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Being the gauge of the overall output of the economy, the GDP is considered the most comprehensive measure of economic activity.

In the US, the GDP actually has… not one… not two… but three releases! These are the advanced, preliminary, and final figures. The advanced reading is released four weeks after the end of the quarter.

A month later, after adjusting for seasonality and other factors, the preliminary GDP is released. This is followed by the final GDP a couple of months hence. As the first glimpse at the nation’s quarterly economic performance, the advanced GDP tends to move markets the most.

According to most economists, the US GDP likely declined for the fourth consecutive time during the second quarter of the year. The pace of contraction, however, is seen to have eased to 1.3% as opposed to the 5.5% drop during the prior period.

Consumer spending, which makes up about 70% of the US’s total output, may be slower due to instability in the labor markets.

Economists indicated that it was the record amount of fiscal stimulus packages that managed to prevent the US economy from bleeding out further. They added that the GDP will likely return to positive growth once the third quarter of 2009 comes along.

The US housing market showed some resiliency during the second quarter. In June, new home sales jumped from 346,000 to 384,000 while existing home sales for the same period climbed from 4.72 million to 4.89 million.

In addition, US retail sales registered decent gains despite poor employment conditions. Retail sales in June were stronger than expected as they rose by 0.6% after rising by 0.5% in May.

Moreover, the US trade balance deficit surprisingly narrowed from $28.8 billion to $26.0 billion, its lowest level since November 1999. A shrinking deficit signals that trade will contribute more to the nation’s GDP.

Exports jumped by 1.6%, the biggest increase since July 2008, to $123.3 billion, due to an increase in sales of petroleum products, chemicals, and industrial machinery.

The thing is, if you look at the big picture, the effect of the recession on the country’s output is terrible. No matter which angle you take, this would be the fourth consecutive quarter of decline if the forecast does hold. The US economy has not seen a fall in GDP like this since the Great Depression.

But does this matter to foreign exchange traders?!? Apparently, it doesn’t matter as exchange rates are slowly inching closer and closer to their pre-recessionary levels while the economy certainly isn’t like it was before the financial crisis.

That being said, how will the market react to a GDP figure that is better than expected? For example, let’s say the report shows just a 1% decline? Will the markets take this as an encouraging sign? After all, the US has the biggest economy in the world – if it is doing better, it may signal the start of a recovery.

Recent statements by Fed officials however have downplayed the chance of early recovery. Many have said that they expect a slow, grueling recovery that will start much later this year. If these officials are right, and the report ends up showing a slightly worse figure, could this dampen the mood of investors looking for higher yields?

Another possible outcome could be initial major volatility upon the release of the report but trading return to the consolidation area a few hours later. Take a look at the most recent GDP report from the UK.

The figure came out significantly worse than expected, which caused a major sell-off in the pound immediately after the release. Yet, a couple of hours later, the pound bounced right back up, as buyers took it as an opportunity to buy the pound. The same thing happened during the last Advance US GDP release on April 29.

Risk sentiment is driving the markets right now as investors are ignoring the weak underlying fundamentals and pricing in an economic recovery in the near future. Are investors right?

We will see if GDP gives us an encouraging sign towards recovery on Friday, but at the end of the day, sometimes traders and investors will see what they want to see and hear what they want to hear. As always, it’s up to the herd…