Do you know the #1 reason why many retail traders underperform compared to their market counterparts namely - interbank dealers, hedge funds, financial institutions?
Studies suggests that despite retail traders having strong requirements to be well informed they are not. They do not anticipate returns on trades, lack trading acumen and are emotional when trading.
What stops traders from being better informed, improving their trading acumen or reducing emotional trades such as hope and wishful thinking?
The answer is - it's not easy to make the connections between the economy, central bank actions and financial instrument prices.
However there are just 4 steps that simplify the process of making the connections between these three factors easier. Continue reading to find out the 4 steps…
As a trader in the interbank market I relied purely on technical analysis for the first few years. Drawing trendlines, using technical indicators such as moving averages, MACD, RSI etc etc to predict returns in the FX markets.
Though I utilised technical analysis I never really understood the "fundamentals" behind the primary trend or reversal of trends; what these linkages between economic indicators, financial markets and central bank policy decisions were...
To quote the guru of technical analysis -
"Market Analysis can be approached from either direction (Technicals or Fundamentals). While I believe that technical factors do lead the known fundamentals, I also believe that any important market move must be caused by underlying fundamental factors. Therefore, it simply makes sense for a technician to have some awareness of the fundamental condition of a market." - John J. Murphy, Technical Analysis of the Futures Market
The 4 steps are -
Step 1 - Identify the price determinants of financial instruments
Step 2 - Understand how each economic indicator contributes to either economic growth or inflation (we use an economic map to demonstrate these connections)
Step 3 - Study the impact of each economic indicator on financial instrument prices
Step 4 - Make the connection between economic indicators, central bank’s monetary policy and financial instrument prices
Second objective - Increase your financial intelligence by understanding markets
Have you ever read Robert Kiyosaki's book 'Rich Dad Poor Dad'? One of the important messages in Robert Kiyosaki's book is that we can increase our financial wealth by increasing our financial intelligence. He mentions that financial intelligence is made up of four technical skills - accounting, investing, understanding markets and understanding the law. The goal of this course is to learn one of those essential technical skills - understanding markets.
The Use of an Economic Map
We make these connections between economic entities, factors, markets and central bank policies through the use of an economic map. The economic map helps us to understand how each small sub-component aggregates to the larger components, which in turn aggregate to the Gross Domestic Product thus giving us a wider perspective of how entities interrelate with one another.
Some of the economic indicators we will study are:
Skills you should be able achieve by the end of this course
By the end of this course, you will have all the tools necessary to start making the connections between these economic indicators, financial markets and the central bank's monetary policy. This is the knowledge that investment bankers acquire during their trading experience and it is this technical skill that we will achieve by the end of this course.
You could also get the Kindle book or iBook. Please search for "Tradeonomics - The Four Steps to Mastering U.S. Economic Indicators" on the Amazon/iBooks store. If you do not have a Kindle reader you can read Kindle books on your computer, phone, tablet by downloading the Kindle app.
"I believe getting educated on the economy and looking forward is vital for any investor or someone looking to get started." - Robert Kiyosaki, author 'Rich Dad Poor Dad'. This is our goal - to get educated on the economy and make the connections between the economy, financial markets and central bank actions. Though we look at US economic indicators these concepts are applicable to any country's economy.
The cash flows of a bond are equivalent to those of a loan product. We learn how to map the cash flows of a bond in a spreadsheet.
In this lesson we demonstrate the inverse relationship between interest rates and bond prices.
Here we understand the relationship between bond prices and the broad economic factors such as growth, inflation and interest rates.
Check your understanding of the Bond Market essentials
We study the relationship between stock prices and corporate profits as economic factors such as growth, inflation and interest rates have a direct impact on corporate profits.
The inflation premium has a direct impact on cash flows. The higher the inflation premium the higher the discount rate and lower the present value of cash flows.
A quick test on the core concepts.
A major determinant of foreign exchange rates is the interest rate differential between 2 currencies.
Test your knowledge on interest rate differentials and carry trades
Completing the attached spreadsheet on stocks, bonds, foreign exchange will increase your understanding of the financial markets and the impact of the broad macroeconomic factors such as growth, inflation and interest rates. This will make it easier to understand the effect of specific macroeconomic factors within the broad categories.
In this section we will learn what the Gross Domestic Product is, what its components are, the various economic entities that contribute to the GDP and the relationship between them, how GDP is computed, the difference between real and nominal GDP and other important concepts such as computing growth rates . By the end of this section you would have actually computed the real and nominal GDP of a hypothetical economy and understood the importance of each component (consumption, investment, government expenditure and net exports) in the US quarterly GDP report published by the Bureau of Economic Analysis.
We compute the Nominal and Real Gross Domestic Product for a hypothetical economy as an exercise to understand the concepts of real and nominal GDP
We quickly browse through some basic economic definitions or terms that you would be required to get comfortable with as you will come across quite frequently while studying how GDP is computed.
Test your understanding of the basic economic definitions
We explain how GDP is computed by starting with a simple two entity model – households and firms.
We introduce savings by households and investments by firms to make our hypothetical economy a more realistic one
We now introduce the third economic entity - the Government
We introduce the fourth and final economic entity - the rest of the world to our hypothetical world to model the realistic world.
Test your understanding of the most important economic indicator - the Gross Domestic Product
Before we begin with the economic indicators we need to understand the historic context of the GDP figure to understand what high growth, sustainable growth and recession is. We need to understand the historical context of growth, inflation and interest rates because when any economic indicators are released we can look back to see how the central bank has reacted in the past when confronted with this data.
We once again understand how growth rates, nominal and real GDP growth are computed in this simple exercise to reinforce our concepts.
Test your knowledge on basic GDP concepts
The quarterly GDP report released by the Bureau of Economic Analysis BEA of the US Department of Commerce is the mother of all US economic indicators
Test your understanding on the components of GDP
We look at three indicators that provide us information on Consumer Expenditure- Car Sales, Retail Sales and Personal Consumption Expenditure
The Car Sales report is published by Automobile manufacturers in the US and is the first report released each month.
Test your knowledge of the basics of the Car Sales Report
The Retail Sales Report is released monthly by the Census Bureau and the U.S. Department of Commerce. Retail sales comprises of durable and non durable goods sold at retail outlets.
Test your knowledge of this very important economic indicator
The Personal Consumption Expenditures Report also called the Personal Incomes and Outlays report is issued by the BEA monthly, 4-5 weeks after the coverage month
A quick quiz on PCE, the most important indicator on consumer spending
Introduction to the Gross Private Investments component of GDP
The New Residential Construction Report, known as "housing starts" on Wall Street, is a monthly report Collected by the Bureau of the Census, which is a part of the Dept of Commerce jointly with the U.S. Department of Housing and Urban Development (HUD)
Test your knowledge of this popular Wall Street report
The Durable Goods Report also known as the Advance Report on Durable Goods, Manufacturers’ Shipments, Inventories and Orders provides information on new orders received from approximately 3000 manufacturing companies of durable goods
Test your knowledge on the largest component of Investments
The Factory Orders and Manufacturing Inventories report or the more formal title Manufacturers' Shipments, Inventories and Orders Report is a mix of new and old information similar to the durable goods report
A quick quiz on the report that gives us much more details on durable goods, non durable goods and inventories
The Construction Spending Report is released monthly by the U.S. Department of Commerce's Census Bureau, it looks at residential and non-residential construction in the private sector, and state and federal at the public level
A small quiz on construction spending
Introduction to the final GDP component Net Exports, the Trade Balance Report and the Balance of Payments Report
The Merchandise Trade Balance Report contains information about transactions of US residents with the rest of the world. We look at Balance of Payments and the US trade deficit in addition to the composition of exports and imports.
Test your knowledge of the Trade Balance Report and the Balance of Payments account
The Employment report is one of the earliest reports to be released hence its importance for the markets. Because unemployment is also a very politically sensitive issue it is closely watched by the Federal Reserve Board and politicians.
A quick quiz on one of the most politically sensitive economic indicator
The index of Leading Economic Index is designed to provide additional information as a sum rather than its parts. Along with this indicator the BEA also releases the coincident and lagging indicator and we will see how the ratio of the two can be used to provide some very interesting result. There are ten components to the Conference Board's Leading Economic Index. The ten components of The Conference Board Leading Economic Index are produced by the BEA of the department of Commerce using data from various sources such as – the Federal Reserve Bank, departments of Labour, Commerce, Treasury, Defence.
A quick quiz on Leading Economic Indicators
Another such popular index on Wall Street which is quite uniquely constructed and timely since it arrives just before the important employment index is a diffusion index, previously known as the National Association of Purchasing Management its now known as the Purchasing Manager's Index
A quick quiz on the PMI originally called the NAPM
The industrial production data measures the unit volume of output for the manufacturing, utilities and mining sector prepared by the Board of Governors of the Federal Reserve System and is available around the middle of the month
The Beige Book is a summary of commentary on the current economic scenario by Federal Reserve District. The book has 12 regional reports from each member of the Federal District Banks and published just before the FOMC meeting.
The Consumer Confidence Report is a survey taken from over 5000 households on the financial health, confidence and spending power of the average consumer. This report is released by the Conference Board on the last tuesday of the month for the prior month's data.
The Federal Reserve Board releases the monthly Consumer Credit Report that estimates changes in the dollar amounts to loans except mortgage loans to individuals that are outstanding.
Test your knowledge of The Beige Book, the Consumer Confidence Index, the Consumer Credit Report, Industrial Production and Capacity Utilization
We briefly revisit the economic indicators in the context of our economic map so that we can reinforce the connections between the indicators and economic entities.
In this session we study the three price deflators published in the Quarterly GDP Report produced by the BEA - the implicit price deflator, fixed weight deflator, and the chain-price index.
A quick quiz on Fixed Weight, Implicit Price and the chain price index
The Consumer Price Index released monthly by the Bureau of Labour Statistics BLS of the Department of Labour is THE measure of inflation. There are three consumer price indices within the CPI report, two of which have been around for a while – the CPI-U and the CPI-W. The third a chain weighted CPI,the C-CPI-U is also released along with the core CPI and its popularity is growing as it captures the shifts in consumer buying preferences.
The most popular inflation indicator
The Producer Price Index is prepared by the Bureau of Labour Statistics of the Labour Department. The PPI report has 3 headline figures based on the 3 stages of production – PPI Commodity Index (Crude), PPI Stage of Processing (SOP) Index- and lastly PPI for finished goods.
A quick quiz on the Producer Price Index
I've completed a Bachelor of Computer Engineering and a MBA from Queen's University Canada. I've worked 8 years in the investment banking division and 11 years in Oracle Financial Services Software Ltd as an IT and banking consultant. During my stint at Oracle I've worked in various projects - at the IMF in Washington, built trading systems at an investment bank in London for the algorithmic trading desk, implemented a complex core banking software system at banks such as Bank of Montreal, Wells Fargo.