What is GDP?
GDP is short for Gross domestic product, and it is the broadest measure of economic activity in a country. Economists, traders, and the financial press widely cite it, as a very weak or strong GDP reading might quickly shift stock market indices and currency rates. It is also one of the economic indicators used to determine if an economy is in a recession or not.
When is the next US GDP report going to be published?
Gross Domestic Product, 1st quarter 2019 April 26, 8:30 AM EST
Gross Domestic Product, 2nd quarter 2019 July 26, 8:30 AM EST
- Gross Domestic Product, 3rd quarter 2019 October 30, 8:30 AM EST
What does GDP Measure?
It is impossible to know exactly what is being produced in a country at any given time, but the GDP is the closest we can get to an estimate.
The income approach is one way of estimating GDP, and in its simplest form, it adds up what the population of a country earned in a whole year. The income approach includes total compensation to employees, gross profits of companies, taxes, and deducts any subsidies.
The expenditure approach is the other way of estimating GDP and is the most commonly used. Here we take the sum of consumer spending, investment, government spending, exports, and deduct imports.
Consumer spending is broken down into goods and services, while investments are broken down into non-residential and residential investment. Exports and imports are categorised into services and goods.
Together these key sectors make up the Gross Domestic Product. We include the word “Domestic” as the measures exclude goods and services produced in another country.
For example, if a country consumes and invests 10 trillion dollars, exports for 2 trillion, has a government spending of 1 trillion, but imports goods for 10 trillion, then GDP will amount to 3 trillion. As 10 + 2 +1 – 10 = 3.
How is GDP Calculated?
The actual GDP amount in dollars is relevant when comparing country economy sizes, while in financial investing and forex trading, the participants are interested in growth rates.
According to the International Monetary Fund, the largest economy in the world in 2018 was China with a total of 25,238.56 billion dollars, followed by the European Union (which is not a country), and the United States in the third position.
In most countries, GDP is published every quarter, with at least one month’s delay. In some countries, such as Canada, GDP is published monthly.
There are two ways the Gross Domestic Product is represented. The first and most popular measure is the quarterly change; this measure is then multiplied by four to obtain an estimate of the annual growth, if the quarterly growth would persist for four straight quarters. Financial markets tend to focus on this annualized measure, but as it is a volatile gauge it is prone to change from quarter to quarter.
Instead, economists tend to focus on the yearly growth rate of GDP.
e.g. the first quarter of 2019 GDP reading is compared with the first quarter GDP reading of 2018. This way of representing GDP gives a smoother representation and is probably most relevant to the public as wages and mortgage contracts etc., change infrequently. The yearly change measure is also preferred by central banks, as single quarters of GDP growth can be misleading to the true state of the economy.
Why does GDP matter for Forex and Stock Market Traders?
GDP is the most complete indicator of the state of the economy and is, therefore, an important input for central banks and governments. As an example, NATO countries are committed to spending a certain percentage of their yearly GDP on military spending. For traders, it is how the central bank such as the Federal Reserve reacts to the growth of GDP.
The central bank itself has little impact on the long-term average of GDP growth. Instead, the long-term average GDP growth is determined by factors such as population growth, investment, and productivity. As an example, as the population increases people will demand more goods and services, which will drive GDP higher. If a country were to invest in education and machinery, the people that are working could increase their output per hour which would then increase GDP.
However, the central bank does control short-term interest rates, and also interest rates with longer investment horizons via different quantitative expansion and tightening programs. It’s via interest rates that the central banks such as the ECB or Federal Reserve can control the economy. If they opt to increase interest rates, then it will make loans and mortgages more expensive, and as most people have a mortgage, they would reduce their spending as the cost of the mortgage increases.
Individuals would also be reluctant to buy new items, such as cars if they need a loan to complete the purchase.
Why do Central Banks change its interest-rates depending on the GDP growth rate?
Most central banks have a mandate to keep annual inflation steady around 2%. An economy that is overheating, i.e. a GDP that is growing much faster than usual, will usually lead to high inflation, and also misallocated investments. To limit both problems, the central bank will usually increase interest rates if the GDP growing too fast, or if they project that GDP will be very high in the next two years.
On the other hand, if the economy is slowing down per GDP, or maybe the unemployment rate is starting to increase rapidly, the central bank will help households and companies by lowering interest rates. The central bank could also potentially introduce a quantitative easing program as they did in the great recession of 2008.
The lower interest rates would allow companies to make investments they would usually hesitate to take if interest rates where high. For households, mortgage costs would decline, but also other costs related to credit will be affected, such as car loans and student loans.
Stock markets and GDP
If GDP was growing from low levels, such as after a recession, and was projected to improve further in the year ahead then this would usually lead to a stronger stock market, as corporations would be expected to make more money and thereby increase their value.
However, a situation could arise where GDP is increasing too rapidly, this tends to be the case when interest rates are too low, and the central bank starts to worry about inflation. To combat any potential inflation in the future the central bank would start to increase interest rates. This would usually lower the profitability of companies causing stock markets to peak, and potentially decline if investors believe that there would be a recession.
Forex Markets and GDP
If GDP growth is running red-hot, and the central banks are increasing interest rates, that tends to cause its currency to increase in value. If the GDP growth is strong then that means that the country is becoming wealthier and tends to attract more investments. Foreigners would need to convert their currency to the domestic country’s currency if they would like to make an investment in the fast-growing country, therefore that would support the domestic currency. For example, if U.S. GDP is strong and a Euro investor wants to buy shares in an American company then they would need to convert their Euros to USD.
Strong GDP growth tends to naturally cause higher interest rates, as more people are interested in borrowing money to invest, and higher interest rates tend to translate into higher Forex swap rates. This could allow traders to profit on currency interest rate differentials. As an example, for decades Japanese interest rates have been low as Japanese GDP growth, and inflation has been anemic. This has caused Japanese investors to invest abroad in countries such as Australia, but also the United States where the return on their money is higher. This sort of trade is called the carry trade.