How to trade the US growth outlook

August 31, 2010, 2:17 pm By Kathy Lien kathylien

The outlook for the US economy has grown murkier by the day

In early August, the US Federal Reserve took the bold and market-moving step of reverting back to easier monetary policy. Its decision to reinvest the principal payments for agency and mortgage-backed securities was considered by some as "quantitative easing light."

Rather than naturally let its massive balance shrink as bonds mature, the US central bank decided to reinvest the money into more securities, keeping the size of its balance sheet unchanged. The outlook for the US economy has grown murkier by the day, economic data has taken a turn for the worse and the bank wanted to maintain the current level of stimulus to provide support for the US economy.

Unusually uncertain...

When Federal Reserve Chairman Ben Bernanke took the stand to deliver his semi-annual testimony on the economy and monetary policy in July, he sounded very pessimistic and said the outlook for the economy is "unusually uncertain."

Although the US economy is currently struggling with net job losses and weak consumer spending, eventually there will be light at the end of the tunnel. As the recovery continues and we see more incoming economic data (that may confirm or deny Bernanke's pessimism), you may form your own view on how the US economy could fare.

Perhaps you may agree with Bernanke, that it will be a slow slog forward with some downside risks - or you believe that the US economy could enter a double dip recession. Maybe you are an optimist who thinks that the worst is over. Regardless, you can trade many different financial instruments to express your views.

Currencies

Your View:

Worst is over - Bullish dollars through the Dollar Index or USD/JPY.

More trouble to come - Bearish dollars through the Dollar Index or USD/JPY.

Currencies are often considered little confidence indicators for a country. When the economy is doing well, investors are open to buying the currency, but if it is deteriorating, then there is a good chance that investors will shun the currency. Therefore, if you believe that the worst is over for the US economy (either now or a few months down the line) the US dollar is a good way to express that view.

There are a few ways to do so. In the spot market, trading the USD/JPY is your best bet, because it tends to have the most rational reaction to US economic data. In other words, good US data tends to be good for USD/JPY, while weak US data tends to be bad. Another alternative is the Dollar Index, which can be traded through contract for differences, or CFDs. The dollar index is a trade weighted index comprised of the currencies of 17 countries. CFDs and spot forex have unique characteristics that you need to be aware of before trading these instruments.

Equities

Your View:

Worst is over - Bullish SPX 500, US Small Cap or Tech Index CFD, or CFDs of Individual Shares.

More trouble to come - Bearish SPX 500, US Small Cap or Tech Index CFD, or CFDs of Individual Shares.

Currencies are of course not your only option - there are a number of equity-related CFD instruments that can also be used to express your outlook on the US economy. The SPX 500 basically tracks the S&P 500 and is the broad US market index. There are also sector specific indices that you can trade if you have a specific view on small caps or the technology sector. Individual shares such as Google are also available as CFD instruments, making it easier for Australians to access the US markets. If you believe that the US economy will improve and the worst is over, then by extension, you expect US stocks to rally. Alternatively, if you believe in a double dip recession, then US shares should suffer.

Some investors may opt to trade Australian shares, which should underperform if the US economy falls into another slump, but they have to be careful because the magnitude of the decline may be different since Australia is also sensitive to Chinese growth. At the same time, higher interest rates in Australia could limit the upside potential of Australian shares.

Gold

Your View:

Worst is over - Bearish gold.

More trouble to come - Bullish gold.

Gold is another option. Although the US dollar and Japanese Yen have benefitted significantly from safe haven flows, the ultimate safe haven is still gold. When the troubles brewed in the global economy, gold headed for the stratosphere. Since then, it has come down to less heady levels. If you believe that the worst behind us, then gold prices should continue to fall. However, should more trouble come, gold prices will probably benefit.

Eurodollar Futures

Your View:

Worst is over - Bearish Eurodollar futures.

More trouble to come - Bullish Eurodollar futures.

Typically when there is uncertainty in the US economy, interest rates fall. This is on the expectation that the central bank will be forced to leave monetary policy easy and rates low to provide support for growth. When the uncertainty settles and the economy improves, the opposite occurs as traders start to bid up interest rate futures. Eurodollar futures are cash-settled futures contracts on US interest rates for three month loans with a US$1 million notional value. They are the most actively traded futures contract in the world and can be used to express your view on US interest rates.

If you believe that the worst behind us, then Eurodollar futures should fall as the Fed considers raising interest rates. However if you expect growth to slow, then you also expect Eurodollar futures to rise. The reason Eurodollar futures and the US outlook are inversely related is because the implied interest rate of Eurodollar futures is 100 minus the Eurodollar rate.

There many ways to express the same views using FX and CFDs. You should pick the one that you are most comfortable with.

Do you think the US economy is headed for a double dip? (Share your views below)

Want to learn more about trading CFDs? Download GFT's free CFD guide, get a risk-free practice account and visit gft.com.au for more information. Ready to start trading? Open an account with GFT with as little as $275. Don't forget to follow Kathy's commentary on FX360.com and Twitter.

Stock Quotes

e.g. BHP, CBA
COMPARE & SAVE