Terms of Trade and its Impact on Forex

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Perhaps the most basic fundamental analysis of a currency pair relates to international commerce. After all, the reason a person would need a foreign currency is to buy something in that foreign country, and vice versa.

Of course in the era of globalization, many more sophisticated instruments tend to drive a currency. Carry trade flows can easily supersede traditional capital flows, for example. But on a real level, money is only worth what you can buy with it, and in the world of forex, that means imports and exports.

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Most traders will usually follow the major economic data releases, which include the trade balance. But that is still a rather superficial view of trade-based impacts on currencies and their relative value to each other.

Generally speaking, the trade balance is related to currency prices based on presumptions of demand. If net export volumes increase, then there is the expectation of demand for the currency to balance out the exported value. In the opposite direction, if net imports increase (in other words, the country is running a trade deficit), then there is an expectation for less demand for the currency since importers have to pay for the products they’ve bought overseas.

The trade balance gives us a more long-term view of currency fluctuations, but there is a less commonly used metric, that reflects volatility better: terms of trade

What is Terms of Trade?

In its basic definition, terms of trade is the ratio of export prices to import prices, often expressed as a percentage:

 

100 * export prices / import prices = terms of trade (ToT)

 

It’s different from the trade balance because it measures only the aggregate price index without considering the volume of products that are traded. For example, an economy that exports oil at $50 per barrel: their export price index would be $50, whether they sold a few thousand or millions of barrels.

If they are trading with a country that sells, say, copper at $2.50/lb, then the terms of trade between the two countries would be the ratio of $50 / $2.5, times 100: that is 2,000%. In other words, for each barrel of oil exported, the country can import 20 lb of copper.

Of course economies don’t export only one product, so in reality, we are comparing a price index of all exports and all imports. If the price of the exports increases, the country can import more products. If the price of exports falls, then the country can import less (or it goes into debt.)

The Impact on Currencies

In the modern world, countries don’t work on a barter system, and instead, use capital flows to balance out trade deficits. This means that if the terms of trade “improves” (that is, the ratio increases), then the country’s exporters are getting more money for the same product, and the economy has more disposable income.

If the terms of trade “deteriorates” (that is, the ratio decreases), this means that the prices of the goods exported are going down, or the prices of the goods imported are going up, which means the country has less foreign currency available.

In practical terms, for the forex trader, improving terms of trade generally means that the currency is getting stronger because there is more demand for it. A deteriorating terms of trade translates into a weaker currency since the country has to spend more to import the same amount of products. Since Forex values are, essentially, the price of the currency, fluctuations in export and import prices are reflected in the currency pairs.

The Loop

The influence on prices is not unidirectional, however. If the value of the currency moves, that will also have an impact on the terms of trade. So, for example, if the central bank were to raise interest rates, that would strengthen the currency.

A stronger currency means that it’s “cheaper” to buy foreign products, and prices for domestic products are higher to foreign buyers. This would improve the terms of trade. The opposite would happen if the central bank cut rates.

This interplay between the prices of goods and currencies is what the market tries to balance, leading to currency volatility. Therefore, there is a strong correlation between terms of trade and forex moves, which happens in real time. Having a good understanding of a country’s basket of exports and imports with their prices can give some valuable insight into how the currency will fluctuate on a day-to-day basis.

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