Forex Trading Library

Three Types of Economic Indicators That You Should Know

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Economic indicators are dime a dozen and the markets react in its own way. While some economic reports cause sharp movements in prices, some economic reports are just ignored. It suffices to say that not all economic indicators are created equally. So what reports move the markets and what reports don’t? More importantly, why does the market sometimes ignore an economic indicator that is deemed to be an important report?

Here are the three types of economic indicators and the impact they have on the markets.

1. Leading indicators

Leading economic indicators or reports, as the name suggest tells you what is going to happen in the economy. Leading indicators offer first glimpses into the economy. Leading indicators have a certain level of importance, but they can be subject to revisions at later times. Due to the leading nature of the economic reports they are quite volatile. Leading indicators come in the form of surveys such as the regional PMI’s (Empire State Manufacturing PMI, Philly Fed Manufacturing Index, UoM inflation expectations, etc. in the U.S.) and also flash PMI’s from Markit/CIPS in the UK and the Eurozone.

2. Coincident indicators

These sets of indicators tend to validate or deny the information from the leading indicators. Coincident indicators tend to be more in touch with the economy such as the business cycle. The movement in the coincident indicators reflects fairly closely the changes in the economic activity and provides information on the pace and extent of activity or contraction in the economy. Perhaps the most popular of coincident economic indicators are the retail sales, personal income, and inflation and so on.

3. Lagging indicators

Lagging indicators as the name suggests come out much later and in most cases, the previous two set of indicators often form a basis that is in most cases confirmed by the lagging indicator. One of the most famous lagging indicators is the unemployment rate. Think of lagging indicators as the effect of a cause. Therefore, when the unemployment rate rises, the cause for this increase actually happened much before, and therefore it does not actually capture the economy as it happens.

If unemployment rate or CPI are lagging indicators why do the markets react strongly?

The term market reaction is relative. A 100 pip move in EURUSD for example on a strong US CPI report can be termed as a strong reaction, but compare it within the larger trend, and the effect of these strong moves tend to fade away.

Furthermore, there is no set period within which you can expect a lagging indicator to confirm the changes already predicted by the leading or coincident indicator. The chart below shows an overlay of the ISM manufacturing PMI (blue line) and the US unemployment rate (black line). On close observation, you can see how the unemployment rate lags the changes in the ISM manufacturing PMI. There are times when the reaction from the lagging indicator is often swift in response, and at times there is a significant lag.

Types of Economic Indicators You Should Know
US ISM Manufacturing PMI and the Unemployment Rate (leading vs. lagging indicator)

The next chart probably illustrates the point the best. In the next chart below you can see how two strong back to back US economic reports failed to push EURUSD any lower. Initially, the GDP report came out which beat estimates by a good margin and a day later, the US unemployment report showed a fairly strong report with previous upward revisions as well.

Yet, in the next session, EURUSD started to rise steadily. Of course, you can blame this on other effects such as the fundamentals governing the single currency, but the chart shows that the effect on these reports tend to be sharp but for a limited period of time before the effect wears off.

Economic Indicators You Should Know
EURUSD recovers and rises after US GDP and Unemployment report

What does this mean for traders?

For short term trading positions, economic reports such as the GDP, unemployment rate, inflation and retail sales can bring significant enough volatility to trade such reports. However, in the longer run, traders who look towards holding positions for months at a stretch, it is essential to pay attention to the changing landscape as signaled by the leading and coincident indicators which indirectly tends to impact the central bank’s decisions on interest rates.

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