FX Data in Focus: US Trade Balance

10/17/2011 6:00 am EST

Focus: FOREX

Currency traders should be monitoring the monthly US Trade Balance Report for important signals about US dollar strength and factoring that information into their trading decisions.

Released on a monthly basis, the US Trade Balance Report is a vital piece of economic data for the foreign exchange markets. Now, it’s not on the level with reports like non-farm payrolls or the consumer price index, but the survey does have relevance.

Worldwide trade between countries affects the supply and demand for certain currencies. If a country’s goods are in high demand, that same country’s currency will also be in high demand. The key is to find and interpret key data points in the report that are relevant to the overall currency trend and apply them when initiating a position.

The US Trade Balance Report

Simply put, the US Trade Balance Report shows the difference in value between the exports of goods and services leaving the US and the imports of goods and services heading into the US. If the trade balance is positive, then the value of US exports is greater than the value of imports coming into the country. Conversely, the trade balance is negative when import values are greater.

Now, a positive trade balance report is vital to an economy that is experiencing expansion. Why?

Higher export growth, a driver of positive trade reports, fuels foundations for further growth and expansion. This is particularly true for manufacturing and industrial sectors.

However, a negative balance can weigh down an economy, potentially placing enormous pressure on a country’s currency. That’s why economists and currency traders always prefer positive trade balance reports to negative ones on a monthly basis.

In charge of this monthly responsibility is the Bureau of Economic Analysis (BEA), a division of the US Department of Commerce. It is the BEA’s job to calculate all components of the report, with the full release scheduled shortly after the end of the reported period. This can take time, and it is the reason why the report isn’t necessarily released on a set date or time like other economic reports (i.e. US non-farm payrolls).

Why the Report Affects Currencies

When it is time for the US trade balance release, currency traders always look for the report to contribute to their overall positions.

First, foreign exchange investors are always concerned about the implications of the report and how it affects the US dollar in the long term. A more positive trade balance report can lead to higher economic growth and production. This, in turn, will boost the likelihood that prices will rise in response to higher consumer spending, and if prices rise, interest rates will rise, attracting more interest and investment into US-based assets. All these things are good for the US dollar.

A negative report would crop US expansion prospects and decrease the likelihood that interest rates will be raised by the Federal Reserve. Moreover, a negative trade balance will become a drag on the US economy, taking away from any economic gains in the short term. This is bearish for the greenback and will prompt money managers and traders to trim dollar holdings.

So, the report contributes a lot of perspective when considering positions on a long-term horizon. This is why currency investors will always review the results of the US trade balance report simultaneously when looking at important data points like consumer prices, gross domestic product, and Federal Reserve rate announcements.

And then there’s the short term…

Short-term investors will consider the trade balance report as it relates to market sentiment. This is similar to the long-term trader, as the report acts as a simple component. But, it’s different in that the investors will use the report as a reason to either buy or sell positions in the currency.

Long-term investors tend to trim their larger currency exposure, rather than completely buying or selling their positions.

NEXT: How the Report Impacts Currency Prices

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How It Works

To clarify, let’s take a look at some examples in the EUR/USD exchange rate.

With Europe’s financial crisis surfacing and concerns over a Greek default mounting, the EUR/USD had come under selling pressure in the beginning of June 2011. Short-term traders saw the pessimism surrounding the EUR/USD exchange rate and had already sold short the EUR while buying the US dollar in the two sessions preceding the US Trade Balance Report release.

If the US trade balance was positive, this would be another great opportunity to sell the EUR/USD pair.

Let’s go back a few months and look at the June report. I chose June because it is particularly instructional about how to trade the announcement profitably.

On June 9, the US Trade Balance Report was better than expected. The figure beat estimates, with the deficit shrinking to just under $44 billion. Now, although not positive, the contraction meant that the overall trade deficit was improving, a dollar positive.

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Figure 1 – Traders referring to the US Trade Balance Report shorted the 1.4630 resistance level

Initiating short EUR/USD positions at resistance of 1.4630 (Figure 1), and corresponding stops 50 pips above, traders were able to capture an intraday gain of about 150 pips (a 3:1 risk/reward ratio). The trade becomes even more profitable in the medium term, as the spot exchange continues to decline to 1.4350 before testing major support.

Fast forward to July 2011 when a different opportunity emerges.

This time, on July 12, 2011, the market sentiment changed a bit. Although traders and investors were still concerned about a European financial crisis, the US debt-ceiling debate had begun to emerge. So, any US dollar-negative news would add to already rising concerns of a US credit downgrade.

Short-term traders referring to technical analysis could already see that the EUR/USD currency decline seemed to be stalling. Confirmation of this signal would be a break of the descending trend line (1.4320-1.4044) in the 15-minute time frame (see Figure 2 below). A penetration of this resistance level would indicate that momentum had shifted and that there was upside potential in the pair.

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Figure 2 – Currency traders initiated buy positions at the retest of a broken trend line barrier

And, that’s just what happened. Hours before the release, the EUR/USD pair broke through the trend line resistance, signaling a move higher. Short-term traders watching this level placed long or buy positions on support of 1.3950 with corresponding stops of 50 pips placed below.

Intraday traders long on this position would have profited nicely, as the EUR/USD topped out at 1.4052 that afternoon, giving traders a 100-pip gain (a 2:1 risk/reward ratio). Medium-term traders who held on would have seen the EUR/USD climb to as high as 1.4100.

The Bottom Line

Given these examples, it’s easy to see that analyzing and applying the trade balance report is necessary to currency portfolio positioning these days. Without it, the FX investor will be missing out on underlying signs of a trend, both in the short and long term. Those who are able to capitalize on this rather obscure report will benefit immensely from it.

By Richard Lee, contributor, Investopedia.com

Richard Lee is currently a contributing analyst for ForexAlliance and BinaryMagnates.com

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