- GDP stands for Gross Domestic Product
- It measures the economic growth and health of an economy in key areas
- Forex traders use GDP as one way of identifying a strong or weak currency.
Developed in 1934 by Simon Kuznets, the Gross Domestic Product, known commonly by the initials G.D.P., measures the output and production of finished goods in a particular country’s economy. Usually, GDP is measured in three different time periods; monthly, quarterly and annually. This enables economists and traders to get an accurate picture of the overall health of the economy.
There are many approaches to calculating GDP, however, the U.S. Bureau of Economic Analysis uses the Expenditure Approach using the formula GDP= Consumption +Investment (I) + Government Spending (G) + (Exports (X)- Imports (M)).
GDP encompasses personal consumption, wholesale inventories, and retail sales. Because each of these components is already measured and released in separate announcements early, GDP is often regarded as “backward looking.” This means that the market may have already priced in GDP based on the other economic releases that make up this number.
The advance release of GDP is four weeks after the quarter ends while the final release happens three months after the quarter ends. Both are released by the Bureau of Economic Analysis (BEA) at 8:30 AM ET.Typically, investors are looking for US GDP to grow between 2.5% to 3.5% per year. Without the specter of inflation in a moderately growing economy, interest rates can be maintained around 3%. However, a reading above 6% GDP would show that the US economy is endanger of overheating which can, in turn, spark inflation fears.
Consequently, the Federal Reserve may have to raise interest rates to curb inflation and put the “brakes” on an overheating economy. Maintaining price stability is one of the jobs of the Federal Reserve. GDP has to stay in a “goldilocks range”; not too hot and not too cold. GDP should not be high enough to trigger inflation or too low where it could lead to recession. A recession is defined by two consecutive negative quarters of GDP growth. The GDP “sweet spot” varies from one country to another. For example, China has had GDP in double digits and 4 or 5% GDP would be unhealthy for that large economy.
Forex traders are most interested in GDP as it is a complete health “report card” for a particular country’s economy. A country is “rewarded” for a high GDP with a higher value of their currency. There is usually a positive expectance for future interest rate hikes because strong economies have a tendency to get stronger creating higher inflation. This, in turn, leads to a central bank raising rates to slow growth and to contain the growing specter of inflation.
On the other hand, a country with weak GDP has a drastically reduced interest rate hike expectations. In fact, the central bank of a country that has two consecutive quarters of negative GDP may even choose to stimulate their economy by cutting interest rates.
GDP is a major news release that Forex traders can use as a barometer to measure economic strength and weakness as well as interest rate expectations. Since Forex is traded in pairs, traders can pair a strong economy with high GDP with a weak economy with low GDP to find powerful trends. Traders are capitalizing on the flow from a weak currency to a strong currency as it oftentimes pays to be long the strong and short the weak.
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---Written by Gregory McLeod Trading Instructor