basic way I explain the usefulness of economics in class is as follows: if the entire world’s economy is growing faster and faster, what are they building? Roads, bridges, buildings, things to sell, etc. If the world economy is slowing/contracting, they are making less of everything just mentioned. If the economy is expanding, what do you need to make all of those things? Raw materials is the answer. Things like copper, oil, silver, etc. are necessary to make all of those things, so who would benefit with a growing world economy? The producers (especially the net exporters) of these raw materials. If the world economy is contracting, the producers will be hit very hard.
So which currencies and which commodities should we focus on? Historically, the Australian Dollar, Canadian Dollar, and the New Zealand Dollar have been considered the “commodity currencies.” According to Wikipedia, Australia is the number 5 copper producer and the number 2 gold producer in the world. If demand (and prices) for those two commodities drops, do you think that there would be a negative impact on the Aussie currency? Probably so! Canada is the number 9 copper producer, number 7 gold producer, and number 6 oil producer. While there are countries that obviously produce more of these raw materials than Australia and Canada, most of those country’s currencies aren’t easily tradable for the retail trader-Iran, China, etc. We will focus on the major currencies.
So now let’s look at a few charts to help us figure out how the commodity prices can help.
So the AUDUSD pair had been stuck in a channel about 500 pips wide for several months. Eventually it will break out, but when and what will cause it? You can see that in early May of this year, it finally broke to the downside. If you take a look at a couple of commodities that the AUD produces, you can certainly get a hint as to what direction the breakout will be.
In this futures chart of copper, you can plainly see that an obvious demand zone was broken in mid-March, followed by another break to the downside in mid-April. This was a clear hint that demand for copper was weakening, and should eventually affect the AUD. In the following gold chart, the obvious demand zone was also broken in mid-April.
So the two commodities that have an effect on the AUD gave us a clear hint nearly a month early that the AUDUSD could be about to break out of the previously mentioned channel. I hope that a one month alarm would give you enough time to look for a supply zone to go short!
So now we’ve seen a couple of examples of how a currency can be affected by commodity prices. How do you choose which currency to trade against the commodity currency? The rule is you look for a currency that has the opposite effect when the commodity moves. If gold and copper going down in price is bad for the AUD, who is it good for? Generally the answer is whoever imports the commodity. Again, focus on the major currencies. Japan is very large importer of copper – take a look at an AUDJPY chart over the last few months, and you will see that it has declined well over 1000 pips!
So let’s break this all down. First of all, I don’t use a country’s announced GDP figures to determine if the economy is growing or not as the figures are too easily manipulated. I prefer to look at the actual futures prices of the commodities in question. Second, do a little internet research to find out who is exporting and who is importing the said commodity. Third, focus on the major currencies. Hopefully with just a little bit of effort, you will be able to squeeze a few more pips out of this great market!
Until next time,