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One of the most common terms you will likely come across in the financial and business news press on a daily basis is gross domestic product (GDP). CEOs, traders and analysts alike make frequent reference to it, often going into a state of panic or euphoria depending on which way the figure is trending.
Despite these frequent references, however, you might often have found yourself wondering what exactly it is and, more importantly, whether it should influence your trading or investment decisions.
What is GDP and why does it matter?
Before we talk about how you can use information on GDP to shape and influence your trading strategies, however, we should first have a clear idea of what is GDP!
Although the definition will vary slightly depending on the economist you are talking to, most definitions describe it as the measure of all the value added to the economy of a country through the production of goods and services within a specified time period. This includes all the income earned from that production, as well as the total amount spent on final goods and services less imports.
For this reason, GDP is often taken to be an indication of the total size of the economy of a given country, as well as a measure of the economy’s health. This makes it more comprehensive than other measures you might use, such as industrial output, wages and consumer spending.
However, although it is a comprehensive measure of all economic activity in a country, it is far from a perfect measurement. There are several clear limits to using GDP as the sole measure of an economy.
Firstly, GDP is a purely economic metric and does not tell you anything about the happiness, well-being or health of a country. It also does not properly account for the costs of that economic growth, such as the environmental impact.
Furthermore, it also tells us nothing about the distribution or concentration of economic activity in a country. Perhaps most importantly, it doesn’t tell you whether income derived from GDP stays in a country to benefit its citizens.
With this basic understanding of GDP in mind, however, how can traders and investors use it to their advantage?
GDP and forex trading
If GDP reflects the overall health of a national economy, albeit at a relatively high level of abstraction, then this will inevitably have an impact on how that country’s currency is viewed on the global foreign exchange (forex) markets.
As with any other economic data, the GDP of a country holds considerable weight for forex traders. It can serve as evidence of growth in an economy, as well as signaling an economic contraction — or even recession!
Due to this relationship, currency traders often seek out currencies attached to higher rates of GDP as they believe that interest rates will follow the same direction. This is because when an economy experiences good levels of growth, which results in higher consumer spending, prices tend to rise. In response, central banks will often use interest rate increases to curb inflation.
Another situation when forex traders start to take notice, is when GDP is reported to be lower than expected. This can sometimes trigger a selloff of a domestic currency, as traders look to protect themselves from losses.
In these ways, we can see that forex traders pay close attention to GDP data in their trading strategies!
GDP and stock trading
Just as currency prices and GDP have a close relationship, so too do equities and stocks!
As we have seen, positive increases in overall GDP are typically taken to be a positive signal for the health of the country’s economy. When we see this happen in real-time, the equities markets attached or closely related to that economy will also experience a boost.
For example, if the US government posts positive GDP data, American assets such as the S&P 500 or even Tesla tend to get a boost. This reflects the general confidence of traders, regardless of where they are located, in the health and direction of the US economy, which is why the prices rise.
How can I use GDP in my trading and investments?
With these two examples in mind, we can see how important it is to pay attention to GDP data. While it is by no means a perfect economic measure — with GNP arguably being a better indicator — it is nevertheless extremely useful.
As a trader, if you spot a country publishing stronger than expected GDP data, this could be a good indicator to seek out buying opportunities in assets associated with that country. The reverse is true when the GDP data is weaker than anticipated.
However, as a trader you should ultimately not be considering GDP in isolation. Instead, you should consider it as simply one of many data inputs you might use to base your trading and investment decisions on. This is particularly true of GDP, as there are three different versions: advanced, preliminary and final.
Despite these limitations, GDP data is still incredibly useful, and definitely has a place in your trading and investment strategies!
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