On Friday this past week, the United Kingdom’s Office for National Statistics released the latest reports on the UK’s Gross Domestic Product (GDP), a means of measuring economic output. It was revealed that their economy grew by -0.6% month-over-month, and -0.1% quarter-over-quarter, which entails a contraction for both timeframes. Although these numbers are less disastrous than had been forecast, they are unfortunately part of a trend: New Zealand has also suffered a contraction in GDP, while the United States has experienced two consecutive quarters of contraction, a technical recession. While these declines in output are historically strange, seemingly contradicting recent phenomena like relatively high levels of employment and stock market rallies, they ought to be taken into account by traders nonetheless. Let’s explore some of the root causes of these contractions as well as factors exacerbating them as we discuss why global recession is still likely.
1) Restricted Supply
Often when inflation occurs, it is because demand for a product or service is rising at a faster rate than the supply of the product or service itself. However, this is not always the case; sometimes, inflation is caused primarily by a decrease in the supply of a thing, rather than growing demand alone. We are experiencing this phenomenon today with high food and energy prices, which explains why CPI has far outpaced core CPI (which excludes volatile food and energy prices) in many countries.
Because commodities like oil and commodity crops are scarce resources that consumers rely on to live, geopolitical problems like the invasion of Ukraine and resulting sanctions, as well as environmental problems such as heatwaves, droughts, and famines, restrict available supply. Many of these problems either are or can become chronic and near-ubiquitous, leading to persistent inflation from shortages that cannot be resolved through contractionary monetary policy.
2) Interest Rate Hikes
While interest rate hikes are a crucial monetary policy tool for curbing inflation and cooling an overheating economy, they also come with a nasty side effect: slower growth. This is because rising interest rate are designed to stifle growth by limiting consumers’ and businesses’ ability and desire to borrow money, restricting spending and thus the chances of inflation.
While lower GDP growth, even a contraction, does not necessarily create a recession, it is nonetheless playing with fire by taking steps in that direction. This is especially relevant considering that many central banks, such as the Federal Reserve and the Bank of Canada, have begun fully embracing hawkishness through unusually aggressive rate hikes.
3) Trade Deficits
Another economic factor that often quite literally detracts from a country’s GDP is trade balance. Some wealthy countries have negative trade balances, or trade deficits, created by their imports exceeding their exports. While a trade deficit might grant consumers more access to lower priced goods from other countries, it also results in a net loss of economic output that is subtracted from GDP. When trade deficits are frequent, as in the case of the US, this can theoretically severely impede economic growth, which likely contributed to the country’s technical recession. Both the UK and New Zealand have recently been reporting trade deficits as well, which is unsurprising.
4) Underfunded Pensions
Across the developed world, underfunded pension programs are proving to be a difficult problem to contend with. With large percentages of many countries’ workforces retiring, public pension systems such as Germany’s are struggling to keep up, with the German government bailing out the program with €100bn in 2021. Likewise, Social Security in the US is expected to be trillions of dollars behind in long-term funding, despite the average annual benefit amounting to less than $20,000 per recipient. Failure to improve pensions severely limits demand and growth within an economy, since a large chunk of many countries’ populations are retired adults who still spend.
5) Real Pay Cuts
Some economists worry about the possibility of high inflation combined with hot labor markets creating a ‘wage-price spiral’ where inflation persists uncontrollably due to rising employee earnings. However, the truth appears to be less fanciful, and grimmer. Even with today’s historically high rates of increasing incomes for working people, year-over-year inflation completely negates these raises in most circumstances. For example, with average hourly earnings increasing over 5% in the US, when we account for 8.5% year-over-year CPI, this implies a real pay cut of approximately 3% for working people. This entails a net loss in consumer spending, which means less revenue for businesses, and thus lower GDP growth.
6) Self-Fulfilling Prophecy
For better or for worse, market sentiment has a hand in creating fundamentals (by allocating capital), not just the other way around. Thus, if dread about a global recession continues to loom in the public consciousness, traders and investors may respond by buying and selling accordingly, potentially accelerating a coming recession with stock market and forex selloffs. In this way, the general perception of an impending global recession alone can play a large role in creating one.
Consequences for Pairs?
Lately, much of traders’ fundamental analysis has focused on how central banks respond to inflation as the primary economic threat. However, if global recession becomes a reality, there is a chance we could see central banks return to their dovish ways, which may warrant reassessing pair biases from scratch. It is also worth noting that these hypothetical dovish pivots may not occur in the face of stagflation, which unfortunately seems possible given supply concerns.
• A number of countries are currently experiencing negative GDP growth, i.e., contractions in economic output, which traders should take into account while gauging the likelihood of global recession.
• One aspect of each contraction likely involves the potentially dwindling supply of scarce resources such as crops and oil due to war, sanctions, droughts, and other potentially chronic problems. This lowers the amount of ‘stuff’ there is to buy, shrinking output.
• While interest rate hikes curb inflation within a currency’s host country, they also disincentivize consumers and businesses from borrowing money, restricting GDP growth.
• Economies prone to trade deficits, i.e., spending more on imports than they receive selling exports, impair their GDP growth by net losing output in the trade process.
• Underfunded pension systems, which cause lower benefits for elderly consumers, are proving to be an international problem, limiting consumer demand and GDP accordingly.
• Although wage growth is rising at the fastest rate in years, it still often pales in comparison to high rates of inflation, limiting consumer demand and GDP accordingly.
• Fear of impending recession can become a self-fulfilling prophecy by spooking investors and speculators, encouraging mass selloffs that create the catastrophes they were afraid of in the first place.
• If a massive event such as global recession, or even stagflation, becomes reality, this could warrant a complete reevaluation of pair biases and fundamentals.
Throughout much of the developed world, housing prices have recently begun taking a tumble. Home valuations and rent costs had soared to unsettling high levels amid near-zero interest rates and other pandemic-era monetary stimulus; however, near-ubiquitous central bank rate hikes are beginning to bring many countries’ housing prices back down to earth. According to the Economist, in Sweden, home prices declined by almost 4% in June, while in New Zealand they have depreciated from highs for three consecutive months. Considering that real estate remains the biggest asset class in existence, and that housing markets arguably lie at the heart of global economic output, forex traders would be wise to consider these fundamentals when buying or selling pairs. Let’s explore 4 ways housing bubbles affect forex, as well as other markets.
1) Measures Inflation Rates
For foreign exchange traders, gauging inflation within a currency’s host country is practically essential to fundamental analysis, since it often correlates with economic growth and helps analysts anticipate potential interest rate hikes. While there are many useful measurements of inflation, such as the Consumer Price Index (CPI) and core Personal Consumption Expenditures price index (PCE), measurements like the House Price Index (HPI) and home sales data are also relevant.
This is because higher housing prices and increased home sales are signs of a hot housing market, which indicates higher levels of consumer demand and thus potential inflation. After all, if house prices are increasing, this is typically because more people have money to spend on purchasing a home, whether through income or borrowing. This presupposes that they have general access to financing that they could use elsewhere, driving up prices in other industries too. Therefore, keeping up with the latest housing market data can be handy when it comes to assessing the severity of existing inflation.
2) Influences the Cost of Living
Besides offering data regarding pre-existing inflationary threats and spending patterns, housing market data can also give traders insight into how home prices transform the cost of living. For example, in the US in 2020, according to the Bureau of Labor Statistics, average housing expenditures were over $21,000 per ‘consumer unit’ and accounted for over one third of all consumer spending. This means that the cost of renting a home or taking out a mortgage has serious implications for the overall cost of living.
While rising home prices in general may not contribute to high levels of inflation, this past year’s sky-high prices are not ordinary circumstances: they are symptomatic of a bubble (when prices are far higher than they fundamentally ought to be), created artificially through low-interest loans. When central banks around the world incentivized easy borrowing through low rates and quantitative easing, they encouraged consumers to take out cheap, fixed rate mortgages and other debts while still spending more elsewhere, for the sake of economic stimulus. However, this short-term solution may have disturbing long-term consequences, as high inflation persists globally while rate hikes now abound in response.
3) Guarantees Revenue for Banks
Because commercial banks have multiple revenue streams that include owning mortgages and selling mortgage-backed securities, they have become instrumental to housing market activity. Due to acutely limited supply across many countries’ housing markets (for example, by some estimates, England is over 150,000 new homes behind in construction per year), many home buyers would not be able to afford the purchase without substantial loans from these banks.
However, ‘money-printing’-induced housing bubbles have further bolstered the banking industries via the housing market, and vice versa. When central banks encouraged bountiful lending, spending, and investing, increasing the number of homebuyers, this meant more clients for banks than would have otherwise existed, often including the central banks themselves.
By propping up the banking industries through these new borrowers and asset purchasing programs, this influx of capital also enabled banks to further profit from new investments, exacerbating inflation in a top-down manner due to the artificial, allocated capital. This is because, in many countries, commercial banks can also legally operate as investment banks, generating higher returns on investment by engaging in more risk. For example, this has been the case in the US since the overturning of Glass–Steagall in 1999.
4) Promotes Fragility, Not Stability
Between the recessions created by the 2008 financial crisis and today’s recessions caused by high inflation rates around the world, recent history offers a compelling case: housing bubbles promote economic fragility by accelerating expansion and contraction (i.e., boom and bust cycles). Unfortunately, for now, it appears that this lesson may have been learned too late, as the world’s central banks embark on a mission to crush consumer demand as a sort of necessary evil by venturing deeper into recessions in search of price stability. However, traders can learn to read housing bubble data accordingly, recognizing it for what it is: indications of severe overheating, followed by indications of impending contraction.
Why Sell USD?
While many USD bulls (including myself) think that bullish momentum in the US Dollar Index has a ways to go before buying pressure is exhausted, there is a compelling argument that this is not the case. First, the United States economy officially met the criteria for a technical recession as of Thursday morning: two consecutive quarters of GDP contraction, which is bearish for USD in theory.
Second, Fed Chair Jerome Powell gave ambiguous comments at the FOMC press conference this past Wednesday, which many analysts and traders interpreted as subtly dovish. If true, this would be monumentally bearish for USD, considering US inflation remains at 40-year highs. For those interested in shorting the US Dollar, here are three major pairs that the EdgeFinder, an A1 Trading tool for supplemental analysis, signals as opportunities for selling USD.
1) Sell USD/CHF
With a rating of -6, earning a ‘strong sell’ signal, fundamentals currently favor CHF for the most part, between Switzerland’s 2% unemployment rate and growing economy. The only strike against it is currently COT data, with a higher percentage of institutional traders buying USD rather than CHF.
2) Sell USD/CAD
With a rating of -4, earning a ‘sell’ signal, fundamentals are somewhat mixed for the pair, and are especially unique considering that the US is one of Canada’s primary trading partners. However, retail sentiment, seasonality, and trend reading currently weigh in CAD’s favor.
3) Buy NZD/USD
With a rating of 4, earning a ‘buy’ signal, fundamentals currently favor NZD in light of New Zealand’s 3.2% unemployment rate and smaller economic contraction, as well as their exports. While institutional and retail sentiment don’t favor NZD, seasonality and trend reading do.
How To Monitor USD
For those who are interested in keeping tabs on USD fundamentals and sentiment before trading major pairs, investing in the EdgeFinder will help you keep up with the latest economic data, COT data, and more. Use this link if you would like to purchase the EdgeFinder, or perhaps try it out for free.
GBPUSD reached a new two-year low today upon falling beneath 1.19 support yet again, the second time since last week. These lows are due in part to USD strength after Friday’s strong Non-Farm Payroll data revealed over 100,000 more new US jobs than were expected; as traders anxiously await Wednesday’s new CPI numbers, anticipation for red-hot US inflation grows. However, much of GBPUSD’s bearish momentum is due to the Pound itself, and unusual, pessimistic circumstances that the UK’s economy is facing. Let’s explore what these conditions are as we issue a warning: how doomed is GBP?
1) Resignations & Other Chaos
On July 7th, a Thursday morning, UK Prime Minister Boris Johnson resigned as leader of the Conservative Party. His stepping down came amid an unexpected mass resignation of over fifty Conservative members of parliament (MPs), due to disappointment in party leadership over a slew of scandals. It is worth noting that while Johnson has resigned as head of his party, he intends to remain Prime Minister over the next few months, until the governing Conservative Party elects a new leader to replace him. These events have aided in throwing Parliament into disarray, and will certainly not improve its economic problem-solving efficacy, nor any sentiment adjacent to it.
While political resignations of this magnitude would be inconvenient for any country to experience, this is especially difficult for the UK, since post-Brexit trade deals are still either in their infancy or have yet to be negotiated. Since 2020, when Brexit took effect and the UK’s trade to GDP ratio declined by 8.31% (from 63.4% to 55.09%), trade statistics have been volatile and tricky to analyze, especially in light of post-COVID supply chain issues. According to the UK’s Office for National Statistics, “It continues to be difficult to assess the extent to which trade movements reflect short-term trade disruption or longer-term supply chain adjustments.”
2) A Reluctant Bank of England
The UK’s annual inflation rate hit a staggering 9.1% in May, the highest among the G7 countries. In theory this should be bullish for GBP, because higher inflation implies a growing economy and serves as an antecedent to rate hikes, which are central bank attempts to stabilize prices. However, despite the Bank of England (BoE), the UK’s central bank, warning that annual inflation could reach 11% in the coming months, they lag significantly behind the US’ Federal Reserve in terms of hawkish aggression. They have thus far only resorted to 25 basis point rate hikes within the past year, with their target interest rate currently at 1.25%; this slow pace is nearly as tepid as tightening monetary policy can be. This hesitancy to stamp out UK hyperinflation is extremely bearish for GBP.
3) A Rising Unemployment Rate
The UK’s unemployment rate recently ticked up to 3.8%. While rising unemployment is a bad sign for the performance of any country’s economy, this is particularly problematic for the UK and the Bank of England for two reasons. First, considering that the BoE’s target interest rate is a relatively low 1.25% while inflation is at 40-year highs, for unemployment to already be increasing is discouraging. This indicates fragility in the UK’s labor market, and by extension their economy, which likely contributes to the BoE being wary of contractionary monetary policy. Second, if the UK labor market continues to be acutely sensitive to a cooling economy, this joblessness might especially aid in slowing consumer spending, reducing the overall need for BoE intervention via rate hikes (unless stagflation surfaces).
4) Bearish Institutional Sentiment
According to recent Commitments of Traders (COT) data, GBP clocks in as the third most shorted COT asset, with 70.75% of all institutional traders selling the Pound. This bearishness is a significant factor in creating GBP selling pressure, since much of forex price action is generated by institutional activity, due to the sheer scale of their purchases and sales.
What Happens Next?
For now, fundamentals for GBP appear rather bleak despite high inflation, and COT data reflects this. However, there is a chance that this hyperinflation in the UK could eventually force the BoE’s hand, prompting them to eventually lean into hawkishness to prevent catastrophic overheating. While this pivot could be around the corner, along with newfound GBP bullish momentum, traders would be wise to not assume this is the case until there are clear signs from the BoE. Unless this happens, GBP seems primed for continued selling.
Best Pairs to Trade
While GBPUSD has received a ‘strong sell’ signal from the EdgeFinder, an A1 Trading tool for supplemental trading analysis, there are many other GBP pairs potentially worth trading too. Such pairs include GBPCAD, which likewise receives a ‘strong sell’ signal, as well as GBPAUD and GBPNZD, which both receive ‘sell’ signals. Along with GBPUSD, these four pairs all rank in the EdgeFinder’s top eight pairs worth selling.