Trade Balances and Currency Strength

When a country exports more than it imports, foreign buyers need its currency to pay for those goods. When it imports more than it exports, its own residents need foreign currency. This simple flow is the trade balance, and it is one of the slowest but most persistent forces in the currency market.

The mechanics

A trade surplus creates steady demand for a currency. A deficit creates steady supply of it. Day to day, these flows are small compared with the money moving on interest rate expectations and risk sentiment. Over years, they add up and help explain why some currencies trend for a long time in one direction.

Commodity exporters feel this most. When the price of their main export rises, their trade balance improves and their currency tends to follow. This is why the Australian and Canadian dollars track metals and oil respectively, and why a currency like the yen, belonging to an economy that imports most of its energy, can weaken when oil rises.

Reading the release

The monthly trade figures rarely move markets on the day, because they are backward looking and lumpy. What traders look for is the trend:

• A surplus that is shrinking or a deficit that is widening month after month
• Export volumes, which strip out price effects
• The share of trade with the largest partners, which reveals exposure to a single economy

Combining it with other drivers

The trade balance is a background force. It sets a direction of travel that other drivers push against or along. A currency with a large surplus and rising interest rate expectations has two tailwinds; one with a deficit and falling rate expectations has two headwinds. The chart tells you when; the flows tell you how much resistance to expect.

Capital flows can offset trade flows. An economy with a trade deficit can still have a strong currency if foreign investors are pouring money into its assets. That is why the current account, which includes investment income, is a fuller picture than the trade balance alone.

What to watch

Watch the trend in the trade balance over several months, the price of the main export or import for the economies you trade, and whether capital flows are reinforcing or offsetting the trade story.