Need to Manage Your Currency Risk?
Rutland FX can help you manage your currency exposure with forward contracts and competitive rates.
What are Leading Economic Indicators?
Leading economic indicators are metrics that predict future economic activity. Unlike lagging indicators, which confirm trends after they have occurred, leading indicators provide insights into where the economy is headed, usually with a varying time lag. They help investors, policymakers, and businesses by providing early signals about the direction of the economy and, in turn, the direction of currency. This foresight helps anticipate and plan for changes effectively.
Examples of Leading Economic Indicators
To better understand how leading economic indicators work, let’s look at some key examples:
Company Earnings Reports
The financial data released in company earnings reports are actually lagging indicators, reflecting past performance. However, most companies provide a Q&A transcript to accompany their earnings reports, which includes forward-looking statements. These forward-looking statements can be used to gauge future economic trends, offering insights into how companies anticipate their performance and the overall economic environment.
Manufacturing Activity
Indicators such as the Purchasing Managers’ Index (PMI) track manufacturing activity and business sentiment. A PMI reading above 50 indicates economic expansion, while a reading below 50 suggests contraction. This report has a high correlation to economic growth or contraction with a 12 to 18-month time lag.
Housing Starts and Mortgage Approvals
Housing starts and mortgage approvals can be used as leading indicators. They show the lending activity of banks: increased lending activity suggests that the economy is in an expansionary state, whereas lower or contracting housing activity can indicate a contractionary phase for the economy.
Consumer Confidence Index
The only things that exist in an economy are consumers and businesses, and businesses can’t survive without consumers. The Consumer Confidence Index measures how optimistic or pessimistic consumers are about the economy’s future. Higher consumer confidence usually predicts increased consumer spending, which drives economic growth. Therefore, the Consumer Confidence Index is a significant leading indicator for future economic expansion or contraction.
Leading Indicators’ Impact on Currency
Economic growth is considered inflationary, leading to a weakening currency, while economic contraction is considered deflationary, leading to a strengthening currency. To use leading indicators effectively for exchange rates, compare the leading indicators of the countries you are exposed to.
For example, to gauge where GBP/USD might trend, compare the leading indicators of the USA and the UK. Determine which economy is more inflationary or deflationary. If the UK’s indicators suggest stronger economic growth compared to the USA, it might indicate a weakening USD against the GBP, and vice versa.
It’s important to remember that if an economy is too deflationary, the central bank of that country might lower interest rates, weakening the currency. Conversely, if an economy is too inflationary, the central bank might raise interest rates, strengthening the currency. Therefore, it’s helpful to also pay attention to what the central banks are doing to avoid getting caught out by unexpected currency movements.
Understanding leading economic indicators helps in making informed financial decisions and managing exchange rates. Unlike lagging indicators, leading indicators provide early signals about future economic trends. Additionally, paying attention to central bank actions is important, as their responses to economic conditions can influence currency values. Using these insights, small businesses can make better financial decisions and avoid unexpected economic shifts.
Still not sure?
If you are still unsure or have any further questions, please call us on 0203 026 0112 or request a callback to discuss your requirements.