Macro-Economic Trading

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.

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.

Exchange Rates

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 20^th 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.

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