In foreign exchange markets, where movements are often dominated by global sentiment and speculative flows, fundamental signals can sometimes be overlooked. One such underappreciated indicator is a country’s terms of trade—the ratio of export to import prices. While this metric can be subtle in its effect, evidence suggests it has meaningful value when systematically applied to currency trading strategies.
The Basics: What Are Terms of Trade?
The terms of trade (ToT) reflect the relative prices of a country’s exports to its imports. An improvement in ToT—meaning export prices rise relative to import prices—indicates that a country is gaining more value from trade. In economic terms, this suggests rising income from abroad and cheaper costs for domestic consumption or investment. All else being equal, such an improvement supports stronger growth prospects and should boost demand for the local currency.
However, official ToT data are often released with significant lags and are purely historical. To gain timely insights, traders have turned to commodity-based proxies. These track the prices of key traded commodities that influence export and import values. Given the volatility and global pricing of commodities, they often drive short-term changes in ToT more than finished goods do.
A More Accurate Proxy: JPMaQS Terms of Trade
Traditional commodity-based indices, such as those previously published by Citibank, offer a daily view of trade dynamics. But newer data sources like the J.P. Morgan Macrosynergy Quantamental System (JPMaQS) offer enhancements specifically tailored for trading use:
- Point-in-time accuracy: JPMaQS uses real-time historical vintages that align with what was known at each point, avoiding look-ahead bias.
- Realistic non-commodity price trends: It adjusts for general price levels by aligning non-commodity prices with U.S. core CPI.
- Localized pricing: Whenever possible, the system applies regional benchmarks—e.g., WTI for U.S. oil, Brent for others—to better represent each country’s export price structure.
- Expanded coverage: Over the years, JPMaQS has broadened its coverage from 36 to over 60 commodity contracts, improving the granularity of its indices.
Why ToT Should Influence Currencies
From a theoretical standpoint, better ToT means a country receives more income per unit of export and spends less on imports, increasing its purchasing power. This should enhance the outlook for growth, investment, and currency appreciation. But this signal often goes underutilized in financial markets for two reasons:
- Subtlety and noise: Most changes in ToT are small and hard to distinguish from other macro noise. Markets may overlook these gradual shifts—an effect consistent with the concept of rational inattention.
- Confounding global factors: Big commodity price swings often happen alongside other macro events, such as financial crises, which may distort currency performance. Even when ToT improves, risk-off behavior can overwhelm fundamentals.
Despite these challenges, ToT remains a fundamentally sound input—especially when framed systematically and combined with robust data sources.
What the Data Shows
An analysis of 23 years of FX forward returns (2000–2023) across 26 currencies—spanning both developed and emerging markets—shows that ToT changes have statistically significant predictive value.
Using vol-adjusted positions and z-scored ToT signals, researchers found:
- Monthly predictive power with 98% statistical confidence.
- Weekly significance at a 99% level.
- Directional prediction accuracy above 50% in over two-thirds of the sample years and across most currencies.
In terms of profitability, a basic strategy based on these signals produced Sharpe ratios of 0.45 to 0.5—respectable figures considering the simplicity of the approach and its limited market assumptions.
Interestingly, most of the value from ToT-based strategies emerged after the global financial crisis. This reflects both the maturation of emerging markets and a shift toward more data-driven currency analysis. Before 2008, EM currencies were largely driven by capital inflows rather than trade fundamentals. But as markets evolved, subtle signals like ToT started playing a larger role.
Differentiating Developed and Emerging Markets
For developed markets, the ToT signal has been steadier. Even with a smaller set of currencies, the strategy delivered consistent positive returns throughout the 2000s, 2010s, and early 2020s. Sharpe ratios ranged from 0.29 to 0.32, and every developed market in the sample exceeded the baseline 50% accuracy threshold for directional predictions.
For emerging markets, the picture is more complex. ToT strategies initially underperformed during the period of heavy capital inflows in the 2000s. But once these inflows slowed or reversed, ToT signals began to shine—often working best when traditional long-only strategies struggled. In fact, combining ToT-based positioning with long-biased EM exposure produced stronger and more stable returns.
Final Thoughts
Terms of trade might not be the flashiest indicator, but when approached methodically, they offer meaningful insights into currency valuation and performance. By focusing on real-time commodity dynamics and local pricing structures, traders can harness this subtle signal to improve forecasting and risk management.
In an environment where investors are flooded with information, the disciplined use of overlooked fundamentals like ToT can uncover durable trading opportunities—especially in markets where behavioral and capital flow dynamics obscure the signal from traditional macro data.
