Economic data reports are essential for a foreign exchange (forex) trader. These important economic indicators create volatility, and plenty of speculation is always surrounding them, and The United States' gross domestic product (GDP) is one such report. Not only do聽forex聽(FX) traders continue to monitor this important piece of economic data, they use it to either establish a new position or support a current one.

What Goes into the GDP Report

Gross domestic product is simply the total聽market value聽of all goods and services produced in a particular country. In the case of the United States, this total can be broken down into four main categories: consumption, investment, government expenditures (or spending) and net exports.

  • Consumption:聽Final consumption expenditures by households. These can include things like food, rent, fuel, and other personal spending.
  • Investment:聽Business spending on new plants and equipment, as well as household investment in property.
  • Government spending and investment:The total of all government spending, including public employee salaries and defense or social program benefits.
  • Net Exports:Total final exports, minus total imports. A higher net export number is more productive for the economy.

The sum of these numbers is the United States' total gross domestic product, which can be compared to another year's performance in order to derive a percentage of GDP growth or contraction in a particular period.

Making the Comparison

Gross domestic product figures can be released on a monthly or quarterly basis. For the United States, the Bureau of Economic Analysis (BEA), a branch of the U.S. Commerce Department, releases final quarterly domestic figures鈥攁long with additional advanced or preliminary figures toward the end of each month. This report can also be released in either real or nominal conditions, the former being adjusted for the effects of inflation. The BEA also releases its GDP price index that has been used in competition with both consumer price index (CPI) and the personal consumption expenditures deflator as a聽gauge聽of consumer inflation.

Trading the Foreign Exchange Markets

Like any other piece of important economic data, the gross domestic product report holds a lot of weight for currency traders. It serves as evidence of growth in a productive economy while signaling contraction in a withering one. As a result, currency traders will tend to seek higher rates of GDP or growth in a belief that interest rates will follow the same direction. If an economy is experiencing a good rate of growth, the benefits will trickle down to the consumer鈥攊ncreasing the likelihood of spending and expansion. In turn, higher spending leads to rising prices, which聽central banks聽attempt to tame through interest rate hikes.

Although there are three versions鈥攁dvanced, preliminary and final鈥攊t's the relation between the three that is important, not just the individual releases. Currency professionals will emphasize the advanced reading when trading. But, they won't dismiss any differences when it comes to comparing the advanced with both the preliminary and final readings.

For example, a final reading of 1.5% growth compared to an earlier advanced release of 3.5% is worse off when compared to a similar 1.5% print in both advanced and final readings. A positive growth figure is always good for the economy, but not when a final GDP figure dips below the advanced reading.

What Investors Can Expect

There are three basic reactions to price action that a trader or investor can reasonably expect:

1.聽A lower-than-expected GDP reading will likely result in a聽selloff聽of the聽domestic currency聽relative to other currencies. In the case of the U.S., a lower GDP figure would signal an economic contraction and hurt the chances of a rise in U.S. interest rates鈥攍owering the value or attractiveness of U.S. dollar-based assets. Additionally, the further below an actual GDP reading is from the estimate, the sharper the decline in the dollar.

2.聽An expected reading requires a bit more comparison by the FX investor. Here, the analyst or trader will want to compare the current reading to the previous quarter's reading鈥攎aybe even the previous year's reading. This way, a better evaluation of the situation can be gathered. Given this factor, you can expect that the resulting price action will tend to be mixed as the market sorts out the details.

3.聽A higher-than-expected reading will tend to strengthen the underlying currency versus other currencies. Therefore, a higher U.S. GDP figure will benefit the聽greenback, lending to some appreciation in the U.S. dollar against counter currencies; the higher an actual GDP reading is, the sharper the incline of the dollar's appreciation.

Putting It All Together

So, let's take a quick look at a recent example:

EUR/USD reacts to the U.S. GDP release on March 28, 2011. Image by Sabrina Jiang 漏 Investopedia聽2020

Above, the聽EUR/USD聽currency pair聽fell from the 1.4200 big figure over the past couple of sessions (far right-hand side聽of the chart) to establish support just below 1.4050 in the 60-minute time frame. Observe how the euro appreciated by about 50聽pips, immediately following the March 28, 2011, release at 8:30 a.m. At that time, it was revealed that the world's largest economy grew by less than what was expected. Instead of rising by an estimated 1.9%, the U.S. grew by an advance figure of only 1.8%. This was also less than the 3.1% from the previous quarter鈥攁 visual slowdown in growth. As a result, traders sided with selling a weaker U.S. dollar, helping the euro to retrace its losses and climb even higher through the 1.4200聽resistance聽barrier.

A currency trader looking to take advantage of this opportunity could easily place a buy entry near the support level鈥adding a relatively narrow stop order of 30-40 pips for risk management sake.

The Bottom Line

The U.S. gross domestic product (GDP) report is - and likely will continue to be - an important release to consider when it comes to trading the foreign exchange markets. The traders who can understand how to interpret this data and apply its relevance to a particular trade will be the ones that come out on top.聽