Macro-Economic Indicator Market Trend
"Successful traders combine knowledge of the macro-economic conditions with some technical as well as fundamental analysis in order stay ahead of the game. By doing this they speculate but they do not gamble and they never buck a trend.
Some macro-economic indicators are leading indicators while others are lagging indicators. A leading indicator predicts the status of the economy in the future. In order to understand and appreciate macro-economic trends - traders should fall in love with leading indicators. They indicate changing market and sector trends.
Lagging indicators only changes direction after business conditions have changed.
|Auto and truck sales||**||Monthly; third business day of the month||Recession Indicator|
|Housing starts and Building Permits||***||Monthly; between the 16th and the 20th of the month||Recession Indicator|
|New home sales||**||Monthly; around the last business day of the month||Recession Indicator|
|Existing home sales||**||Monthly; around the 25th of the month||Recession Indicator|
|Construction Spending||*||Monthly; first business day of the month||Recession Indicator|
|Initial claims||***||Weekly; every Thursday||Recession Indicator|
|The jobs report||****||Monthly; first Friday of the month||Recession Indicator|
|Gross domestic product||***||Quarterly; third or fourth week of the month||Business Cycle Indicator|
|Retail sales||****||Monthly; between the 11th and 14th of the month||Consumption Indicator|
|Personal income and consumption||**||Monthly; first business day of the month for two month prior||Consumption Indicator|
|Consumer confidence (Conference Board)||***||Monthly; last Tuesday of the month||Consumption Indicator|
|Consumer confidence (Univ. of Mich.)||***||Preliminary; Friday following the second weekend of the month||Consumption Indicator|
|Consumer confidence (SRC)||***||Final; Friday following the last weekend of the month.||Consumption Indicator|
|Consumer credit||*||Monthly, fifth business day of the month.||Consumption Indicator|
|Purchasing Manager's Index||*****||Monthly; first business day of the month||Investment Indicator|
|Durable goods orders||**||Monthly; third or fourth week of the month||Investment Indicator|
|Factory orders||*||Monthly; about a week after the durable goods report||Investment Indicator|
|Business inventories||*||Monthly; around the 15th of the month||Investment Indicator|
|Industrial production and capacity utilization||***||Monthly; around the 15th of the month||Investment Indicator|
|Consumer Price Index||*****||Monthly between the 15th and the 21st of each month||Inflation Indicator|
|Producer Price Index||***||Monthly; around the 11th of each month for the prior month||Inflation Indicator|
|Index of Leading Indicators||*||First week of every month|
|GDP Deflator||**||Quarterly; third or fourth week of the month for prior month||Inflation Indicator|
|Average hourly earnings||***||Monthly; first of the month||Inflation Indicator|
|Employment Cost Index||****||Quarterly; near end of the month of the quarter for prior quarter.||Inflation Indicator|
|Productivity and costs||***||Quarterly; the 7th of the second month of the quarter for the prior quarter||Inflation Indicator|
|International trade||****||Monthly; around the 20th of the month|
|The Federal budget||**||Monthly; third week of every month for the previous month.|
A leading indicator predicts the status of the economy in the future. In order to understand and appreciate macro-economic trends - traders should fall in love with leading indicators. They indicate changing market and sector trends.
Lagging indicators only changes direction after business conditions have changed. The average duration of employment is considered a lagging indicator. Decreases in the average duration of employment occur after an expansion gains strength, while the most acute increase tend to occur after a recession has begun.
This report is so very important because it tracks the first indicator (along with housing starts) to turn down when the economy begins to slide into a recession. When consumers begin to worry about the economy, they will be hesitant to spend money on big ticket items such as SUVs and cars.
The housing industry is no doubt a leading indicator for the rest of the economy. The housing industry accounts for over a quarter of all investment spending. When housing sales slow, people do not purchase as many appliances, furniture and other accessories. Now what does this mean for the market? If inflation is a concern in the mid to late stages of an expansion, the stock market views a strong housing start report as bearish, while earlier in the cycle or in recessionary trough, good housing news is bullish.
This report includes information on home sales, inventory levels and median home prices. The sale of new homes is very sensitive to interest rates and will react quickly. The inventory data are important because a low inventory level may signal an increase in new housing starts. The median price is a good indicator of inflation in the market.
The data in this report is volatile and subject to major revisions. This report is not given its due although some people will look at it for emerging trends.
Some analysts look at the data as a four week moving average because it is also volatile. This is however one of the components of the Index of Leading Indicators. New people on the unemployment line represent a very early warning that all is not well in the economy.
The jobs report provides crucial information on the unemployment rate, non-farm pay-rolls, average hours worked and average hourly earnings. It is so crucial to the market that some traders will clear their positions ahead of the report. It is published by the Department of Labor on the first Friday of every month for the previous month. It is possible to predict what will happen to some of the other macro-economic indicators from the jobs report. If we know how many people are working and we know how many hours they have worked and we know their cumulative overtime hours, then we can estimate how much these workers have produced. This data will show up two weeks later on industrial production. We can also gage the data for personal income from the jobs report. We can examine a specific sector such as the construction industry which in turn will help us to predict housing starts.
The jobs report is also important because it can be a driving force for swift fiscal or monetary policy change. The political aspect of this report cannot be undermined.
The unemployment rate will get Wall Street's attention only because of its political implications. Policy makers will want to lower the unemployment rate, especially in an election year. However, most traders get nervous when this unemployment rate approaches the natural rate of unemployment. When unemployment falls below this natural rate, inflationary pressures will start to build.
The rate of growth of the money supply is the driving force of both inflation and recession. Inflation happens when the government prints too much money and recession happens when it prints too little. The repeated use of activist fiscal and monetary policy to push the economy beyond its growth limits will result in stagflation. These growth limits are the referred to as the "natural rate of unemployment"
The jobs report also contain data on nonfarm payrolls as a second measure of the level of unemployment. Problems inevitably arise when looking at the data - they stem from double-counting, labor strikes, and surges in government employment.
People sometimes work a part time job to supplement their income and they may quit when they feel they have earn enough. When labor strikes happen, this may look like a drop in employment - when in fact it isn't. Surges in government employment such as census workers can create an impression of a rapidly growing economy.
The Average Workweek (Recession Indicator)
The average workweek measures the number of hours people have worked. This is considered a leading indicator of economic activity. This is because businesses will increase the number of hours their workers put in as a first step before hiring new workers. When the average workweek increases in the early stages of a business cycle, this may be the first sign that employers may begin to augment their payroll - this is a bullish sign. On the other hand, when the work week is rising late in the business cycle, this may indicate a tight labor market and potential wage inflation - a bearish signal.
Buy strong stocks in strong sectors in market uptrend
Short weak stocks in weak sectors in market downtrend.
|Stock Market Cycle||Sectors to Invest||Best Sectors|
|Early to Middle Bull||Technology||Computer|
|Middle to Late Bull||Capital Goods||Electrical equipment|
|Machinery and machine tools|
|Late Bull||Basic Industry (chemicals, paper, steel)||Aluminum|
|Paper and forest products|
|Top to Early Bear||Consumer Noncyclicals (food, drugs, cosmetics)||Beverages|
|Pole and wire telecommunications|
|Bottom (mid-recession)||Consumer cyclicals (auto, housing) & Financials||Auto|
Although the GDP gives us an accurate measure of the economy over the long term, the report is quarterly and the information is highly volatile. Most often, the information we get from the GDP data can be obtained from all the other data available.
The GDP equals consumption plus investment plus government spending plus net exports.
Two-thirds of the GDP data is as a result of consumption. If consumers stop spending, economic growth will come to a halt.
Retail sales provide us with very important evidence of consumer patterns for the month as well as the most timely indicator of broad consumer spending patterns. This report is a key stock market mover and any unexpectedly negative retail sales can result in a massive sell-off. When examining this report, one should look to see if any changes in consumption patterns are broad based or linked to specific sectors.
Personal Income and Consumption
The largest component of personal income is wages and salaries. Other categories of income include rental income, government transfer payments such as social security payments to retirees, subsidies like welfare and dividend and interest income. This data which is released on the first day of the business month for the two months prior is not as critical as the retails sales data, but it does provide further insight into economic activity.
Two separate consumer confidence reports are issued monthly by private institutions - one by the Conference Board and the other by the University of Michigan Survey Research Center. The future expectations portion of this report is considered a leading economic indicator. The data collection for these two reports is conducted in a similar fashion. A monthly survey asks 5000 households about their current appraisal of current economic conditions as well as their expectations for the future. Questions about future purchase of big ticket items like houses, cars appliances are also on the survey. Future expectations make up about 60 percent of the report, while current conditions account for 40 percent.
Because it is highly volatile and subject to large revisions, the consumer credit data, which is published monthly, is not considered to be very important by the market. The data is broken down into three categories: autos, credit cards and other revolving credit and the ominous "other" category.
Investment and Production
Investment spending accounts for less than 20 percent of the GDP (compared with 70 percent for consumption spending). It is important to the market because of its volatility and its sometimes dramatic effects on the business cycle. During an economic expansion, the growth in investment usually grows faster than actual GDP growth and it also declines faster during a recession. The investment indicators include the Purchasing Managers' Report, business inventories and sales, durable goods and factory orders.
This report, published by the National Association of Purchasing Managers, surveys purchasing managers in more than 300 companies representing 20 industries in 50 states of the country. This report comes out on the first of the month and so the trader gets very useful information very early, hence this is a very closely watched report.
The Purchasing Managers' Index is a composite of five series dealing with new orders, production, slow delivery performance, inventories and inflation. New orders are considered a leading indicator for obvious reasons. Production and employment are coincident indicators representing the current status of the manufacturing sector. Inventories is a lagging indicator because the build-up of inventories will occur after a downturn has begun. Slow delivery performance (supplier delivery or vendor performance) is a key component of the index of leading economic indicators. The Purchasing Managers create what is known as a "diffusion index" from these five series. The total index is based on these weights: 30 percent for new orders, 25 percent for production, 20 percent for employment, 15 percent for deliveries and 10 percent for inventories. This diffusion index is very different from the numbers reported on Wall Street. It is calculated by adding the percentage of positive responses to a half of those responses that were unchanged. For example if 80 percent of managers say that things are unchanged and 24 percent report positive responses then the index will be at 52. The manufacturing sector is considered to be in expansion phase for any number over 50.
The adroit trader will also look at some of the individual components of the index. New orders and slow delivery performance are leading indicators and those would be good ones to watch for changes in the business cycle and market trend. The purchasing managers' report fits in snugly with the durable goods order, the index of industrial production and the jobs report. When all these star reports are aligned, it is hard to argue with whatever trend they suggest.
This data is released three to four weeks after the end of the current month. Since the production of durable goods account for 15 percent of total GDP one would think this is data would be followed closely. Again, this data is volatile and subject to major revisions.
The Department of Commerce releases the factory orders report approximately one week after releasing the durable goods report. The factory orders report consists of durable good and nondurable goods such as food and tobacco and paper goods. The factory orders report is mainly a repeat of the durable goods report because nondurable tend to grow at a fairly predictable clip. However, it features some new and useful information on manufacturing inventories. The inventory data will become acutely important at possible key turning points in the business cycle. In a growing economy with increasing demand, an inventory build-up points to more growth. In a contracting economy with decreasing demand, an inventory build-up points to "SELL, SELL, SELL".
Business Inventories and Sales Report
This report includes inventory and sales statistics for all three stages of the manufacturing process including manufacturing, wholesale and retail. Technically, this report should be greeted with some zeal by Wall Street, but in practice it is not. Let's examine the recessionary chain reaction. First, when sales start to slump and inventories begin to build, businesses start to cut back on production to halt the buildup in inventories and also begin layoffs. Secondly, these unemployed workers will have less to spend so inventories build some more as sales fall further. This leads to more production cutbacks and layoffs. Next, the downward recessionary spiral continues. This report is greeted with the same degree of apathy as both the durable goods and the factory orders report. This report contains no new information other than on retail inventories.
Industrial Production and Capacity Utilization
Capacity utilization provides a clear signal for inflation while industrial production is viewed as a signal of economic growth. The Index of Industrial Production reports on three main categories in the economy - manufacturing, mining and utilities and it has been designed to capture the physical volume of output. The interesting thing about this index is that it covers a large portion of our cyclical sectors including paper, chemicals, machinery and equipment. This makes the index well worth watching for most traders who use movements in the business cycle to rotate in and out of sectors. In fact, this measure is one of the four coincident indicators used by the Conference Board to help define key turning points in the business cycle.
The Fed's measure of capacity utilization is simply the ratio of the Index of Industrial Production to a related index of capacity. It measures the extent to which manufacturing plants are being used to produce goods. Most economists believe that when the rate of capacity utilization is above 85 percent, inflationary pressures will begin to build. At this point (the threshold point for inflation), any further increase in demand will outstrip the ability to produce. Bottlenecks will emerge in the production process if the capacity levels increase further. This is a bearish signal since it raises the probability that the Federal Reserve will raise interest rates.
|Leading Indicators||What does it mean|
|The average workweek||More overtime precedes an expansion and less a recession|
|Initial jobless claims for unemployment benefits||Claims rise as the economy begins to enter a recession and fall with an expansion|
|Percent of companies receiving slower inventories||Slower deliveries mean business is booming|
|New factory orders for consumer goods||This is the first step in the production process. As orders increase, production soon follows. As they fall, there's trouble in the horizon|
|New building permits||As the Fed raises or lowers interest rates to slow or stimulate the economy, this sector is the first to feel it|
|Consumer confidence||When consumer spirits soar, the economy will start to soar; when confidence falls the GDP goes with it|
|New orders for non-defense capital goods||A bullish sign when rising investment foreshadows expansion; a bearish signal when falling investment signals contraction|
|S&P 500 Stock Market Index||Historically, the market peaks months before a recession hits and troughs months before the recovery begins.|
|The Money Supply (M2)||More money means lower interest rates and more investment; less means the opposite|
|The interest rate spread (10-year bond less Fed funds rate)||An inverted yield curve (when short term rates rise above long term rates) signals recession|
I recently took some finance classes at the local university and the professor talked about the markets being efficient or semi-form efficient. He claims you cannot make any money on news that comes out in the Wall Street Journal or any such publication because that news is old news by the time you read it. Anyway, time and again I have seen news in the paper or on CNBC and make a killing on the news - even though it is "old news".
If you do not know how to interpret the news you hear or read, you could lose your shirt. There was the time when we heard that the Producer Price Index was showing a sharp rise in inflation because of rising oil prices. We thought the Nasdaq would trend down on the news...instead it went up. Later we heard that the CPI numbers were blazing hot - due to a jump in the CPI's core inflation rate. Now, having been burnt the first time around, which way should we place our bets this time.
To figure out which way the market will trend on inflation news, we have to understand the driving force behind the inflation numbers. First there is the demand-pull variety that comes during economic booms - here there is too much money chasing too few goods. Second there is the cost-push variety that results from supply shocks like oil price hikes or drought induced food price hikes. Finally, there is wage inflation. This latter kind is the most dangerous of all and it can be triggered by either the demand-pull or cost-push varieties of inflation. When faced with inflation news, Wall Street and the Federal Reserve will react differently.
Remember when we learned in science class that an object already in motion will continue in motion unless acted upon by some external force. This law is Newton's second law of motion. A similar law holds for inflation. Most economists believe that there is a core inflation rate that is present until some kind of shock comes along to change things. Embedded in the idea of core inflation, is the concept of inflationary expectations. Inflationary expectations are important because it becomes a self fulfilling prophecy since expectations of inflation can contribute to actual inflation. Inflationary expectations strongly influence the behavior of businesses, investors and consumers.
For example, as an operations manager at a large conglomerate, if I strongly believe can affect productivity increases of 2 percent over the next year. In addition, if the inflationary expectations are 3 percent for the next year, come review time, I will ask for a minimum salary increase of 5 percent. I assume, as most people do, that inflation will continue to be what it already is - this is called adaptive expectations.
Up until about 1960, inflation was largely viewed as a demand-pull phenomenon. Whenever there was a general rise in prices, it was typically attributed to excess aggregate demand - too much money chasing too few goods. According to the Keynesian thought, this could be fixed using contractionary fiscal or monetary policies.
Cost-push (supply shock) inflation is very much feared by the Fed because this supply side shock will cause both inflation and recession. This is the deadly economic disease know as stagflation. Contrast this with demand pull inflation, there is no simply Keynesian policy solution to cost-push inflation.
One of the reasons why Alan Greenspan is treated like a rock star is rooted in his actions in the year 2000. The Fed was fighting both cost-push and demand pull inflation. When the OPEC cartel began raising oil prices sharply, the economy was suddenly faced with rising energy prices. Interestingly, Alan Greenspan was smart enough to realize that OPEC was helping the Fed to do its job by bringing the economy under control. In this case higher oil prices worked the same way as contractionary fiscal policy in the form of higher taxes. As oil prices rose, consumers had less money to spend on other goods being produced in other sectors of the economy. This means, the Fed could be less aggressive about raising interest rates to fight demand-pull inflation.
The Fed is very likely to raise interest rates when demand-pull inflation is the driving force behind the inflation phenomenon. However, they are less likely to raise rates when supply side shocks like rising energy prices are creating cost-push inflationary pressures.
Wage inflation is more likely to occur in the latter stages of an economic recovery, usually as a result of demand-pull pressures. Here, labor unions, smelling green, will likely see their bargaining power rise to a maximum. Large wage increases paid to union workers, will ripple through the wider economy. As labor markets in the non-union sectors get tighter and tighter, firms will begin to bid against each other for workers hence driving up the cost of labor.
Don't be misguided, as wage inflation can also be driven by cost-push pressures. When the economy was fighting stagflation in the 1970s, many labor unions negotiated the inclusion of cost of living adjustment clauses into their contracts. As cost-push inflation soared, wages were driven up leading to higher prices, fewer sales and more layoffs.
Any sign of wage inflation will be met with a very strong response from the Fed and in-turn, the market will react harshly. Both the Fed and the Street know that wage inflation typically occurs in the advanced stages of the inflationary cycle and will require the strongest medicine to cure.
The major inflation indicators are important to watch - these are the Consumer Price Index (CPI), the Producer Price Index (PPI), the GDP deflators, average hourly earnings, and the Employment Cost Index.
The CPI is a very important gauge of inflationary pressures. It is probably the most closely watched of all the major inflation indicators. Any unexpected changes in the CPI will have a major impact on both the stock and bond markets. The data is released by the Department of Labor between the 15th and the 21st of every month. The data is released at 8:30 a.m. EST before the market opens, as is the case with most economic indicators.
The CPI measures inflation at the retail level. To put things in perspective, most traders are very careful to analyze the CPI without food and energy. Let's say the CPI (without food and energy) is increasing, this means that demand-pull inflationary pressures are building and the Fed is more likely to raise rates.
The Producer Price Index
If the CPI measures inflation at the retail level, then the Producer Price Index or PPI measures inflation at the wholesale level. The data are released around the 11th of each month for the prior month by the Department of Labor. The PPI is actually three indexes instead of one. The first PPI reflects prices of crude materials such as grains, livestock, oil and raw cotton. A second PPI reflects prices of partially processed intermediate foods such as flour, leather, auto-parts. The third PPI looks at finished goods such as bread, shoes, autos and clothes. It is the finished goods PPI that gets the attention of most traders - Wall Street and Main Street.
The GDP Deflators
The GDP deflators are the broadest measure of inflation. They cover price changes for over 500 items in every sector, from consumer products and capital goods to foreign imports and the government sector. The deflators - a chain price index, a fixed weight deflator and an implicit deflator are reported quarterly and are considered lagging indicators. They do not generate a lot of interest from traders because of the above reasons.
Productivity growth has been a major driving force of economic growth in the United States. Productivity matters a whole lot to the stock market. Increasing productivity allows the gross domestic product to expand at a much faster rate without fear of inflation. Generally, for corporations, higher productivity means higher earnings and thus higher stock prices. Increased productivity is also the only way that workers can enjoy increases in their real inflation-adjusted wages. If workers want to see a boost in their paychecks, they must produce more during any given hour. This, of course, has an indirect effect on the stock market. Workers with more discretionary income, will consume more and this consumption leads to more products being produced, which in turn leads to more products sold, thus higher earnings and higher stock prices.
A very astute observation is that the Fed will react very differently to a rise or fall in productivity depending on where the economy is in the business cycle. Productivity will fall when the economy contracts and enter a recession. This happens because businesses will cut back on production at a faster pace and then start to lay off workers. Secondly, businesses operate with much more idle capacity and must therefore spread their fixed cost over a smaller level of output. These two factors drive up costs while production is falling so that the unit costs of labor increases.
This increase in unit labor cost will not be viewed as a symptom of inflationary pressures. The Fed knows that the business cycle would have created this mirage and they would not be likely to raise interest rates.
When the economy is expanding, productivity will lead the expansion as unit labor costs will fall. At this point, factories will increase their capacity and hence they operate more efficiently because the same amount of workers are producing more output. As long as productivity gains rise at a pace that keeps wages from rising – the Fed will be happy to keep interest rates unchanged. However, later in the business cycle, as raw material costs increase and as the labor market gets tighter, the Fed will take a more critical look at productivity and unit labor cost to check inflationary pressures. If unit labor costs outruns productivity gains – then this is a clear sign of wage inflation and the Fed will be more likely to raise interest rates.
Productivity is measured as the ratio of worker output to the number of hours worked. Unit labor cost is compensation per hour per hour divided by output per hour. Compensation includes wages, salaries, commissions, payments in kind and employer contribution to taxes and benefit packages. Unit labor costs will increase as compensation rises. As productivity rises, it pushes up the output per hour and this tends to drive down unit labor costs – hence productivity offsets increases in unit labor costs.
After all that discussion, not many traders look at the productivity report because the data is highly volatile and it is only reported quarterly. However, be aware that strong productivity reports at key points in the business cycle can move the markets.
The Budget Deficit
How does the budget deficit affect the stock and bond market. The government can raise money to finance the deficit by either raising taxes, selling bonds or printing money. Raising taxes is politically risky and so most politicians shy away from this option. The other remaining options are selling bonds or printing money. The government (US Treasury) can sell bonds to the private capital markets and use the proceeds of the sales to finance the deficit. The Treasury is in effect competing in the capital markets, directly with private corporations that may also be selling bonds. To compete, the Treasury typically will raise the interest rate it is offering in order to attract enough funds. This actually crowds out private investment by using money that normally would have been borrowed and spent by corporations and businesses on private investment. This crowding out effect raises the cost of capital for these businesses and corporations. In the bond market, higher interest rates mean lower bond prices.
To avoid the crowing out effect, the government could, buy the Treasury’s securities itself rather than letting these securities be sold in the open capital markets. The government will simply print new money to pay for this expenditure. However, the increase in the money supply may cause inflation. If this inflation drives up interest rates and drives private investment down, the end result of printing money may be a crowding-out effect as well. Hence most traders have a strong distaste for budget deficits.
Ironically, when the government releases the Treasury budget report, there is typically no earth shaking movement on Wall Street – they hardly notice. This happens because the government’s pattern of spending is highly seasonal. Revenues will increase in January, June, September and December because that is when quarterly tax payments are due. The point here is that the data is subject to very large month-to-month fluctuations.
The astute macro-economic watcher will compare the current month’s receipts and outlays to the same monthly data from the year before. This may signal a decline if the numbers for the current month is smaller than the same month’s data last year.
The Trade Deficit
If you want to round out your knowledge about global economy and the international monetary system, this will be an important section to study. The monthly report on international trade can have a big impact on the stock, bond and currency markets. This impact is very difficult to predict because of the many forces that are acting against and with the market as the data are released.
To dig into this section, we will first look at some basic terminology like learning the difference between current account and the capital account. Next we will explain exchange rates and why the values of currencies move relative to one another. We will then try to understand the trade report issued monthly by the Department of Commerce and try to understand what drives Wall Street’s actions and reactions. Lastly, we will learn how and why the markets react to different scenarios based on the trade data.
Let us first understand what is meant by the current account and what is meant by capital account. The current account consists of both goods and services and net investment income. The capital account tracks the flow of capital both into and out of the US. Most important, “the current account and the capital account balance”. That is, if a country runs a trade deficit in its current account, it must balance that deficit with inflows into its capital account. This simple trade identity equation will help the investor to grasp the concept of how trade affects both the values of currencies and the levels of interest rates across countries.
Table – Balance of Payments for a Typical Year for the U.S.
|Merchandise trade balance|
|US goods export||537|
|US goods imports||-704|
|Fees for services||+97|
|US export of services||254|
|US imports of services||-157|
|Net investment income||-27|
|Income earned by US investors holding foreign assets||200|
|Income earned by foreigners holding US assets||-227|
|Current Account Balance||-97|
|Foreign purchase of assets in the United States||600|
|US purchase of assets abroad||-503|
|Capital Account Balance||+97|
When you read in the newspapers that the US is running a trade deficit, they are referring to the merchandise trade balance. It reflects trade in commodities such as food, fuel, and manufactured goods. In the table, the merchandise trade balance shows a deficit of $167 billion. The second item in the table is fees for services – which show a surplus of $97 billion. In recent years, these fees have helped to offset some of the large merchandise trade deficit. The third item in the table is investment income. As foreigners have accumulated more and more US assets, this category is running in the red. The table shows a deficit of $27 billion.
Summing the items in the table, we arrive at a deficit in the current account of $97 billion. According to the basic trade identity equation, this deficit must be offset by a net surplus in the capital account. Capital has to flow into the US to offset the negative balance in the current account. This means that interest rates in the US has to be attractive to attract foreign investment. We now know that when interest rates move so too do stocks and bond prices.
The capital account monitors the purchase of real assets such as hotels and factories and financial assets such as stocks and bonds. Foreign purchases of US assets such as government bonds and stocks or even plant and equipment represent capital inflows. The table shows this as a credit of $600 billion. Capital outflows occur when US investors purchase assets in other countries. The table shows this as a debit of $503 billion. Summing these capital inflows and capital outflows we end up with a surplus of $97 billion.
If a country buys more goods and services than it sells, it runs a current account deficit. Any country doing this must raise its interest rates to a high enough level to attract enough foreign capital to offset the current account deficit. How does raising interest rates affect the value of a country’s currency?
There are several reasons for the value of currencies to fluctuate. First, different countries have different rates of economic growth. If, for example, the U.S. GDP is growing faster than the Japanese GDP, the US dollar will depreciate relative to the Japanese yen. This happens because robust growth in the US will attract relatively more Japanese imports. This in turn will lead to a surplus of dollars relative to yen and will put downward pressure on the dollar.
Another reason that exchanges rates move is related to the changes in relative interest rates. If the Fed raises interest rates relative to the British interest rates, the dollar will appreciate relative to the British pound. This happens because higher US interest rates will attract relatively more British investment. In order to invest, the British must buy dollars with their pounds. This drives up the value of the dollar.
Still another reason for exchange rate fluctuations pertains to rates of inflation. If inflation in Japan is higher than inflation in the US, then the yen will depreciate relative to the U.S. dollar. This is somewhat commonsensical, since a television made in Japan would have to be adjusted for inflation so that the same television would cost the same in the U.S. This is called the law of one price by economists. Exchange rates in the currency market reflect real inflation-adjusted price differences in the goods market.
When the Department of Commerce releases the trade report around the 20th of each month, it will contain detailed information on imports, exports, trade deficit as well as trade flows by category and country. Even though the data are reported in several ways, it is generally better to look at the inflation-adjusted data. Another point is that most people will focus on whether the trade deficit has been rising of falling but it is also important to look at the individual import and export data.
The export data will tell you whether U.S. companies are gaining or losing competitive advantage. The export data will also tell whether the economies of the U.S.’s trading partners are strengthening or weakening.
Trade Deficit Scenarios and Resulting Market Effect
|Scenario||Reason||Currency||Stock Market||Bond Market|
|Deficit Increase||U.S. GDP growth||Dollar down||Rise||Fall|
|Deficit Increase||Recession in Europe & Asia||Dollar up||Fall||Rise|
|Deficit Increase||OPEC Oil price increase||Dollar down||Mixed||Rise|
|Deficit Increase||Fed raises interest rates||Dollar up||Fall||Fall|
Generally speaking an increase in the trade deficit will weaken the dollar while a fall in the deficit will strengthen the dollar. An increasing deficit means more dollars in the hands of the U.S. trading partners. When they exchange these dollars for euros or pesos, that puts downward pressure on the dollar.
Trade Deficit Increases Because of Strong U.S. GDP Growth
The table above shows that when the trade deficit increases because of strong U.S. GDP growth, the stock market will rally. In this case both Europe and Asia are growing at moderate to strong rates. However, the U.S. economy is growing at a faster clip and will tend to draw in more imports. The stock market views this as a good thing because strong economies around the world spell good news for corporate earnings. The bond market, on the other hand, fearing inflation, may view this as a sign that the U.S. economy is overheating and bond prices will fall.
U.S. Trade Deficit Increase Because of Recession in Europe or Asia
If there is a recession in Europe and Asia, then the deficit may rise because of falling exports. This is bearish news for the stock market. Export dependent sectors like aerospace, agriculture, autos, telecommunications are likely to suffer. The bond market prefers a trade deficit that is a result of weak exports as opposed to increasing imports. This will put downward pressure on interest rates because the U.S. economy will slow and lessen the credit demand of those industries.
U.S. Trade Deficit Increase Because of OPEC Oil Price Shock
If the OPEC cartel suddenly increases oil price, certain sectors in the stock market may view this as a positive event. Energy stocks may rise because of anticipation of stronger earnings while food and pharmaceuticals may benefit from sector rotation. The bond market will assess whether the oil price increase will dissuade the Fed from raising interest rates. The bond Market may rally if it appears that OPEC’s actions are viewed as recessionary and hence put downward pressure on interest rates. Remember that an oil price shock may cause both inflation and recession and there is no easy monetary policy solution to this problem. In any event, we believe it unlikely that the Fed would raise interest rates to combat inflation in the event of an oil price shock.
U.S. Trade Deficit Increase Because the Federal Reserve Raised Interest Rates
The value of the dollar will increase relative to other currencies if the Fed raises interest rates. When this happens, exports become more expensive to sell and imports become cheaper to buy. The trade deficit will most likely increase spelling big trouble both for U.S. export industries and multinational corporations like GE, Honeywell, and IBM that derive a large percent of their sales and profits from abroad. An increase in the trade deficit as a result of rising interest rates and a strengthening dollar will be bad news for both the stock and bond markets.
When the Fed raises rates to strengthen the dollar, European investors will flock to the U.S. in search for greater returns. This will weaken the Euro as investors sell Euros to buy dollars hence possibly fostering inflation within Europe. On the other hand, a weak Euro will help export focused European industries – chemical products, agriculture, mobile phones and so on.
If the Europeans counter the Feds’ action by raising their own interest rates, this will heighten the contractionary effects of the Feds’ rate hikes and lead to global recessionary concerns. The action taken by the Europeans will depend on the state of their economy at the time. If the European economy is weak, it will be difficult for them to counter with a rate hike. If, on the other hand, the European economy is robust and growing nicely and inflation looms as a problem – the Europeans will most likely raise interest rates to match the Feds’ rate hike.
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