Fundamental Analysis
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What are Fundamental Factors?
In the currency market, there exist two basic types of analysis: fundamental analysis and technical analysis. Technical analysis will be discussed in the next lesson. Fundamental analysis gauges the intrinsic value of a country's economy, and judging on its expected future performance, positions are opened to take advantage of the anticipated trends in the currency market.
Fundamental Factors
News that has an impact on the economy both directly and indirectly is considered a fundamental factor. These fundamentals are separated into three major categories: economic factors, financial factors, and political factors which include crises.
Economic and financial factors have the biggest impact on currencies movements. The reason that economic and financial data releases are watched is the uncertainty concerning the release's outcome or results. The fundamental reports are kept under strict secrecy up to the time of the actual occurrence. Central banks, for example, change the discount rate confidentially and even though the markets closely watch these events, sometimes the outcomes do not coincide with the predictions. The deciding factor in whether a fundamental release will have an effect on the currency market is how closely the actual results come to economists' predictions. If the fundamental release matches predictions then it should have already been "priced in" to the market beforehand. However, if the release strays from the anticipated numbers, then it will have a bigger impact on the market.
The dates and times of economic data release are well known and are anticipated by the market. There are many resources available on the Internet concerning financial, and economic indicators.
Political factors can include elections, high level talks, and crises. Some political factors, such as a presidential election or a G-7 meeting are scheduled beforehand and can be anticipated. A political crisis such as a nuclear test by a rouge nation such as N. Korea, or a terrorist attack such as 9/11 can have dramatic effects on the currency markets and are almost impossible to predict. However, only big political events that can affect the patterns of trade or working of an economy or group of economies will have an effect on the financial markets.
Next we will look at an example of a fundamental release and a political crisis.
Reaction of the Forex Market to a Fundamental Release
Lets take one through an example of how to use a fundamental data release to trade Forex. Then we will show an example of a political crisis.
Release of a Fundamental Indicator (Non-Farm Employment Change)
On November 3rd, 2006, the United States Department of Labor released a monthly report called the Non Farm Payroll. This fundamental indicator (the term for a report or release) measures the change in employment in the United States for the previous month, excluding the farming sector.
For this release the figures came in above expectations of economists. As a result the Dollar strengthened that day as the data suggested that the labor sector of the US economy was doing better than expected.
As you can see, on November 3rd, there was a huge surge as price moved downward from around 1.2770 to 1.2680, a move of 90 points, or "pips" in forex lingo. There aren't any other candles in the surrounding time period where price moves as much as the 30 minutes after the release of the Non Farm Employment data.
A Political Crisis
Nukes This chart shows the reaction of the currency market to a geopolitical crisis. In this crisis, North Korea detonated a nuclear weapon in a test of their nuclear capabilities. How a particular currency will respond to geopolitical dangers depends on many factors. Here, the Japanese Yen suffers because it is a neighbor of North Korea and because the two countries have tense relations they are opposed to each other militarily. Obviously, any attack by North Korea on Japan would damage the Japanese economy. When traders got wind of these developments on Friday, October 6th, they sold the Yen and bought the Dollar. The price changed around 100 pips, meaning the amount of Yen you needed to get one Dollar went up from 117.90 to 118.90. Or, in other words it now cost one more Yen to buy a US Dollar.
Safe Haven
Since a nuclear test by North Korea is very Yen negative, the Dollar would do better since it's the opposite currency in this particular pair. The Yen's weakness withstanding, the Dollar would have still gained on this geopolitical event because it is considered a "safe haven" currency. During times of danger, investors will move their money out of riskier investments and put them into more stable ones. Since the US is the sole superpower left in the world, it naturally attracts those investors that want to park their money in a safer economy.
The US's "safe haven" status doesn't always work in times of danger in the world. If there is a geopolitical event that directly affects the United States, such as a terrorist attack, or something less immediate, such as military posturing against a state like Iran investors might sell the Dollar. Traders would be worried that the threats might come to action and there would be a war between the two countries. A war with Iran weakens the Dollar because the US economy is so tied to the oil market, of which a large proportion travels through the Persian Gulf. A military engagement against Iran would disrupt oil deliveries and cause hardship for the American economy in other ways. So, as we mentioned before, there are many factors to consider during a political crisis to see what effect it will have on a particular currency.
Macroeconomic Indicators
In the Forex market, traders are speculating on the health of countries' economies. In order to have an understanding of an economy's "fundamentals", one needs to look at how productive and vibrant the different sectors of the economy are. This involves looking at data on manufacturing, retail sales, housing construction and sales, consumer spending and confidence, and the status of the labor market. Data on these different sectors can be found in reports released by government agencies, academic institutions, and private firms.
Gross Domestic Product (GDP)
Gross Domestic Product is one of the major economic indicators that generally reflect the state of the economy of the whole country. GDP measures an economy's total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. In particular, the GDP is the market value of all final goods and services produced within a country in a given period of time. The formula used to compute GDP is: GDP= Consumption spending + Investment spending + Government spending + Imports and Exports. GDP does not discriminate between those goods and services made by the people of that country or by foreigners. As long as the goods and services are made within that country's borders, it counts towards the GDP.
Gross National Product (GNP)
GNP is the total income earned by a nation's permanent residents. Whereas GDP is the total of all final goods and services made within an economy, GNP measures the goods and services made by a nation's residents throughout the world. If a Japanese car company opens a plant in Michigan, the value of the cars made and the money spent on investment, will count towards US GDP but also to Japanese GNP as they own the capital and profits. GNP and GDP are released every quarter, but preliminary measures come out in between those releases. The formula for GNP differs from GDP by including income that US citizens earn abroad and excluding income that foreigners earn within the US.
New Durable Goods Orders
Consumers primarily use these goods. New Durable Goods Orders measures the strength of manufacturing because durable goods are designed to last three years or more. These goods can include airplanes, machine parts for factories, cars and buses, cranes, appliances, etc... Since this fundamental indicator measures new orders, it will be an indication of how actual production will perform in the near future. Production firms will have to make the durable goods to fill all the new orders. New orders directly affect the level of both unfilled orders and inventories that firms monitor when making production decisions. The Conference Board attempts to take into account inflation when measuring. In the US, New Durable Goods Orders data uses price indexes constructed from various sources at the industry level and a chain-weighted aggregate price index formula to try and "deflate" the results.
Retail Sales Indicator
The retail sales indicator is released on a monthly basis and is important to the foreign exchange trader because it shows the overall strength of consumer spending and the success of retail stores. Retail Sales impart information on the economy because it measures the amount of shopping consumers are doing. If the consumers have enough income to purchase goods at stores, then more merchandise will be produced or imported. Retail Sales is a "seasonal" indicator, meaning that during certain months retail sales are always expected to be up, for example September (when kids are going back to school) and December (the holiday season). The Retail Sales indicator is particularly important in the US, where all business is aimed toward the consumer.
Building Permits, Construction Spending, Housing Starts, New Home Sales, Existing Home Sales
Home Sales These indicators measure the vitality of an economy's housing sector. Building Permits, Construction Spending, and Housing Starts show respectively how many new homes are being planned to be constructed, how much construction is currently happening, and how many new homes have finished being built. New and Existing Home Sales show how the housing market is doing. If people are buying more homes, that means they have more money, and therefore the economy is doing better. When homes sales fall, the economy can weaken because housing is such a big sector. There are other indicators that deal with housing such as the change of prices of homes. Home price data is usually released side by side with home sales data.
Stock Prices
The stock market of a country reflects the price movements, and value of a country's biggest company's and firms. Increases (decreases) of a stock index can reflect both the general sentiments of investors and the movements of interest rates.
Interest rates and inflation are financial indicators, which are very important to future economic activity and to the foreign exchange market. We look at these indicators next.
Inflation Indicators
Inflation’s Impact on an Economy
Inflation measures at what rate prices in an economy are rising. Inflation is tied directly to the purchasing power of a currency within its borders and affects its standing on the international markets. Prices of goods, houses, labor, production materials, etc., are all closely monitored to see if their prices are increasing or not, and at what speed. Inflation can come about for different reasons.
Very Fast Growth in an Economy
In one simple example, inflation can start rising as a result of unchecked growth in an economy. Fast economic growth increases the amount of money printed and circulated throughout the economy. Extra money is necessary because consumers are taking money out of their banks and purchasing products. If businesses and stores are bringing in larger revenue and profits, then it can be expected that workers' wages will increase as well. As wages increase, consumers go out and buy even more goods.
Businesses that did not benefit from the initial extra economic activity see that the consumers, with their extra wages, have more money. They purchase more of other goods now expanding the economic activity to other sectors. In order to keep up with the extra demand the businesses may choose to raise their prices.
If these cyclical prices changes are not contained, then it takes away from the actual economic growth of the economy, as on paper people have more money, but the money buys less goods due to higher prices. For example, a retired person with retirement funds in a bank will be adversely affected if prices start rising because that nest egg is not able to buy the same amount of goods prior to inflation.
Volatile Items
In a second example, inflation can be set off by an increase in the price of just one crucial item, such as energy. If the price of oil went up, many other items that use oil in their production process will increase in price. Not only that, but consumers and businesses have to spend more of their incomes and revenues to pay for the same amount of gasoline (a products that uses oil). Inflation erodes the purchasing power of their currency. Since an economy such as the US is heavily dependent on oil for its economic activity, a rapid rise in energy costs could begin a period of inflationary pressure.
Curbing Inflation
Inflation is troublesome. It is the job of the central bank of an economy to manage price stability. The main tool that central banks have is the power to set the country's base interest rate. If inflation is running high, a central bank would raise rates in order to cool economic activity, and hopefully stem inflation. If inflation is low and the central bank wants to stimulate economic growth, they might lower rates. Since inflation has such a direct impact on a country's interest rates policy it is very important in the currency markets.
Consumer Price Index
The Consumer Price Index measures the average price level of a basket of goods and services that are purchased by consumers. Changes in the CPI represent the inflationary pressures surrounding the economy. The CPI figure is probably the most crucial indicator of inflation within the United States. Consumers buy goods and use services and the changes they experience in prices will reflect the inflation in the economy.
Producer Price Index
Producer Price Index measures the average price level for a fixed basket of capital, rent and materials needed for producers to manufacture consumer goods. Just as the CPI measures the prices from a consumer perspective, the PPI measures the prices at the producer level. PPI can show inflation before CPI because it will influence consumers next as they purchase these more expensive goods and services. Part of the inflation at the producer level is passed onto the consumers and therefore influences the CPI figure.
Average Hourly Earnings
This indicator measures the change in worker's wages. It sheds light on consumers' disposable income and on the costs to firms for their labor. Changes in wages also highlight the tightness of the labor market, as firms will have to pay their skilled workers more to retain them.
The Role of Central Banks
Central Banks Set Interest Rates
Since central banks, also known as reserve banks, play the crucial role of setting interest rates they need to be followed and studied by a fundamental (and even technical) Forex trader. Central banks want to achieve financial stability of their currency (i.e. battle inflation) and maintain overall economic growth in their country. Their primary responsibility is to oversee the monetary policy of a particular country or group of countries (in the case of the European Union). Monetary policy refers to the various efforts made to effectively control and manage the amount of money circulating within a nation. Skilled investors are able to properly identify which currency will experience an increase in interest rates based upon a central bank’s statements and incoming financial data. Those investors that are correct in their speculations can predict how the respective currencies should move, and as a result should be able to take the proper long or short positions.
Central Bank’s Role in Fighting Inflation
Central banks act in ways to lessen the effects of inflation on an economy. Inflation refers to a rise in price levels which causes a fall in the purchasing power of a currency. Inflation accounts for an entire basket of goods and services, not just an increase in the price of one item. Monitoring prices of a particular basket is known as indexing and provides a reliable method of tracking inflationary movement.
Inflation’s effects can be felt on just about everyone within a society regardless of whether one engages in trading or not. At times of high inflation, employees will demand more money for their work as the previous hourly wage no longer reflects the same value. In order to pay their employees more, businesses have to raise their prices so that they can also manage to raise the wages of its employees.
Inflation and Oil (Example)
Inflation Interestingly, inflation can be set off by the increase in price of just one crucial item (food or energy) as well. An example of a volatile commodity that can cause inflation is oil. An increase in the price of oil would cause many other items that use it as an input in the production process (such as gasoline) to also increase in price and therefore begin the inflationary process. Inflation poses a problem to the population because it erodes people’s wealth and standard of living as their bank accounts and wages seem to diminish while prices get higher. The purchasing power of the currency decreases and the currency loses strength. Therefore inflation’s erosive nature necessitates the actions taken by the central bank.
Affects of Inflation on Interest Rates and Investment
If inflation is a concern then the central bank will raise interest rates to appease the inflationary pressure. Higher interest rates will cause inflation to slow because it will cost more for companies and consumers to borrow from banks to fund either investment spending or consumption (i.e. for consumers it will be harder to refinance a mortgage on a house to free up spending money). With more restrictive access to money, economic activity slows down and so do inflationary pressures.
The higher interest rate will cause the currency to appreciate in the eyes of investors, both domestic and foreign, as they will benefit from a higher yield on the country's assets. If the currency is now appreciating relative to other currencies, then Forex traders will buy into it in order to trade with the trend, sending even more money towards that economy.
It is therefore a delicate balance that central banks have to strike. They would like higher interest rates to strengthen the currency and promote foreign investment, but they must be aware that higher interest rates hurt domestic businesses and consumers that rely on borrowing money from banks.
In the following pages, we shall look at an example of interest rates and central banks, and their impact on the Forex market at work.
Market Reactions to Central Banks - FOMC Example
We will attempt to show how important interest rates are to currency movements by examining price action on the Forex market during a recent central bank tightening campaign. The following example focuses on the EUR/USD pair.
Let’s investigate the implication of the United States Federal Reserve’s interest rate decisions to the value of the US Dollar.
Dollar Gaining
EUR/USD - December 2004 - December 2006:
The Euro started 2005 at a high exchange rate, 1.3500 Dollars per Euro. US interest rates had been hovering at very low rate of 1% prior to this time and the Euro was appreciating. In 2005, on the other hand, there was steady Euro depreciation. The US central bank, the Federal Reserve, continued a campaign, started in July 2005 to gradually raise interest rates from 1%. At every subsequent meeting of the Federal Open Market Committee (FOMC), federal officials increased the base interest rate by .25%. Financial markets reacted to this gradual hiking campaign by favoring and strength ending the Dollar. When 2006 started, the EUR/USD pair traded around 1.2000, a change of 13 cents or 1300 pips. The central bank's actions were a major cause for the Dollar appreciating in 2005.
Trend Reverses
EUR/USD - March 2005 - April 2006:
In December ‘05, at the 1.2000 level, the Euro finds support and begins to gain (second rectangle). At this time investors are speculating that the Fed tightening campaign is likely coming to an end. Similar speculation, and Euro appreciation, happened between July and August ‘05 (first rectangle). In February the Fed’s base rate was raised to 4.50%. Speculation that the Federal Reserve would finally pause after 15 straight rate hikes continued throughout March and the first half of April, creating an upward trend favoring the Euro.
FOMC Example Continued
Let's continue examining how the market reacts to changes in the US interest rate outlook. We turn to 2006.
Euro Uptrend Continues
1. On March 28th the Federal Open Market Committee (FOMC) continued their campaign to hike rates by increasing the base rate for the 15th consecutive time by .25% to 4.75%.
Even though the FOMC raised rates, which would favor the currency, the Euro continued climbing against the Dollar. Investors and traders kept up the speculation that the Federal Reserve was ready to end their campaign. The only question was how much further further they would go.
EUR/USD - December 2005 - May 2006
2. On April 14th, Greg Ip, a prominent Wall Street Journal reporter that follows the Federal Reserve closely, wrote that its officials were divided regarding the need for further tightening, fueling investors’ expectations that the base rate would stop at 5%. This news along with other Dollar negative factors (a standoff with Iran over their nuclear ambitions) accelerated Dollar losses for the next four weeks.
The EUR/USD pair went from trading at 1.2100 to 1.2900 which is a significant 800 pip move that translates to a change of $8,000 dollars for a 1 Lot position. Whether the position gained or lost the 800 pips depends on whether the open position was a buy or sell of the pair.
3. On May 10th, the FOMC met and raised the rate to 5%. In the announcement that accompanied the rate hike the Federal Reserve officials said that “further tightening would depend on incoming economic data”. This statement clouded the intentions of the FOMC for their next meeting, which was scheduled for June 29th. A couple of days later when the pair closed in on 1.3000, it stopped trending and entered a ranging market as investors analyzed what the Federal Reserve would do next.
Federal Reserve Chairman Moves Markets with Hawkish Talk on Interest Rates
The start of June brought some clarification to investors and traders. The still new Federal Reserve chairman Ben Bernanke, at a speech, said that “recent inflation measures were higher than his comfort zone”. These comments were regarded as highly “hawkish” a term to mean an official that favors higher interest rates. “Dovish” statements are those that favor cutting rates. Bernanke's comments caused the Dollar to immediately strengthen as it seemed that the base rate would not stop at 5%, contradicting the earlier speculation that had built up following the Wall Street Journal news report and analysts predictions.
In the next 7 trading sessions, the EUR/USD moved from 1.2950 down to 1.2550 a change of 400 pips (or $4,000 for a 1 Lot position). We have already explained what role inflation plays in the considerations of central bank officials.
The Dollar strengthened on the changing US interest rate outlook, touching the older upper (green) trendline we had drawn previously in March/April. From this point, the pair enters another, larger ranging market with price bouncing between 1.2900 and 1.2500. The ranging market developed because investors and traders were unsure about what would happen next since higher inflation readings meant that the FOMC could continue raising rates. If inflation did not pose a problem then the FOMC could pause in their rate hiking campaign.
Now that we have taken you through an example of how central banks impact the Forex market let’s take a closer look at the main central banks.
8 Central Banks You Need to Know
The world’s central banks possess similar forms of operation and structure although their long term goals may vary.
There are eight major central banks within the world economy today:
1.US Federal Reserve Bank (USD)
2.European Central Bank (EUR)
3.Bank of England (GBP)
4.Bank of Japan (JPY)
5.Swiss National Bank (CHF)
6.Bank of Canada (CAD)
7.Reserve Bank of Australia (AUD)
8.Reserve Bank of New Zealand (NZD)
Federal Reserve Bank- United States
The Federal Reserve The most influential bank is the US Federal Reserve Bank because the US dollar is the most heavily traded currency. The Federal Reserve’s Federal Open Markets Committee (FOMC) decides on interest rates and is made up of 7 governors of the Reserve Board and 5 of the 12 district reserve presidents. The Federal Reserve meets 8 times a year and its key official is Ben Bernanke, the chairman of the Federal Reserve. Twelve regional Federal Reserve Banks were created so that the economic operations of the United States can be monitored efficiently.
The FOMC committee meets about every six weeks. The FOMC is comprised of members from the Federal Reserve Board that are both appointed and approved through joint efforts of the President, Congress and regional Federal Reserve Bank presidents. The decisions made by the FOMC are closely watched by investors both within and outside of the US because it gives traders an idea of the economic sentiment, which can be used to predict possible interest rate movements.
The European Central Bank
European Central Bank The European Central Bank was established after the creation of the Euro in 1998. It oversees the actions of the other member European central banks such as the Banque de France or Ufficio Italiano dei Cambi. The European Central Bank has a group similar to the Federal Open Markets Committee that helps decide on the changes that may need to be made to monetary policy. The committee is known as the Governing Council and is comprised of 6 members of the executive board of the European Central Bank in addition to all the governors of the national central banks from the countries which use the Euro. The Governing Council meets twice a week but only changes policy at 11 of these meetings. The key official associated with the Governing Council is Jean-Claude Trichet, who is the President of European Central Bank.
The Bank of England
Bank of EnglandThe Bank of England consists of a committee known as the Monetary Policy Committee. It is comprised of 9 members, which include a governor, 2 deputy governors, 2 executive directors and 4 outside experts. The main official associated with the Bank of England is a man by the name of Mervyn King who is the governor of the Bank of England. The Monetary Policy Committee meets once every month in order to discuss any policy changes.
The Bank of Japan
Bank of Japan The Bank of Japan also has a committee that consists of the Bank of Japan governor, two deputy governors along with 6 other members.
It meets once or twice a month and the key official associated with the Bank of Japan is Toshihiko Fukui who is the governor of the Bank of Japan.
The Swiss National Bank
Swiss BankThe Swiss National Bank has a very small committee that consists of just 3 people and is typically more conservative as far as interest rate movements are concerned.
The committee meets quarterly and the key official associated with the Swiss Bank is Jean-Pierre Roth who is the Chairman of the Swiss National Bank.
The Royal Bank of Canada
The Bank of Canada also has a committee which is known as the governing council. The governing council consists of the governor of the Bank of Canada, the senior deputy governor and four deputy governors. The committee meets about 8 times a year and the key official associated with the bank is David Dodge, who is the governor of the Bank of Canada.
The Reserve Bank of Australia
The Reserve Bank of Australia consists of a monetary policy committee which contains a central bank governor, deputy governor, the secretary to the treasurer and 6 independent members appointed by the government. The committee meets about eleven times a year and the key official for the Reserve Bank is Ian Macfarlane, who is the Governor of the Reserve Bank of Australia.
The National Bank of New Zealand
Finally, the National Bank of New Zealand unlike all the other banks has no committee. In fact, all the power of monetary policy lies in the hands of one individual: the central bank governor. The decision is made about 8 times a year by Alan Bollard who is the governor.
