What Is the Effect of GDP on Financial Markets?
The term GDP appears daily in the financial and business press. Chief Executives, investors and savvy traders make frequent references to it. But what is GDP? What is the effect of GDP on financial markets? How can you keep track of it and its changes? And is it possible to build trading and investment strategies around it?
What Is GDP?
GDP (Gross Domestic Product) is a measure that aims to give a monetary value to the overall size of an economy over a specified period of time, usually a year. When we speak of an economy, we typically refer to that of a country but sometimes also of a region (such as South East Asia) or a city.
Comparing the GDPs of different countries can inform you about the relative sizes and strengths of their economies. Although it is not perfect, GDP is the best guide to an economy's size and its ups and downs.
Who Publishes GDP?
The official GDP figures are calculated and reported in the United States on a quarterly basis by the Bureau of Economic Analysis (BEA). In the UK the Office for National Statistics (ONS) publishes monthly, quarterly and annual figures.
What Can GDP Tell Me?
As with many other economic and financial measures, one figure on its own is not very informative. However, comparing the size of GDP, or its rate of change, over a number of months, quarters or years can tell you a lot about the health of an economy.
Economists and investors like an economy to grow steadily and healthily. GDP growth of 1.5% - 3% per year is considered healthy for a developed economy like the UK or US. Faster growth would lead to concerns about inflation and/or unsustainable economic bubbles. Slower growth would lead to concerns about stagnation and declining economic standards.
For developing economies faster growth rates can be considered healthy. For example, official figures show the Chinese economy to have grown consistently by over 6% per year, for almost three decades.
Changes in GDP growth are even more closely monitored than GDP itself.
GDP and GDP growth are treated as indicators of the overall health of an economy. When growth is high, the economy 'feels' healthy. Employment increases as companies hire more people. Those people have more money to spend within the economy, which is good for companies and reinforces the overall positive effect.
What Happens If GDP Growth Falls Outside of the Usual Range?
It is possible to have too much of a good thing. Too much GDP growth for too long will result in high inflation, which governments and central banks try to fight, typically by increasing interest rates. Higher interest rates slow down the economy and have a direct and fairly immediate impact on most financial markets which we will examine below.
Of course, when GDP shrinks the opposite occurs; businesses cut back and some workers lose their jobs resulting in less overall expenditure in the economy. This can lead to the economy shrinking, or negative growth. Two consecutive quarters of negative GDP growth is typically viewed as a recession.
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How Is GDP Calculated?
There are three common ways of measuring GDP, each method should result in the same figure:
- Adding the total value of all goods and services produced in the economy;
- Adding all income earned by individuals and organisations in the economy;
- Adding all expenditure - consumption, investment, government expenditure and net exports
What Else Can Traders Learn From GDP?
GDP is an important figure in itself, but it is also an important component of other statistics which are closely watched. GDP growth, discussed above, is the most important of these, but there are others.
Comparing the GDPs of two countries can tell you which one has the larger economy. But that does not necessarily mean that their population is better off for it. There are two main reasons for this.
Firstly, the country with the larger GDP may have a lot more citizens to divide that income between. To allow for this, economists often divide a country's GDP by the number of citizens. This produces what is known as the GDP per capita. GDP per capita is the most common statistic used when comparing standards of living in different countries.
The second reason is that the costs of living in one country can be very different from the costs of living in another. For this reason, GDP figures are often adjusted by the cost of living, to give Purchasing Power Parity (PPP) GDP figures.
These two concepts are perhaps better understood with an example.
The International Monetary Fund's (IMF) 2019 estimates rank China and the US as the world's two largest economies:
But the US is a more expensive place to live than China. Adjusting for this is, by using PPP, the two countries reverse places in the global league table:
PPP GDP (USD)
China has many times more people than the US (1.4bn vs 330m), so the GDP per capita figures give a very different picture:
GDP per capita (USD)
Another common adjustment made to GDP figures is to extract inflation. Nominal (or unadjusted) GDP shows GDP figures in their "raw" market prices. Economists subtract inflation to produce Real GDP figures. For example, if Nominal GDP grows by 10% and Inflation is 3% over the same period, then Real GDP is said to have grown by 7%.
Real GDP = Nominal GDP - Inflation
Economists will tend to focus on Real GDP when assessing the health of an economy.
The Effect of GDP on Financial Markets
Hopefully you should now understand what GDP is, how it is calculated and some of the useful statistics that can be derived from it. But how do changes in GDP affect the financial markets? The relationship between the two is not straightforward and, consequently, there are many factors to consider when answering this question.
Firstly, GDP is a lagging indicator – it is calculated retrospectively, looking backwards at the period of time in question. In contrast, financial markets tend to be forward-looking and are affected more by expectations of what will happen in the future. GDP will affect financial markets most when it changes people's expectations of what will happen in the future.
Another thing to consider is that GDP affects other variables, such as individual incomes, appetite for investment and inflation. These variables in turn can have a knock-on effect on others. Inflation, for example, can affect interest rates.
All these variables themselves can have an impact on investments, often more directly and immediately than GDP. Therefore, to assess or predict the full impact of the effect of GDP on financial markets, we need to consider these second-order and sometimes even third-order effects.
To examine the effects of GDP on financial markets more fully, we will look separately at the main asset classes.
GDP and Forex Markets
Fundamental traders use GDP data as a key measure in determining the strength of a country's economy and therefore the strength of its currency. However, this is a complex relationship.
One important component of GDP is exports and increased exports have a direct, non-ambiguous and positive impact on the value of a currency. Looking beyond the main GDP figure to see what is happening with a country's exports can, therefore, provide useful insight into currency expectations.
High GDP growth can lead to an increase in inflation. High inflation will, in turn, tend to erode the value of a currency over time, negatively affecting FX rates.
However, if a country's central bank decides to fight inflation by increasing interest rates (the most common reaction), the increases in interest rates will have a positive effect on the value of the currency.
Remember that Forex is traded in pairs. For this reason it is important to compare GDPs, and other figures, behind both of the currencies you are planning to trade. What traders need to focus on is the difference between the two currencies' GDP growth rates. The one that has a higher growth rate will usually experience an appreciation over the other one.
On 28 May 2020, the Bureau of Economic Analysis announced their second estimate of the USA's GDP for the first quarter of 2020. Their revised estimate stated that US GDP fell by 5%, 0.2% more than their previous estimate of 4.8% which they had announced on 29 April of the same year.
In the USD/CHF chart below, the highlighted candle represents the time of the above announcement. The value of USD subsequently depreciated over the next few hours.
Depicted: Admiral Markets MetaTrader 5 - USDCHF M15 Chart. Date Range: 28 May 2020 - 29 May 2020. Disclaimer: Charts for financial instruments in this article are for illustrative purposes and do not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (Contracts For Difference, Exchange-Traded Funds, Shares). Past performance is not necessarily an indication of future performance.
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GDP and Equities
Companies perform better in stronger economies, therefore, strong GDP growth is generally good for equities. But there is not a straightforward linear relationship between the two.
After the 2008 financial crisis, the S&P 500 fell more than 40%, while US GDP growth fell by about nine percentage points from its peak in 2005 to the lowest point in 2009, when the economy shrank by 2%.
Since then, share prices have risen sharply even though GDP growth has been much smaller. For example, annual US GDP growth has averaged less than 2% since the recession of 2008. During that time the S&P 500 has seen an average annual gain of more than 27%, excluding dividends.
Depicted: Admiral Markets MetaTrader 5 - [SP500] Weekly Chart. Date Range: 22 May 2005 - 11 September 2020. Disclaimer: Charts for financial instruments in this article are for illustrative purposes and do not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
Low interest rates and the forward-looking nature of the stock markets are two reasons for the above divergence – but there can be other reasons.
Generally, larger companies tend to make more of their money from exports, than smaller companies. This means their performance is likely to depend on the health of many different economies rather than just its own. This is another reason why their performance may diverge from national GDP figures.
That effect is magnified in blue chip indices like the FTSE100 which, as well as containing mainly large exporters, includes 14 foreign companies.
Companies can manufacture in one country, sell in another and be listed in a third, so it is important to be familiar with the basic facts of the business when looking for links between GDP figures and the performance of the shares of any individual company.
It's also important to understand what the company does. No matter how bad the economy gets, everyone still needs to buy things like food, medicines and utilities. In contrast, purchases of products such as cars, washing machines and mobile phones are more likely to take a hit in an unhealthy economy. Share prices will react accordingly.
One effect is much more predictable. Because of the complex relationship between GDP and the stock market, as well as between GDP and FX rates, volatility is likely to increase in these two markets around the time of publication of GDP figures. And volatility can be a trader's best friend! Traders who like volatility should get ready to trade their favourite assets around the time of publication of GDP figures.
GDP and Bond Prices
The effect of GDP on investment in corporate bonds often has the opposite effect that it has on shares.
Strong GDP growth usually means a greater demand for borrowing by businesses and consumers, and sometimes it is a sign of impending inflation. Both increased borrowing and inflation usually translates into higher interest rates, which depresses corporate bond prices.
In addition, increased corporate borrowing is usually done through corporate bonds; increasing the supply of bonds in the market. This also exerts downward pressure on bond prices.
Conversely, declining GDP generally means lower inflationary pressures as well as lessening demand for borrowing, which then generally means lower interest rates and, in turn, higher corporate bond prices.
Government bonds are seen as a safe refuge by many investors, meaning there is increased demand for them in bad economic times (times of disappointing GDP figures) and less investor interest in good times. This means the inverse relationship between GDP and government bond prices is even stronger than for corporate bonds.
This is generally the case for developed economies. For weaker, developing markets, if the GDP performance starts to look so bad that the government may struggle to pay its debts, then negative GDP figures will lead to falls in the prices of government bonds.
GDP and Commodity Prices
The impact of GDP and GDP growth on commodity prices depends on the type of commodity in question.
Strong GDP growth tends to increase the demand for a whole list of "industrial commodities". These include copper, aluminium and, of course, oil. This type of commodity will tend to go up with strong GDP figures.
The same is true for commodities associated with luxury like coffee, sugar and cocoa.
The opposite is true for the type of commodity that is seen as a safe refuge for investors during bad economic periods – like gold, silver and platinum. These tend to fall in price when the economy is healthy.
In the gold chart below, we can see that in 2020, amid global economic difficulty and falling GDP, the price of gold has been rising.
Depicted: Admiral Markets MetaTrader 5 - Gold Daily Chart. Date Range: 11 December 2019 - 15 September 2020. Disclaimer: Charts for financial instruments in this article are for illustrative purposes and do not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
A Summary of the Effects of GDP
The table below summarises the effect of GDP on the different financial markets:
When GDP or GDP-Growth Increases
Likely to increase the value of the local currency. This is particularly the case when exports (an important component of GDP) also increase – and if it leads to rises in interest rates.
Persistent and large GDP growth can lead to inflation which, if unchecked, will erode the value of the relevant currency.
Generally, positive impact on share prices – unless there are fears of inflation or of central banks increasing interest rates. Increasing interest rates will have a bigger and more immediate downwards impact on share prices.
Likely to lead to a fall in bond prices. Three reasons:
1) it increases the chances that interest rates will rise sooner, rather than later.
2) it will encourage companies to issue more bonds, increasing the supply of bonds, adding downward pressure to bond prices.
3) As positive news on GDP is acknowledged to be positive for the stock market, some investors will sell their bonds in order to buy more shares.
The same as Corporate Bonds, only more so.
This relationship will break down if GDP performance starts to look so bad that the government seems at risk of being unable to pay its debts.
Increased demand for industrial & luxury commodities, therefore, prices grow.
Increases the opportunity cost of investing in non-yielding, safe-haven commodities like gold, silver and platinum, therefore, prices decrease.
Does GDP Affect Volatility?
As we have seen, there is a complex relationship between GDP and the financial markets. This typically means there is an increase in volatility for most assets around the time of GDP releases.
If that suits your trading style, you can take advantage of that volatility to look for relevant opportunities.
How Can You Keep Track of GDP?
Admiral Markets provides a Forex Economic Calendar which summarises the announcements and events expected during the upcoming trading sessions – including GDP announcements.
Depicted: Admiral Markets' Economic Calendar
The FX Calendar is one of the most important tools for traders wishing to stay ahead of the fundamental news affecting the markets.
The calendar provides the following information:
- The time of publication, in your local time;
- The country of origin of the announcement;
- The level of importance of the announcement;
- The forecast statistics and previous results;
- The results.
By showing forecasts and previous results, we make it easy to evaluate differences in the data released and compare them with the previous market consensus.
With all this information, the trader can follow the trends in the markets and prepare to take advantage of the opportunities presented by the release of GDP figures.
How to Create Your Own GDP Trading Strategy
Here are some steps to help you construct your own GDP trading strategy, one that suits your style of trading and your investment interests
- Select an asset class and a specific instrument (a currency pair, share, bond or commodity).
- Think through the likely impact of changes in GDP and GDP-growth on your chosen instrument. Make sure you consider the potential secondary effects of inflation, interest rates, etc.
- Become as familiar as possible with what the market is expecting in terms of GDP and GDP growth. These expectations are likely to be contained in the press and in research published by banks, brokers and economists.
- Get ready to position yourself on "both sides of the trade": what will you do if GDP-growth is higher than expected? What will you do if it is lower?
- Watch the GDP publications closely and get ready to place one of your orders.
- Experiment your GDP trading strategy with small sums or in a demo account until you are confident you have found relationships that work. If some of your experiments don't go as planned, work out why.
One possible approach to trading the GDP news is by using an OCO (One Cancels the Other) order. An OCO order consists of two separate, but linked, conditional orders and, as the name suggests, if the market conditions are met for one order to be executed, the other order will be automatically cancelled.
Therefore, it is possible to set up an OCO order in anticipation of a GDP announcement by which if the price moves in either direction, a trade will be opened on your behalf automatically to take advantage of the possible price movement.
OCO orders are not part of the standard MetaTrader 5 trading platform. However, luckily for you, they can be made with the Admiral Markets MetaTrader Supreme Edition add-on! In order to place an OCO order, simply follow these steps:
1. Download the MetaTrader Supreme Edition add-on
2. Click 'File' and select 'New Chart' to open a price chart, as shown below:
Depicted: Admiral Markets MetaTrader 5 Supreme Edition
3. Once you have selected a chart, press Ctrl+N on your keyboard to open the 'Navigator' window (if it is not already open on the left hand side)
4. From the 'Navigator' window, select 'Expert Advisors' and then click and drag the 'Admiral - Mini Terminal' onto your open price chart
Depicted: Admiral Markets MetaTrader 5 Supreme Edition - Expert Advisors
5. Once opened, you need to click the yellow cog on the top right hand corner of the Mini Terminal in order to open a trade
Depicted: Admiral Markets MetaTrader 5 Supreme Edition - Mini Terminal
6. On the subsequent dialogue box, select an order type of OCO breakout and then fill in your desired conditions to create the order!
Depicted: Admiral Markets MetaTrader 5 Supreme Edition - Mini Terminal New Order
You should now be fully aware of what GDP is, the effect of GDP on financial markets and how you can use these to your advantage when trading. As with any new trading approach or strategy, it is important to test its viability in a virtual environment prior to risking your capital on the live markets.
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Did you know that it's possible to trade with virtual currency, using real-time market data without putting any of your capital at risk? That's right. With an Admiral Markets' risk-free demo trading account, traders can test their GDP trading strategies and perfect them without risking their money.
A demo account is the perfect place for a beginner trader to get comfortable with trading, or for seasoned traders to practice. Whatever the purpose may be, a demo account is a necessity for the modern trader. Open your FREE demo trading account today by clicking the banner below!
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.