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What is a Leading Indicator?

July 9, 2024No Comments
Mariel Rhetta
Content Strategist at Rutland FX
Published on: (Updated ) - minute read
As information becomes more readily available, small businesses want to embrace it to make better financial decisions, including those related to exchange rates. However, many make the mistake of focusing too much on lagging economic indicators, which reflect past economic performance. In this article, we will explore what leading indicators are, provide examples, and explain how to use them to make informed economic, financial, and currency decisions.

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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.

In November 2008, mortgage approvals in the United Kingdom hit a low of 26,390 per month and started gradually increasing. Twelve months later, GDP growth in the UK turned positive. This is a great example of how mortgage approvals in the United Kingdom served as a leading indicator for economic growth post the financial crisis of 2008.

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 crucial 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.

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