Forex First Grade: Fundamental Analysis 2: The Core

FOREX FIRST GRADE: Fundamental analysis 2: The Core

(this is a pretty long article, but after you've read it you'll definitely be more up to speed with the most important factors concerning fundamental analysis)

Fundamental Indicators

Look at the average Forex Events Calendar and you'll be confronted with a buffet of figures. A small selection:

Unemployment Rate
Building permits
Crude Oil Inventories
CPI y/y
CPI Underlying m/m
Housing Starts
Pending Home Sales
Fed Chairmen Speaks

And of course the complete list is much longer. Those of us who don't know anything about economics but have an aptitude for mathematics may feel the urge to skip this article and go straight to the section about technical indicators, but if you do, you'd really be boxing with one arm. Besides, it really isn't all that hard (that's what she said) once you get a frame of reference. After all, you don't have to calculate or find these numbers yourself, you only have to learn how to interpret them.

Now, most of us will turn out to become short term traders, maybe even ultra intra-day, meaning opening and closing positions in the span of an hour or so. This is important, because the golden rule concerning economic news is: the shorter the term you trade in, the more important economic news becomes. Generally, the first half hour after a news event hits the market is crucial.
Example: If everybody expects the US GDP (Gross Domestic Product) over the last quarter to have risen 2%, and it turns out to be 0,5%, there is a high chance of this impacting the markets in the first 30 hour after the release. But it probably won't still have an impact after 2 days.

But because 90% of the Forex traders focusses on the short term (shorter than 2 days), this kind of news will influence pairs like the EUR/USD, GBP/USD immediately.

The famous/infamous (denomination depending on whether you/re a capitalist or a socialist) investor Warren Buffet has held on to a Long EUR/USD position for years. Some analysts have criticized him over this, mainly in times the EUR/USD gave back lots of his gains since 2002 (when the EUR/USD was at 0,8 USD), but Mr. Buffet is in it for the long haul, and clearly that strategy has made him a very rich man. Clearly he is not using day to day news to determine whether or not he's going to hang on to his position, but uses the more fundamental approach of long term comparison between the US and EUROzone economy.

For most of us hyperactive traders though, the world goes around a lot faster....:)


The 4 Fundamental Theme's

The 4 fundamental theme's that drive the currency market are:
1) Economic growth
2) Interest Rates
3) Trade Balance
4) Political stability

Economic Growth
Obviously important. The power of a national currency will be determined first and foremost by the power of the economy in which it functions. And like a companies' quarterly/yearly figures tell a lot about the health of that company, so do quarterlies / yearlies of a country say a lot about the economic health of that country. And so the first focus of attention for forex traders is the economic power of national economies.

So when the GDP of Germany (The EURO zone's biggest economy) has increased with 1% MORE than expected by analysts -with stable inflation- the value of the EURO will probably go up. On the one hand because companies will want to invest more in the German economy (increasing the demand for the EURO) -which is economic reality- on the other hand because forex traders will start speculating a rise in the Euro (which is speculative reality).

Important indicators for economic growth are, among others: GDP q/q, GDP y/y, unemployment rate, non-farm payrolls, Industrial Production and consumer confidence.

Interest Rates
Everybody that had some economics classes in high school knows that economies develop in a wave like trend (conjuncture), going up and down. There are both short term trends as there are long term ones (spanning about 50 years).

Roughly speaking, national governments have 2 tasks when it comes to macro-economics:
1) To stimulate growth of the GDP
2) To take the edge of the highs and the lows of the economic trend lines.

Point 1: Makes sense of course. The bigger the economy, the richer the country, the more prosperous it's citizens (on the whole that is)
Point 2: Little less obvious at first sight perhaps. That nobody likes the lows is clear (recession), but what's wrong with the highs? Well, it sort of comes down to this: 'What goes up, must come down.' A super fast growing economy that isn't restrained a bit can get over stressed and over stretched. Not enough workers for all the jobs out there, ever increasing wages, ever increasing prices, increasing shortage on the money market (because everybody is investing it) and therefor increasing interest rates, and then, at some point...The Big Reverse.
The sentiment turns, and all of a sudden there is much more production capacity than there is demand; people are laid of, social welfare costs skyrocket, the amount of investment money rapidly decreases and the economy races down. (which is exactly what happened in 1929, when the Great Depression started)

Nobody wants this, so the government tries to keep the trend line of it's economy in check, to produces lower highs and higher lows.

An important means to achieve this the Interest Rates, the rates that the Central Banks (FED, ECB, BOE, BOJ) charge to commercial banks for loaning money on the short term. This is important, because when it gets more expensive for commercial banks to loan money, it will also get more expensive for companies to borrow money; this, in turn, will slow down economic growth. And of course the reverse is true as well: lower interest rates stimulate the economy.

So when a Central Bank changes the interest rates it says something about: a) how the Central Bank thinks about the situation of the economy and b) whether growth is stimulated or slowed down.
When interest rates are increased the money market will tighten (because it gets more expensive to loan money) and the value of the currency whose rates are increased, generally goes up. And vice versa.

Exception
An important exception is when the Central Bank increases Interest Rates to curb inflation while there is no high economic growth (after GDP is compensated for inflated prices). If investors and traders continue to fear that the currency will keep loosing purchasing power there will be no added strength for the currency despite the rate hike.

But in general we could say:
Interest Rate up = Value of currency up
Interest Rate down = Value of currency down

Trade Balance
Suppose the US buys a $100 billion worth of goods more from the EU than it sells back. To buy those goods the Americans need Euros, so in fact they would buy $100 billion worth of Euros and sell that same amount of dollars. This trade deficit with the EU will make the EURO increase in value when compared to the USD.

The reality is often more complex than this simple example, but it is important to understand that the value of a currency as compared to another can decrease if a country has a(n) (increasing) trade deficit. So if the there is an economic event stating that the US trade balance -which was expected to be +2%- turns out to be -3%, that is a strong indicator that the USD is going to loose strength.

Political Stability
Much more than the stock market, the FX market is influenced by politics. This is understandable when you consider that the forex market 'trades' in economies, instead of individual companies.

Political instability can harm economic growth or a country and thus the currency of that country. A corruption scandal within the government can especially hurt a currency.
An example of this is the decline of the CAD as compared to the USD in the summer of 2005. This despite rising oil prices, something the Canadian Dollar profits from more often than not (they are the largest supplier of oil to the US), because the ruling Liberal Party was subject to a political scandal. After a motion for resignation of the administration was voted away (by 1 vote!) the CAD climbed up again....

Conclusion
Even though your natural inclination might be more towards technical indicators (that we'll talk about further on) it would still be smart to keep an eye on these 4 fundamental key factors. An example of using the best from both worlds is the situation surrounding the EUR/USD in 2004, when the USD continued to make new lows against the EUR, even though there were several surprisingly positive economic developments in the US. After the technical indicators also started to show weakness in the EUR/USD, technical traders that had also watched the fundamentals could open short EUR/USD positions with much more confidence, and profit from the dollar rally that followed.