Trading and Investments, what Macroeconomic analysis is and Why is it Fundamental

18 November 2022 - 13:10

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Macroeconomic analysis is a fundamental component for operational decisions in trading and investments.

Trading and Investments, what Macroeconomic analysis is and Why is it Fundamental

Macroeconomic analysis is most likely the most important to carry out if our choice is to invest or trade. Many traders avoid this approach, yet this component is fundamental for the largest market players (Hedge Funds, Investment Funds) which certainly obtain different results from the average retail trader.

The purpose of the retail trader is therefore to bring his approach ever closer to that of the big players, a sort of imitation that will be used to obtain results, be they in terms of risk management or direct return objectives. Macro analysis is absolutely fundamental in terms of training for every trader and must be an integral part of his training and consequently of his operations. Let’s see together what are the aspects that a trader and/or an investor must keep an eye on with regard to this type of analysis.

What is macroeconomic analysis?

The macroeconomic analysis consists in the study of the main economic-financial components in a global perspective. Fundamental factors are analyzed individually and then as a whole, like the cogs in a mechanism. This is because the factors carry weight as individuals as well as within the analysis as a whole.

To simplify, we can compare the economic-financial system with the human body or any complex machine where the malfunction of an organ or part, in some cases, compromises the functioning of the whole system.

As in a human body, circulatory problems derive from the inefficiency of the heart, for example, the malfunctioning of the financial system can derive from the inefficiency of factors such as high inflation, excessively high interest rates, a market sector bubble and so on. To identify inefficiencies, whether it is a human body, a machine or the financial economic system, we need to have an overview that macroeconomic analysis provides us with. And precisely because of this characteristic, macro analysis is fundamental for investment choices and risk management in the short and long term.

The main drivers of macroeconomic analysis: interest rates and inflation

Let us take the example of the human body again and imagine that in the economic-financial system the blood is represented by money (liquidity) and the heart are the central banks, i.e. the organs that "pump" liquidity into the system. The center of the system is represented by the brain where we can imagine that there are interest rates and inflation.

The brain, in the moment of danger sends signals to the heart which will pump more blood and in our case when interest rates and inflation go out of control or beyond their standards, the central banks (the heart) will act consequently pumping more or less blood (liquidity).

This helps us understand how important central banks are within the economic system and how they are dependent and at the same time determining for interest rates and inflation.

But back to reality, the most important component of all for the economic-financial system is the interest rate, which represents the cost of money: the higher it is, the more the economy will struggle to turn. Simply put, the velocity of money decreases because money is expensive. The opposite is also true, ie when interest rates are low the economy will run more easily, the speed of circulation of money will be higher.

Another key factor is certainly inflation, the generalized level of prices. Very high inflation can lead to an emergency situation where prices may be too high within the economy, just as too low inflation leads to an emergency situation for the economy to recover. These two factors are essential and fundamental within a macroeconomic analysis, without which we could never have a truly efficient picture of the economic context.

What role interest rates and inflation play in the economy

Understanding how interest rates and inflation work and how they move is theoretically simple but at the same time difficult. For example, when inflation is high, the need to bring it down consequently arises. But how? Just raise interest rates so that the cost of money increases, the speed of circulation of money decreases and prices will fall accordingly. But who decides when inflation is high or low? And according to what criteria?

Central banks set a "target" inflation rate that equates to a healthy economy. In the case of the ECB, the Fed and the BoE - for example - the target rate is 2%, so these central banks will ensure that interest rates always drive inflation to these levels.

When inflation deviates greatly from this target, it is time to act promptly on interest rate levels and the cost of money in general, by raising or lowering interest rates.

Macroeconomics in investing and trading

The macro analysis therefore consists in establishing which are the forces that guide the economic-financial system and how these can directly influence the prices on the financial markets. High inflation, for example, erodes returns and in this regard knowing how to read how inflation will move is an advantage in measuring possible returns and consequently risks. Interest rates determine how much money circulates in the economy and financial markets, therefore knowing how interest rates will move will be essential in understanding how much to invest and where to invest based on the availability of liquidity that will be present in a given market.

The investor’s task is therefore to understand whether the prices on the market correspond to what is happening in the economy so as to be able to exploit the inefficiencies that will allow him to obtain a good ratio between risk and return. Macro analysis is also very useful for short-term traders, those who are defined as intraday traders, i.e. those who operate by trading day by day. For these traders, macro analysis allows them to understand whether some movements within the day are in line with the economic-financial context, therefore it will be useful for them to frame any squeeze movements that usually occur precisely with strong macroeconomic changes.

To be investors or traders of a certain level, it is very important to train in this discipline which, without a shadow of a doubt, will be fundamental both in investment decisions and in daily life in order to have a global and complete vision of what is happening in the economic system in which we live.

Original article published on Italy 2022-11-17 08:57:00.
Original title: Trading e investimenti, cos’è l’analisi macroeconomica e perché è fondamentale

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