8 Economic Indicators and Events All Forex Traders Need to know

Consider Infosys as an example of a stock; when you purchase or sell it your opinion of the stock is basically either optimistic or pessimistic. Consequently, you buy/sell accordingly. A currency pair such as USD INR is a different matter – even if you are unaware of it, your viewpoint is twofold. When buying USD INR for example, it expresses that you are bullish on the US Dollar and bearish on the Indian Rupee.

Why is it this way you may ask?

The worth of a currency is always quoted in comparison to another. As discussed in the preceding chapter, foreign exchange is typically illustrated by a currency pair, represented as such:

Base Currency / Quotation Currency = Value

In other words, this format tells us how many units of quotation currency one can buy for 1 unit of the base currency.

When purchasing a currency pair, it’s because you anticipate its value to increase. Let’s say the rate for USD INR is 65, with the aim of it eventually reaching 68.

If the price of the pair is anticipated to rise, then it indicates that in the foreseeable future one unit of base currency will be worth more quotation currency; in other words, 1 USD could purchase a greater amount of INR.

This implies that you anticipate a rise in the Base currency’s value, indicating the Quotation currency will weaken. Thus, you are bullish on the former and bearish on the latter.

Likewise, if you sell the USD INR pair, it implies that you anticipate the Base Currency to become weaker compared to the Quotation Currency. This indicates a bearish outlook on the base currency and a bullish one on the quotation currency.

Given this, “strengthening/weakening of a currency” refers to the following situations –

1.     The base currency (USD) strengthens when it can purchase more units of the quote currency (INR). For instance, when USD INR moves from 67 to 68, this indicates that the base currency has increased in strength while the quotation currency has weakened.
2. When the base currency buys fewer units of quotation currency, it weakens and the latter strengthens. For instance, if USD INR moves from 66 to 65, this would suggest that USD has weakened and INR strengthened.

Strengthening and weakening a currency are the same as it appreciating and depreciating. These terms are frequently used in place of each other.

Before we move on, it’s important to remember that, similar to a stock, currencies (and currency pairs) possess a ‘two-way quote’. This quote reveals the rate at which one can buy and sell these monetary units.

You might be pondering the meaning of ‘two-way quote’, which is essentially an abbreviation for ‘Bid and Ask’ rates. It’s important for us to discuss this in greater detail.

Have a look at the image below –

Here is a view of the currency spot rates as posted by a Forex trading site. I have singled out EUR USD and GBP USD, in particular, to illustrate the two-way quote they provide; indicating how much you can buy or sell a given pair.

For example, if you desire to purchase the EUR/USD, then you will have to acquire it at the ‘Ask’ value of 1.1270. Technically, this would mean that you are taking a long position in the European currency and a short stance in its US counterpart, as per the dual view concept. Inversely, should you wish to sell the pair; this could be done at 1.1269 (Bid) which reflects being short EUR and long USD.

Sometimes, currency pairs are expressed in a concise manner, which is a common way to quote currencies internationally. For example, the EUR/USD pair can be represented thus:

EUR/USD – 1.1269/70.

In the shortened version, ‘bid’ is written out completely, whereas only the last two digits of ‘ask’ are indicated.

Further, in the Forex lingo, digits are referred to as ‘pips’. Therefore, if the EURUSD moves from 1.1270 to 1.1272, then it means that the pair has moved 2 pips.

 – Rate fixing and conversion path

As of today, the USD/INR rate stands at 67.0737, which is determined daily by the RBI and termed ‘Reference Rate’. The Reserve Bank publishes these rates on their website, making it an essential factor in currency futures trading, as all settlements are based off this Reference rate.

Have a look at this –

The above is a snapshot from the RBI’s site revealing the reference rate for 14th June 2016. These are spot rates, not future rates – those can be found on NSE’s website.

Anyway, the obvious question is – how does the RBI arrive at this rate?

No hi-tech involved here, the RBI sticks to their traditional procedure of surveying to determine the spot rate! You could check out the RBI circular that explains how they set the rate, or just get a gist by reading through these points.

1.     The Reserve Bank of India has come up with a list of banks, derived on the basis of their market share in the foreign exchange market, and labels them as the ‘contributing banks’.
2.     The Reserve Bank of India contacts a group of banks (randomly chosen) listed among the contributing institutions between 11:30 AM and 12:30 PM and requests two-way prices for USD INR.
3.     RBI collates these rates and averages out the rate based on the bid and ask
4.     The average rate is determined by the USD INR exchange rate for the day.
5. The same procedure is carried out on a daily basis, excluding weekends and bank holidays.

That’s all there is to it!

The procedure is straightforward; RBI surveys only USD INR rates. For the other major rates like EUR INR, GBP INR and JPY INR, it uses a technique called ‘Crossing’ or cross rate mechanism.

Crossing one currency to another is not always straightforward. For example, to determine the rate of Euro in INR, one needs to convert them through a shared unit of value.

As an example, I will explain the process of finding the EUR INR rate by crossing, with USD being used as the common denominator. Hopefully, this will help to better understand the concept of crossing.

Let us start by looking at the USD INR spot rate; visible in the snapshot above, it is –

USD INR – 67.0737

This spot rate serves as the basis for a two-way quote, which would look something like this.

USD INR – 67.0730 / 67.0740

This means if I have to buy 1 USD, I need to pay INR 67.0740 and if I have to sell 1 USD, I will receive INR 67.0730.

Let’s keep this information aside. We now focus on EUR USD spot rates from the international markets.

The two-way quote from Bloomberg suggests –

EUR USD – 1.1134/40

To purchase 1 Euro, I must have USD 1.1140 (Ask price). In other words, to acquire 1 Euro in US Dollars would cost me 1.1140. Converting this amount to INR allows me to purchase the Euro, and also obtains the EUR/INR rate.

Now going back to the USD INR rate –

1 USD = Rs.67.0740

1.1140 USD = How many Rupees?

= 67.0740 * 1.1140

= 74.72044

Hence to buy 1 Euro I need 74.72400 INR, or EUR INR = 74.72400

Notice how the USD acts as a pivot in the crossing technique.

Would you be up to a challenge? We’ve used crossing technique to work out the ASK price of the EUR INR pair. Can you use that same logic to figure out the Bid? We’d love to know what you come up with. Let us know your thoughts in the comments section!

It is evident that the reference and cross rates fluctuate daily, depending on the attitude of the financial institutions involved. This raises a further question – what aspects affect their outlook?

It’s easy to see that domestic and international events both play a role.

 – Events that matter

Consider an event that could influence sentiment about a stock. Quarterly results for the firm is one such example; it’s simple to anticipate the sentiment shift based on this event. If the quarterly result is positive, sentiment is going to be upbeat and the stock price anticipated to increase. On the other hand, if the quarterly outcome isn’t as good, sentiment will take a hit and thus, it’s expected that the stock value would fall. The thing to take away is there can be some correlation between the event and its expected effect.

There is a lack of linearity when considering currency pairs, making it very difficult to evaluate the effect of fundamentals on them. This complexity is due to currencies being quoted in pairs, meaning that some forces could cause one pair to gain strength while others simultaneously lead to its depreciation.

Let me give you an example to illustrate this – imagine two economic events running in parallel. Event 1 – India attracts a steady influx of Foreign Direct Investments (FDI) for long-term investments, which is beneficial for the economy, leading to the INR strengthening. Event 2 – There is either an improvement in the US economy or anxiety about commodities crashing, resulting in an appreciation of the US Dollar.

What direction will the USD INR currency pair take? It’s not a straightforward answer. Until it becomes clear which event is more influential, the currency will continue to be volatile. Therefore, keeping an eye on global happenings and their impact on certain pairs is essential for successful trading.

Here are few such events and data that you should track –

Import/Export Data – Data on imports and exports are particularly noteworthy for India, given the nation’s vulnerability to trade deficits. Indian exports encompass products such as rice and software, while commodities imported include crude oil and bullion. Generally, an increase in exports contributes to a stronger domestic currency, while an uptick in imports tends to erode it. So why is that?

When buying imports such as crude oil, one has to make the purchase in the International market where payment is made in USD. To facilitate this, INR must be sold in exchange for USD. This increased demand for USD causes its value to strengthen.

We can apply the same principle to exports. When we export goods, we receive USD; thereafter, exchanging these for INR makes the Indian Rupee stronger.

The Trade Deficit – or ‘Current Account deficit’ – which is the excess of imports over exports, is critical in assessing currency movements. Generally, when it’s narrowed, it’s beneficial for domestic currency. I highly recommend you read this news article to better grasp this topic.

Interest Rates – Investors often use the ‘carry trade’ to their advantage, borrowing from countries with low interest rates and investing in those with higher ones. This influx of foreign investment leads to a strengthening of the domestic currency, making clear the critical role that interest rate plays when it comes to currency traders.

The monetary policy review conducted by the central banks (RBI in India, Federal Reserves in the US, and ECB in the Euro region) is subject to much scrutiny. Market participants not only take account of the actual change in the interest rate numbers during this review, but also search for clues related to future policies. This way they can predict potential changes to interest rates while getting an understanding of their respective bank’s stance.

Dovish – The term “dovish” is used to depict how a dovish stance from the central bank has the potential to weaken the domestic currency. Dovish is used to describe when a central bank is likely to lower interest rates in the future, which can have an impact on the strength of a nation’s currency.

Hawkish – The term “hawkish” is used to refer to the stance of a central bank that is likely to raise interest rates in the future. An increase in interest rates can be beneficial for a country, as it typically leads to an influx of foreign investments and strengthens the local currency.

Inflation – Inflation is the rate at which prices of commodities, necessities and services rise over time. If the rate of inflation is high, then it stands to reason that the cost of living would be affected as well. This means that central banks try their best to keep it steady. The relationship between inflation and currency exchange rates can be quite complex.

In order to control inflation, one of the direct methods is to adjust interest rates. If the rate is perceived as too high, then the central bank would likely take a strict approach and raise interest rates.

What is your take on the reasoning behind this?

The availability of easy money to consumers and corporations makes them more likely to spend, prompting merchants to look for greater profits which then causes a surge in prices resulting in increased inflation. To counteract this, central banks raise interest rates to limit access to easy money, consequently reducing spending.

Therefore, when inflation is on the rise, the central banks will take a hawkish stance and raise interest rates. This in turn leads to an appreciation of the domestic currency!

As previously mentioned, the relationship between interest rates and currencies can be difficult. Traders carefully monitor inflation figures to anticipate what central banks are likely to do, so they can make informed decisions regarding the currency pair.

Remember, when the inflation rate is high, the central government will adopt a hawkish stance and this means the domestic currency will strengthen. Conversely, if inflation is low, the central bankers will likely take a dovish stance in order to encourage spending, which will cause interest rates to drop and the domestic currency weaken.

Consumer Price Index (CPI) – The Consumer Price Index (CPI) is an important measure of inflation. This time-series data gives an average of the prices of basic goods and services. If the CPI increases, it indicates that inflation is on the rise; a decrease shows a drop in inflation. To access reliable Indian CPI information, please visit this website.

Gross Domestic Product (GDP) – The GDP of a nation represents the total Rupee value (of Indian GDP in particular) of all the goods and services produced for a given year. It would obviously be a huge figure, and therefore it does not make sense to recite the exact number when estimating or talking. Instead one usually just refers to it as its growth rate – e.g., if the country’s GDP is 7.1%, that means that the GDP is rising at a rate of 7.1%.

The GDP growth rate reflects investor confidence, and this has a direct effect on the strength of the domestic currency.

The sheer number of events pertinent to trading currencies is vast. It certainly helps if you can recognize the unseen correlations between each piece of data. As an economist would, understanding the chain of cause and effect effects is useful knowledge indeed. To help get you started, here are some key events/data points to bear in mind. This should provide a suitable starting point.