At first glance, you may think that the global economy is bound to be larger than the international forex market. However, the cumulative value of the market is thought to be $1.934 quadrillion, which is a staggering 2.5-times larger than the global GDP.
Interestingly, there’s a strong and inextricable link between the economy and forex trading, from the vast size of these entities to the impact that various macroeconomic factors have on the value of currencies and real-time exchange rates.
In this post, we’ll explore the link between economic knowledge and successful forex trading, while asking how understanding the former can actively boost your profitability.
The Role of Macroeconomics and International Trade
The term macroeconomics isn’t a complicated one, as it studies the performance of the overall economy and the behaviour of the market systems that operate on a large and complex scale.
Within this model, there’s an array of macroeconomic factors to consider, including phenomena such as price levels, inflation, GDP, labour market changes and a country’s rate of economic growth.
A nation’s base interest rate is also an important macroeconomic factor, and one that has a direct impact on currency values.
More specifically, a low base interest rate minimises foreign investment and capital inflows, devaluing the associated currency in the process. Conversely, a higher rate of interest attracts more sustained investment from overseas, causing the currency to become more attractive and appreciate in value as a result.
When it comes to economic growth, international trade (and the balance of trade between nations) is also linked to currency values and forex trading.
More specifically, a trade balance between two nations serves as a proxy for the relative and real-time demand for goods in a particular country, with those that benefit from high demand for its offering likely to see an appreciation in the value of its currency.
The reason for this is simple; as buyers must convert their domestic money into the relevant currency if they want to purchase goods from a particular nation, creating higher demand for this asset and increasing its value incrementally.
On the other hand, nations with large trade deficits tend to be net buyers of international goods, meaning that more of their currency is sold. This drives long-term depreciation of its value, especially if a country has an overall deficit across all of its trading partners.
What About the Capital Markets and Forex Trading?
When exploring the link between the economy and forex trading, it’s hard to ignore the importance of global capital markets.
Make no mistake; these represent the single most visible indicators of an economy’s health, thanks largely to the public nature of large corporate entities and the steady flow of media coverage pertaining to businesses, financial institutions and government agencies.
In this respect, a rally or sell-off of securities originating from one country to another is a clear indicator for the future of a particular economy, while this can also have a direct influence on currency speculation and the subsequent value of assets.
On a similar note, political and socio-economic news has a significant effect on forex trading, particularly in terms of informing investor sentiment. This makes perfect sense when you think of it, as geopolitical events play a seminal role in shaping the outlook for a country and its underlying currency value.
One of the best examples of this emerged recently, when countries across the globe introduced quantitative easing measures and increased government investment.
This was reported widely, and in conjunction with the widespread decline in base interest rates, sent currency values tumbling across the globe.