How supply and demand impact financial markets

 

What are supply and demand?

Supply and demand are the driving force behind market movements. Supply is the number of goods and services that are available to buy, and demand is the number of goods and services that are being bought.

Whether just daily consumer goods, or financial markets such as forex, shares and commodities, supply and demand shape the actions of buyers and sellers.  

If there is an imbalance between supply and demand, then prices will change. A shortage of goods occurs when demand exceeds supply – this causes prices to rise as consumers need to outbid each other to purchase the product. Conversely, a surplus occurs when supply outweighs demand. Consumers use less of the product or purchase substitutes in order to save money, which drives the price down.

First, we’re going to go back to economics 101 and look at the very basic laws of supply and demand. Then we’ll explore how this relationship plays out in financial markets specifically.

What is the law of supply and demand?

The law of supply and demand is the economic theory behind the relationship between businesses and consumers.

From a consumer’s point of view, the rule is usually: an asset that is easy to buy is cheap, and something that is scarce is more expensive. There can be exceptions but that’s the basic premise.

But for businesses, it’s more complicated. They have to consider a range of factors that will influence the price they can offer goods at, as well as whether consumers would be willing to buy their products at that price.

Let’s consider gasoline, or petrol, as an example.

Consumers will always attempt to find the most reasonable station to fill up their tank at, resulting in the lowest personal cost. If the average cost of gasoline is 140p per litre, people might be willing to buy 50 litres per week. If the price increased to 160p per litre, consumers might only be willing to buy 40 litres per week. But if the price fell to 120p per litre, they’d likely buy 60 litres.

Essentially, as the price of gas falls, demand increases, and people will be more likely to drive their cars. But if the price of gas rises, demand falls, and people won’t take non-essential trips. We saw this in the 2021 petrol crisis in the UK, when supply chain issues caused panic buying, resulted in little to no petrol available and people had to restrict car usage.

In other words, the consumer has an inverse relationship between price and quantity, which would look like this:

From the point of view of a petrol supplier, the reverse would be true. When the prices of products increase, producers are willing to manufacture more to increase their profits and price decreases would depress production as it becomes more difficult to cover costs.

Many might assume that suppliers can set the market price – but that isn’t true. The only input they have is how much supply to give the market dependant on whether they can afford to increase or decrease their capacity.

This would be represented as so:

Understanding the relationship between consumer and business is crucial for traders and investors because it will determine whether a market’s price rises or falls. During the UK petrol crisis, the price of oil had risen drastically, which when combined with supply issues saw Brent crude futures hit a two-month high of $77 a barrel.

The supply and demand curve explained

As we have just seen, the depiction of supply and demand’s impact changes depending on whether you’re considering the consumer or the producer. To understand the relationship between the two sides, both are represented on a supply and demand curve.

The most basic supply and demand curve looks like this:

The midpoint between supply and demand is called the ‘equilibrium’, it’s where the demand for a good perfectly equals the quantity supplied – meaning there’s no surplus and no shortage.

What factors affect supply and demand?

There is a huge range of factors that can affect supply and demand, and these will vary from market to market. But the basic principle is the same: when demand is greater than supply, prices rise, and when supply is greater than demand, prices fall.

Take shares. If the demand for a company’s stock rises without a rise in the number of shares on offer, its price will increase and if the number of shares in circulation increases without a rise in demand, its price will fall.

If we look at the forex market instead, the exchange rate between two currencies is the representation of demand and supply for a particular currency against another currency. For example, in the GBP/USD pair, if the demand for the British pound increased then the pair would rise in value as it takes more US dollars to buy a single pound.

The key difference is that rising prices don’t necessarily put investors off. A lot of financial markets are based on speculation, which can push prices up and up.

We see this in speculative bubbles, where the price rises far beyond the intrinsic value of the asset, and in blue-chip stocks that are deemed expensive for most investors.

The points at which financial markets find supply and demand imbalance are known as support and resistance lines. When a price reaches a level that’s deemed expensive, and no one is willing to buy it anymore, the market is said to have reached a resistance level. When there’s a fall in price, and suddenly the asset is cheap enough that there’s buying interest again, it’s said to have reached a support level.

What’s crucial is that these levels change over time. Markets break out from their support and resistance regularly, so using technical and fundamental analysis to understand market sentiment is crucial.

Each financial market will have different factors that influence its supply and demand. Let’s look at some examples.

Stock market supply and demand factors

Factors that influence supply:

• Share issues – when a company increases the supply of its shares via new share issues and stock dividends
• Share buybacks – when a company decreases the supply of its shares via buyback schemes or delisting stock

Factors that influence demand:

• Economic data – if an economy is exceeding expectations, it creates demand for stocks out of a belief they’ll report higher revenues. Economic data releases can provide key insights into a country's performance
• Interest rates – when interest rates fall, demand for stocks increase as investors seek other means of earning capital rather than storing cash in savings accounts
• Earnings – positive earnings will boost investor sentiment around a stock, while negative earnings or below expectations earnings can cause bearish sentiment

Forex market supply and demand factors

Factors that influence supply in forex:

• Demand for imports – when domestic demand for imports rises, the national currency will be sold to buy foreign currency. The more imports, the greater the supply of pounds on FX markets
• Central bank policy – when central banks lower the reserve requirements for banks, it allows them to lend more money out to consumers which increases the money supply. This typically lowers interest rates and increases investments

Factors that influence demand in forex:

• Inflation rates – a high inflation rate reduces demand for currencies because it means domestic goods increase in price compared to international goods. The currency becomes less competitive and less appealing
• Interest rates – the higher the rate of interest on returns, the higher the profit. So, currency traders tend to buy currencies with higher interest, buying them with low-interest currencies. When banks change interest rates, it impacts carry trade strategies of FX traders
• Government debt – large government debt increases inflation, and as we’ve seen high inflation directly impacts the appeal of currencies
• Political stability – a country with lower political risk is a more attractive investment for currency traders. As a result, changes in policy, bad conduct by politicians and protests can have a serious impact on the economy and weaken the domestic currency

Commodity market supply and demand factors

Factors that influence commodity supply are:

• Production capacity – as company’s increase their capacity, supply will increase. Usually, companies only increase capacity if there is a rise in demand. Falling capacity can have disastrous consequences, as we saw in the shortage of energy toward the end of 2021. Low capacity forces prices up
• Research and exploration budgets – the more money companies are willing to put toward research and exploration, the more likely it is that reserves of gold, oil and other raw materials are going to be found
• Weather events – favourable weather can result in a great harvest, leading to an oversupply of a commodity. Cold weather can increase demand for energy products, pushing products higher. But a weather disaster can not only impact the physical commodity but result in staffing shortages

Factors that influence commodity demand are:

• Economic growth – as countries grow and prosper, the purchasing power of their economies increase. Consumers buy more goods, more raw materials are needed for infrastructure projects and companies reinvest in production. In economic downturns, demand for commodities declines and investment in the industry dwindles
• Currency movements – commodity prices are directly tied to the US Dollar. If the value of the USD rises, commodity prices will fall as people become less willing to pay more for their goods
• Competition – when there is a new, cheaper or more readily-available commodity on the market, traditional commodities can see a decline in demand. For example, the rise of alternative energies is predicted to hit oil and gas prices going forward

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