Fundamental Analysis for Forex

Fundamental analysis is the study of economic factors that influence foreign exchange rates in the hope of trying to forecast future rates. Fundamental analysis in forex attempts to predict currency moves by studying interest rates, government policies, business cycles, and economic growth in the 2 countries where the currencies are being compared. Both countries must be compared because the foreign exchange rate is determined by the relative value of the currencies in the 2 countries, so if economic factors increase the strength of the currency in 1 country, that will have the same effect on the exchange rate if economic factors in the other country weakens its currency. So any change in exchange rates can result either because a currency strengthened or the other weakened, or both, and vice versa. In contrast, technical analysis involves the study of volume and price levels, and chart patterns of currencies to forecast future currency moves, which is predicated on the assumption that certain patterns in the charts can forecast, more often than not, exchange rates.

It is fundamental analysis, however, that examines the economic factors that ultimately determines currency rates, since it is based on cause and effect. Since any forex transaction involves the exchange of 1 currency for another, fundamental analysis must, by necessity, take into account the supply and demand of each currency with respect to the other, which determines the exchange rate. Hence, proponents of fundamental analysis try to ascertain supply and demand by studying various economic indicators and other economic data which will affect the supply and demand of each currency with respect to the other.

The most important economic factors of the 2 currencies being compared are inflation rates, interest rates, and investment opportunities. The 2 factors that governments have the most influence over are inflation and interest rates.

Inflation is generally caused when the government increases the money supply faster than the economy is growing. If the inflation rate is higher in one country then in another, then the relative value of its currency will decline. Indeed, some countries print so much money that the currency becomes worthless as money. For instance, people in Zimbabwe would sometimes use Zim dollars as toilet paper. Because money has such an important function in all societies, people will often find substitutes when the domestic currency becomes worthless — even using the currency of another country, in what is known as dollarization.

While inflation lowers the value of currency, higher interest rates increase it, since higher interest rates draws capital from around the world as money seeks a higher rate of return, thereby, increasing the demand for the currency as foreigners convert their domestic currency into the investment currency. One such example is the so-called carry trade, which involves borrowing currency from a country with low interest rates to invest it in a country with higher rates, such as when investors borrow Japanese yen at low interest rates to invest in New Zealand and Australia, which usually have the highest interest rates.

Investment opportunities have the same effect as higher interest rates; indeed, higher interest rates are simply another form of investment opportunity. However, other than interest rates, governments do not have as much control over investment opportunities, although they exert influence by their stewardship of their economies. Another major factor is the size of the economies. If an economy is underdeveloped, compared with the rest of the world, then it will have a much greater potential for growth relative to a developed economy, since foreign companies will seek to sell their goods and services in a market that is far from being saturated. Such is the case today, as companies around the world strive to have a presence in China and India, where the potential for sales growth is much greater than in, say, the United States or Europe.

Investment risks have the opposite effect of higher interest rates and greater investment opportunities, in that higher investment risks will lower the demand for the investments. In foreign exchange, after inflation and interest rate risk, the main investment risks in foreign countries, especially smaller, volatile countries, is political risk. Political risk often takes the form of market volatility, when it becomes difficult to forecast interest rates or other economic factors that may affect businesses. High taxes may reduce investment returns and the country may institute capital controls, restricting the flow of capital either into the country or out of the country or both. Any type of capital control will reduce the demand for the currency, since investors usually don't like to lose control of their capital.

Since inflation, interest rates, and returns on investments are the most important factors in determining exchange rates, foreign exchange traders frequently scan publications — mostly issued by central banks, since they usually determine interest rates and control the supply of money — for any indication on how these factors will change. Forex traders generally have expectations about what a country will do, so any surprises from what was expected may change exchange rates dramatically. Hence, the key to forecasting exchange rate moves using fundamental analysis requires that the trader know the publication schedule of major reports for each relevant country and understand their significance.

Economic Indicators

Economic indicators are statistics, published periodically, that measure various factors of the economy, many of which affect, or are affected, by the supply and demand of the domestic currency. Moreover, central banks rely on economic indicators to formulate monetary policy, which can have a significant effect on foreign exchange rates. Virtually every country has its own economic indicators, and in trying to forecast the exchange rate between 2 currencies, the economic indicators of both countries must be considered in trying to forecast the direction of the movement of the currency pair. Because the United States dollar is arguably the most important currency, and because economic indicators for other major countries are similar, some of the more important indicators for the United States are listed below.

Beige Book

In formulating the nation's monetary policy, the Federal Reserve considers a number of factors, including the economic and financial indicators which follow, as well as the anecdotal reports compiled as summaries for each Federal Reserve District that are published 8 times per year in the Beige Book, otherwise known as the Summary of Commentary on Current Economic Conditions. Information on economic conditions is gathered by each Federal Reserve Bank in its District through reports from bank and branch directors and interviews with key business contacts, economists, market experts, and other sources.

Main Economic Indicators

Real Gross Domestic Product (GDP)

The real gross domestic product (GDP) measures the total real value, with the effects of inflation removed, of goods and services produced within the borders of the United States, regardless of who owns the assets or the nationality of the labor used in producing that output. Along with the unemployment rate and inflation rate, this is the best measure of the effectiveness of monetary policy. (In contrast, Gross National Product (GNP) measures the output of U.S. citizens and the income earned from assets owned by US entities, regardless of where located.)

Quarterly publication by the US Department of Commerce, Bureau of Economic Analysis.

Real Gross Domestic Product (GDP) Chart

Consumer Price Index (CPI)

The Consumer Price Index is the main barometer of inflation, designed to measure the price change of a fixed market basket of goods and services, adjusted to remove differences in the quality of the goods and services, that are representative of the purchases of a typical urban consumer. The objective of the index is to measure price changes that result from changes in the quantity of money rather than changes that resulted from differences in quality of the goods and services. Most economists, however, agree that CPI overstates inflation by about 1%.

Published monthly by the U.S. Department of Labor, Bureau of Labor Statistics.

Consumer Price Index (CPI) Chart

Nonfarm Payroll Employment

Nonfarm Payroll Employment is an estimate of the number of payroll jobs at all nonfarm businesses and government agencies, the average number of hours worked per week, and the average hourly and weekly earnings. Because labor is an important economic factor of production, the unemployment rate is a good indicator of how closely economic output is to the potential output, which is a measure of economic efficiency. A falling unemployment rate is a good indicator of economic growth, while an increasing unemployment rate indicates economic decline.

Published monthly by the U.S. Department of Labor, Bureau of Labor Statistics.

Nonfarm Payroll Employment Chart

Less Important Economic Indicators

Housing Starts

Housing starts are an estimate of the number of housing units starting construction, which is defined as excavation for the foundation, which is generally the first thing to be done to actually build the house. Because of natural disasters, such as Hurricane Andrew in August of 1992, starting construction also includes housing units built on existing foundations after the previous structures have been completely destroyed. One housing start is counted for each single-family unit, so the construction of an apartment building with 10 apartments is counted as 10 starts.

Because housing starts are very sensitive to long-term interest rates and represent a volatile segment of the economy, it has a great influence on the changes in GDP, even though residential investments represents just 4% of GDP. Hence, it is considered a good barometer of near-term economic performance.

Published monthly by the U.S. Department of Commerce, Bureau of the Census.

Housing Starts Chart

Industrial Production/Capacity Utilization

The industrial production/capacity utilization index is grouped by both products (consumer goods, business equipment, intermediate goods, and materials) and industry (manufacturing, mining, and utilities) and is designed to measure changes in the industrial sector output, which constitutes about 20% of GDP. This index is considered a good indicator of near-term inflation rates because when industrial production nears its limits on capacity utilization, inflation tends to increase.

Published monthly by the Board of Governors of the Federal Reserve System.

Industrial Production/Capacity Utilization Chart

Retail Sales

The retail sales index provides an estimate of the total sales of goods, but not services, by all retail establishments in the U.S. Sales are categorized by type of establishment, not by type of good. Although the data are adjusted for seasonal, holiday, and trading-day differences between the months of the year, it is not adjusted for inflation.

Because personal consumption expenditures (PCE) represent roughly 2/3 of GDP, retail sales are a good indicator of the likely growth of PCE for the current and future quarters.

Published monthly by the U.S. Department of Commerce, Bureau of the Census.

Retail Sales Chart

Business Sales and Inventories

The business sales and inventories index shows the total dollar sales and inventories for the manufacturing, wholesale, and retail sectors of the economy, unadjusted for inflation. The level of inventories is considered a good indicator of near-term economic activity — when inventory turnover ratios are high, businesses will increase production; whereas low inventory turnover ratios will cause businesses to cut back on production, and may also lay off workers until the excess inventory is eliminated.

Published monthly by the U.S. Department of Commerce, Bureau of the Census.

Business Sales and Inventories Chart

Advance Durable Goods Shipments, New Orders and Unfilled Orders

Provides data on shipments, new orders, and unfilled orders, expressed in current dollars, for things such as primary metals, fabricated metals, electric generating equipment, nonelectrical machinery, information processing equipment, and transportation equipment, including civilian and military aircraft and ships, light-, medium-, and heavy-duty trucks, and automobiles. Indicates the strength of demand, from both domestic and foreign sources, for U.S. manufactured durable goods. Strengthening demand causes orders, shipments, and unfilled orders to increase. As a result, production and employment will also probably increase. Falling orders, shipments, and unfilled orders, on the other hand, is an indicator of a possible economic slowdown. This index also indicates the current and likely future pace of business investment in new equipment.

Published monthly by the U.S. Department of Commerce, Bureau of the Census.

Advance Durable Goods Shipments, New Orders and Unfilled Orders Chart

Light-Weight Vehicle Sales

Total unit sales and leases, to both consumers and businesses, of domestic and imported new automobiles and light-weight trucks (up to 10,000 pounds gross vehicle weight). Lightweight vehicle sales are a good indicator of quarterly changes in GDP growth rate.

There are 2 major sources of lightweight vehicle sales: information provided by Ward's Automotive Reports and the American Automobile Manufacturers Association is not seasonally adjusted, whereas sales data provided by the U.S. Department of Commerce, Bureau of Economic Analysis is seasonally adjusted.

These reports are published monthly and on the 1st, 2nd, and 3rd 10 days of each month.

Light-Weight Vehicle Sales Chart

Yield on 10-year Treasury Bond

The current market interest rate or yield on 10-year U.S. Treasuries, which indicates the market's expectations for future interest rates. Higher interest rates could mean either higher expected inflation or a tighter monetary policy by the Federal Reserve. In either case, higher interest rates dampen economic activity, particularly the housing market.

Published daily by the Board of Governors of the Federal Reserve System.

Yield on 10-year Treasury Bond Chart

S&P 500 Stock Index

The S&P 500 Stock Index is but one of many stock indexes that reflects the change in prices of many stocks. Stock prices, and therefore the S&P 500, generally presage future economic activity. Stock indexes usually rise before the economy does and falls before the economy reaches a peak; hence, the S&P 500 is one of the components of the Index of Leading Indicators.

Compiled by Standard & Poor's and published throughout the business day on many financial websites.

S&P 500 Stock Index Chart

M2

M2 is a measure of the nation's money supply, defined as M1 (currency in circulation, demand deposits, travelers' checks, and other checkable deposits) plus non-institutional money market funds and small time and savings deposits. M2 is not considered a good indicator of future economic activity since the growth of the money supply and the growth of nominal GDP is considered relatively weak.

The H.6 report, as it is called, is published weekly and monthly by the Board of Governors of the Federal Reserve System.

M2 Chart