Understanding the factors that influence economic performance can help investors and traders predict potential economic outcomes and how they might influence asset prices. Exploring the key factors that shape the economy is crucial for being able to identify the best trading opportunities. Learn what economic factors are, as well as the most common ones you should know about.
A nation’s economic output is driven by a range of ever-changing variables, including consumer spending, the investment and optimism levels of business leaders, borrowing rates and labor supply, among many others. Gaining a profound understanding of how these variables work is very important, as each one has the potential to impact the price of financial instruments.
Tip: Many economic factors are closely connected, meaning that a change in one, can trigger changes in others.
What are economic factors?
Economic factors are variables that impact the overall economy, as well as individuals and businesses. They are created by collating and aggregating data from various sectors of the economy. Importantly for investors, factors can be measured and tracked over time, providing opportunities to identify underlying trends.
Macroeconomic factors can be divided into two groups. The first consists of factors such as tax rates, fiscal policies and monetary policies, all of which are under the control of governments and central banks. These factors can influence economic growth rates, inflation levels and unemployment rates.
These macroeconomic factors can therefore have a knock-on impact on the wider economy. For example, if inflation rates are high, the country’s currency will likely weaken; as goods become more expensive, the country becomes less attractive for investors to do business in.
The second group comprises factors such as consumer spending and business confidence, which are equally significant in determining how an economy might perform. Although political and business leaders have less direct control over this category of factors, they may still attempt to react to them using the factors they do have control over.
Common economic factors
There are many economic factors that can impact the wider economy, and different factors will influence certain sectors more than others. For example, retail sales are more likely to affect the hospitality industry and hospitality stocks more than the healthcare sector. It is therefore important to understand how your investments or potential investments might react to macroeconomic changes.
We will delve into some of the most common economic factors below.
Monetary policy
The central banks of most major economies are tasked with maintaining price stability and economic growth. To achieve these goals, they use money supply and interest rate policies, both of which influence the cost of borrowing money and the rates provided to savers.
When borrowing rates rise, business investment becomes less attractive, and household budgets can become tight, resulting in a reduction in consumer spending.
Interest rate policies can lead to significant movements in asset prices. These policies are a relatively blunt tool, impacting all corners of the economy. As a result, central banks such as the US Federal Reserve typically provide transparent calendars that outline the timing of their announcements.
Yield curve
A yield curve is a graphical line that displays the yields of bonds with equal credit quality but varying maturity dates. The US Treasuries yield curve is a commonly tracked example that showcases the rates at which market participants are willing to hold different securities.
The slope of the yield curve can help to predict future interest rate changes. Moreover, it is interesting to note that every economic recession since World War II has been preceded by a yield curve inversion.
Given that yield curves are a relatively reliable indicator of future interest rates, the methodology for their calculation, alongside historical records, can be easily accessed through publicly available sources, such as the website maintained by the US Treasury Department.
Tip: The phrase “inverted yield curve” describes the scenario where short-term debt offers higher yields than longer-term bonds.
Fiscal policy
Fiscal policy refers to governmental handling of taxes and spending. When taxes are lowered or public spending is increased, it usually leads to more consumption and economic production. On the other hand, higher taxes and reduced public spending tend to have the opposite effect.
Fiscal policy can be directed at specific sectors with a high level of accuracy. For example, the US Green Energy Bill is a long-term strategy to spend $11 billion dollars of public funds on advancing the development of clean energy initiatives across the US.
As public entities, governments provide regular updates about their spending and taxation level on official websites.
Tip: State-funding levels can influence the prices of financial market assets, such as stocks in electric vehicle (EV) manufacturers.
Currency
The exchange rate of a country’s currency is one of the most important factors in demonstrating its relative level of economic health. A “stronger” currency makes a country’s imports less expensive and its exports more expensive, while a “weaker” currency has the opposite effect. This factor can significantly influence a country’s overall growth prospects.
In addition, the evolving prospects of an economy can influence the attractiveness of its currency to international investors. Depending on the circumstances, a currency can become more or less appealing.
Currency markets operate on global exchanges without much regulation. Tracking the relative value of currency pairs can be done using price charts, which can be set to short- or long-term time frames.
Tip: Certain currency trends are long-term in nature and can be capitalised upon by trading forex pairs such as EURUSD.
Other factors
Any data point that offers insights into the potential prospects of an economy can be utilized to develop an effective trading strategy. These data points can be related to demographics, social trends or consumer confidence.
Financial markets are influenced by a wide range of economic factors, making it easy to find data that can help build a strategy. However, this abundance of impactful economic factors also highlights the large number of interrelated variables, which can cloud analysis.
Other economic factors include:
| Laws and policies | International trade agreements |
| Wage levels | Technological advances |
| Gross Domestic Product (GDP) | Consumer confidence |
| Retail sales | Business investment |
| Supply side and logistics | Worker productivity |
| Taxation rates | Deregulation |
Final thoughts
Economic factors can be used by traders employing both short-term and long-term strategies. When important news announcements are released, market prices can react in an instant, leading to the formation of longer lasting trends that can last for months, or even years.
Remember, the influence of certain economic factors can change over time, so it is important to regularly assess the impact that they might have on your investments. Although it is more time-consuming than a passive investing strategy, being reactive to macroeconomic changes can help to strengthen your portfolio.
Visit the eToro Academy to learn about how economic factors impact asset prices.
Quiz
FAQs
- How do I know which economic factors are worth following?
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A quick scan of financial news reports can provide you with valuable insights into what upcoming news announcements hold the greatest interest among market participants. Many of these data reports are released at predetermined times, making it possible for you to prepare in advance and subsequently monitor the impact they have on asset prices.
It is worth mentioning that economic factors will impact traders and investors differently. Certain pieces of data will be relevant to a day trader, for example, but insignificant for a long-term investor.
- Why do markets not always react as expected to news announcements?
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While there are general guidelines about how markets may respond to certain changes in the underlying economy, history has demonstrated that sometimes price movements can be counter-intuitive. This is because each factor must be considered in conjunction with others.
For example, an announcement of a decrease in unemployment could be perceived as good news for stock prices, as more people would have the means to afford goods and services. However, this could also be seen as a sign that the economy is overheating and that interest rates may rise, which could lead to a fall in stock prices.
- How can I keep track of economic factors?
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If you want to stay informed about upcoming news announcements relating to economic factors, use an economic calendar. Reliable brokers typically include this as a part of their standard package, allowing their clients to remain up to date with the latest information.
This communication is for information and education purposes only and should not be taken as investment advice, a personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments.
This material has been prepared without taking into account any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
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