The foreign exchange market is the largest and most liquid financial market in the world. With daily trading volumes that exceed $7.5 trillion according to the Triennial Central Bank Survey, the nuanced dynamics of this market are driven by forces that can be broadly categorised into two camps: macroeconomic and microeconomic factors. For those dealing in currency markets, an understanding of the difference between these concepts, and the numerous factors that can drive currency prices, is key for making informed decisions when trading. Throughout this article, we will explore the definitions of macroeconomics and microeconomics, what makes them different and their respective influences on the foreign exchange market.
What is Macroeconomics?
Macroeconomics is defined as the study of large-scale, general economic factors. Taking a wide-lensed approach, economists seek to investigate and gain insights from the overall structure and behaviour of an economy, at a national and global scale. For the foreign exchange market, analysis on a macroeconomic scale can give us insights into economic conditions of a country or region, which can prove extremely useful for analysing currency movements. There are a number of key indicators that we use in macroeconomics:
Gross Domestic Product (GDP)
GDP is a measure of the total value of goods and services produced in a country. A country with relatively strong GDP growth is a strong outward signal to the market that their economy is healthy. As a consequence, a local currency is strengthened, as investors gain confidence.
Inflation Rates
This refers to the rate at which the prices of goods and services increase. Economists tend to look for moderate levels of inflation as a healthy sign of a growing economy. As discussed in this article, central banks are key to levels of inflation by their control over interest rates. Through higher rates of inflation, currencies tend to weaken as their purchasing power is reduced.
Trade Surplus
Looking at the difference between a country’s exports and imports can give us insights into the health of a country’s manufacturing sector. One of the easiest ways to assess this status is to look at whether the country is running at a trade surplus or deficit.
Employment Figures
Looking at data such as non-farm payroll in the US, for example, can provide us with an indication of economic stability in a country. High levels of employment reflect a robust economy, which result in generally positive outcomes for a local currency.
Black Swan Events
Referring to an influential geopolitical event that occurred without prior warning, events such as conflicts, elections or trade disputes can result in increased currency volatility and alter values rapidly.
Overall, macroeconomic analysis allows us to assess trends from a distance, with numerous key indicators that can be used for predicting currency movements. In forex trading circles, this is referred to as ‘fundamental analysis’, examining these indicators in order to make informed trading decisions. A broader picture of the global economy helps us to anticipate shifts in supply and demand for currencies.
What is Microeconomics?
Taking a closer look at individual agents, economists categorise ‘microeconomics’ as the analysis of behaviour when looking at individual entities like businesses, consumers and investors. When talking about the forex market specifically, microeconomic factors are most commonly cited in relation to the dynamics of supply and demand, which influence the movements of currency prices in the short term. Some key concepts to understand are as follows:
Supply and Demand
The most basic principle of microeconomics, supply and demand is what influences the prices of goods, services and currencies. In the forex market, increased demand leads to higher currency prices, whereas an excess of supply will lead to the inverse.
The Order Book
Analysis of the flow of buy and sell orders can give tangible, quantified evidence of microeconomic activity. If the order book is suddenly flooded with buy orders, currency prices can be pushed higher sharply, without the precursor of a macroeconomic event.
Participant Analysis
No two market participants are the same – it would be foolish to assume every participant carries the same reputational weight. The movements of influential traders, commercial banks, hedge funds and corporations can greatly influence overall market sentiment by their actions alone.
Consumer Psychology
Traditionally, microeconomics has been presented through the ‘general equilibrium theory’, presented by Leon Walras in ‘Elements of Pure Economics’. This assets that consumers and producers tend towards rationality, i.e. maximising their economic well-being. Microeconomists have formulated various models, through logic and observable consumer behaviour, and applied them to different markets. Extending these principles to the forex market, it neatly ties together all the various influencing factors (macro included) and provides models for how they interact.
For those trading on short-term movements, microeconomics are particularly relevant. ‘Technical analysis’ refers to the approach of considering order flow, chart pattern and market depth in order to make profitable trades. For example, even in the context of a relatively quiet macroeconomic environment, dramatic price movements can be seen through sudden demand increases from a particularly large transaction.
Combining both approaches
To remain on top of market movements, it’s important to combine both approaches in your market research. Macroeconomics can aid you in identifying long term trends, and draw your attention to relevant currency pairs. For example, if the US Federal Reserve announces an increase in rates, a stronger dollar can be expected.
In combination with this, microeconomic analysis can aid you in identifying precise points of entry and exit. Technical analysis, as discussed earlier, can aid you in noting points of support and resistance, helping to navigate any short term movements or volatility. To walk through an example: if you learnt that the European Central Bank is announcing higher interest rates, you would make an informed decision to look at potential appreciation of the Euro. You then turn to microeconomic factors, considering order flow and technical indicators to avoid unfavourable exchange rates.
Conclusion
Both Macroeconomics and Microeconomics are fundamental pillars of the currency market. Representing both big picture and ‘zoomed-in’ analysis, the combination of understanding long-term trends in addition to the actions of individual market participants, for example, is invaluable in improving your decision making and success when dealing with currency trades. By becoming well-versed in the basic concepts of each, you can be more confident in getting the most value from your foreign exchange transactions.
As always, for currency news and insight into the world of currency, make sure to stay up to date with our Expert Analysis, as well as our daily Market Commentary.
Caleb Hinton
Caleb is a writer specialising in financial copy. He has a background in copywriting, banking, digital wallets, and SEO – and enjoys writing in his spare time too, as well as language learning, chess and investing.
