It is commonly accepted that there are two major schools when formulating a trading strategy for any market, be it securities, futures, or currencies. These two disciplines are called fundamental analysis and technical analysis. The former is based on economic factors while the latter is concerned with price actions. The trader may opt to include elements of both disciplines while honing his or her personal trading strategy. Typically, fundamentals are about the long term; technicals are about the short term. Keep in mind what Lord Keynes once wrote: “In the long run we are all dead.”
Supply and Demand
Fundamental analysis is a study of the economy and is based on the assumption that the supply and demand for currencies is a result of economic processes that can be observed in practice and that can be predicted. Fundamental analysis studies the relationship between the evolution of exchange rates and economic indicators, a relationship that it verifies and uses to make predictions.
For currencies, a fundamental trading strategy consists of strategic assessments in which a certain currency is traded based on virtually any criteria excluding the price action. These criteria include the economic condition of the country that the currency represents, monetary policy, and other elements that are fundamental to economies.
The focus of fundamental analysis lies in the economic, social, and political forces that drive supply and demand. There is no single set of beliefs that guides fundamental analysis, yet most fundamental analysts look at various macroeconomic indicators, such as economic growth rates, interest rates, inflation, and unemployment. Several theories prevail as to how currencies should be valued.
Done alone, fundamental analysis can be stressful for traders who deal with commodities, currencies, and other margined products. The reason for this is that fundamental analysis often does not provide specific entry and exit points, and therefore it can be difficult for traders to control risk when utilizing leverage techniques.
Currency prices are a reflection of the balance between supply and demand for currencies. Interest rates and the overall strength of the economy are the two primary factors that affect supply and demand. Economic indicators (for example, gross domestic product, foreign investment, and the trade balance) reflect the overall health of an economy. Therefore, they are responsible for the underlying changes in supply and demand for a particular currency. A tremendous amount of data relating to these indicators is released at regular intervals, and some of this data is significant. Data that is related to interest rates and international trade is analyzed closely.
Interest Rates
If there is an uncertainty in the market in terms of interest rates, then any developments regarding interest rates can have a direct effect on the currency markets. Generally, when a country raises its interest rates, the country’s currency strengthens in relation to other currencies as assets are shifted away from it to gain a higher return elsewhere. Interest rate hikes, however, are usually not good news for stock markets. This is because many investors withdraw money from a country’s stock market when there is an increase in interest rates, causing the country’s currency to weaken. See Figure 10.1.
Knowing which effect prevails can be tricky, but usually there is an agreement among practitioners in the field as to what the interest rate move will do. The producer price index, the consumer price index, and the gross domestic product have proven to be the indicators with the biggest impact. The timing of interest rate moves is usually known in advance. It is generally known that these moves take place after regular meetings of the BOE (Bank of England), Fed (U.S. Federal Reserve), ECB (European Central Bank), BOJ (Bank of Japan), and other central banks.
Balance of Trade
The trade balance portrays the net difference (over a period of time) between the imports and exports of a nation. When the value of imports becomes more than that of exports, the trade balance shows a deficit (this is, for the most part, considered unfavorable). For example, if Euros are sold for other domestic national currencies, such as U.S. dollars, to pay for imports, the value of the currency will depreciate due to the flow of dollars outside the country. By contrast, if trade figures show an increase in exports, money will flow into the country and increase the value of the currency.
Fig 2: U.S. Balance of Trade
In some ways, however, a deficit is not necessarily a bad thing. A deficit is only negative if the deficit is greater than market expectations and therefore will trigger a negative price movement. See Figure 2 above.
Purchasing Power Parity
Purchasing power parity (PPP) is a theory that states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries’ price levels of a fixed basket of goods and services. When a country’s domestic price level is increasing (i.e., a country experiences inflation), that country’s exchange rate must depreciate in order to return to PPP.
The basis for PPP is the “law of one price.” In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 500 U.S. Dollars (USD) in Seattle should cost 750 Canadian Dollars (CAD) in Vancouver when the exchange rate between Canada and the United States is 1.50 USD/CAD. If the price of the TV in Vancouver costs only 700 CAD, however, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called arbitrage) is carried out on a large scale, the U.S. consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods again have the same price. There are three caveats with this law of one price: (1) as mentioned earlier, transportation costs, barriers to trade, and other transaction costs can be significant; (2) there must be competitive markets for the goods and services in both countries; (3) the law of one price only applies to tradable goods— immobile goods such as houses and many services that are local are not traded between countries.
Economists use two versions of purchasing power parity: absolute PPP and relative PPP. Absolute PPP was described in the previous paragraph; it refers to the equalization of price levels across countries. Put formally, the exchange rate between Canada and the United States ECAD/USD is equal to the price level in Canada PCAN divided by the price level in the United States PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1 USD. If today’s exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get stronger) against the USD, and the USD will in turn depreciate (get weaker) against the CAD.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For example, if Canada has an inflation rate of 1 percent and the United States has an inflation rate of 3 percent, the U.S. Dollar will depreciate against the Canadian Dollar by 2 percent per year. This proposition holds well empirically, especially when the inflation differences are large.
The simplest way to calculate purchasing power parity between two countries is to compare the price of a “standard” good that is, in fact, identical across countries. Every year the Economist magazine publishes a lighthearted version of PPP: Its “Hamburger Index” lists the price of a McDonald’s hamburger in various countries around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems in computing a comprehensive PPP is that people in different countries consume different sets of goods and services, making it difficult to compare the purchasing power between countries.
Gross Domestic Product
The gross domestic product (GDP) is the total market value of all goods and services produced either by domestic or foreign companies within a country’s borders. GDP indicates the pace at which a country’s economy is growing (or shrinking) and is considered the broadest indicator of economic output and growth.
GDPs of different countries can be compared by converting their value in national currency according to either exchange rates prevailing on international currency markets or the purchasing power parity (PPP) of each currency relative to a selected standard (usually the U.S. Dollar).
The relative ranking of countries may differ dramatically depending on which approach is used: Using official exchange rates can routinely understate the relative effective domestic purchasing power of the average producer or consumer within a less-developed economy by 50 percent to 60 percent, owing to the weakness of local currencies on world markets.
However, comparison based on official exchange rates can offer a better indication of a country’s purchasing power on the international market for goods and services.
Intervention
Another important fundamental influence on FOREX currency prices is called intervention. This occurs when an official regulatory agency or a financial institution with one government directly coerces the exchange rate of its currency, usually by reevaluation, devaluation, or by the manipulation of imports and exports in some way.
Such actions may cause broad and erratic changes in the exchange rate with foreign currencies. However, it is from such anomalies that the FOREX trader may profit, if the proper stop-loss safeguards are in place.
Other Economic Indicators
The range of economic indicators and the standing reports generated from them are extensive. Here are a few others that impact currency prices.
Industrial Production
Industrial production (IP) is a chain-weighted measure of the change in the production of the nation’s factories, mines, and utilities, as well as a measure of their industrial capacity and how many available resources among factories, utilities, and mines are being used (commonly known as capacity utilization). The manufacturing sector accounts for one-quarter of the economy. The capacity utilization rate provides an estimate of how much factory capacity is in use.
Purchasing Managers Index
The National Association of Purchasing Managers (NAPM), now called the Institute for Supply Management, releases a monthly composite index of national manufacturing conditions, constructed from data on new orders, production, supplier delivery times, backlogs, inventories, prices, employment, export orders, and import orders. It is divided into manufacturing and nonmanufacturing subindices.
Producer Price Index
The producer price index (PPI) is a measure of price changes in the manufacturing sector. It measures average changes in selling prices received by domestic producers in the manufacturing, mining, agriculture, and electric utility industries for their output. The PPIs most often used for economic analysis are those for finished goods, intermediate goods, and crude goods.
Consumer Price Index
The consumer price index (CPI) is a measure of the average price level paid by urban consumers (80 percent of the population) for a fixed basket of goods and services. It reports price changes in more than 200 categories. The CPI also includes various user fees and taxes directly associated with the prices of specific goods and services.
Durable Goods
The durable goods orders indicator measures new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods. A durable good is defined as a good that lasts an extended period of time (three years or more) during which its services are extended.
Employment Index
Payroll employment is a measure of the number of jobs in more than 500 industries in all 50 states and 255 metropolitan areas. The employment estimates are based on a survey of larger businesses and count the number of paid employees working part-time or full-time in the nation’s business and government establishments. Currently, the Non-Farm Payroll Report (NFP), issued the first Friday of each month, is closely watched by traders of the USD. News traders much anticipate this report because the prereport consensus of the number is typically incorrect—resulting in short-term fireworks for the USD currency pairs.
Retail Sales
The retail sales report is a measure of the total receipts of retail stores from samples representing all sizes and kinds of business in retail trade throughout the nation. It is the timeliest indicator of broad consumer spending patterns and is adjusted for normal seasonal variation, holidays, and trading-day differences. Retail sales include durable and nondurable merchandise sold, and services and excise taxes incidental to the sale of merchandise. Excluded are sales taxes collected directly from the customer.
Housing Starts
The housing starts report measures the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing. Housing is interest rate–sensitive and is one of the first sectors to react to changes in interest rates. Significant reaction of starts/permits to changing interest rates signals that interest rates are nearing a trough or a peak. To analyze the data, focus on the percentage change in levels from the previous month. The report is released around the middle of the following month.
Forecasting
Fundamental analysis refers to the study of the core underlying elements that influence the economy of a particular entity. It is a method of study that attempts to predict price action and market trends by analyzing economic indicators, government policy, and societal factors (to name just a few elements) within a business cycle framework. If you think of the financial markets as a big clock, the fundamentals are the gears and springs that move the hands around the face. Anyone walking down the street can look at this clock and tell you what time it is now, but the fundamentalist can tell you how it came to be this time and, more importantly, what time (or more precisely, what price) it will be in the future.
There is a tendency to pigeonhole traders into two distinct schools of market analysis—fundamental and technical. Indeed, the first question posed to you after you tell someone that you are a trader is generally “Are you a technician or a fundamentalist?” The reality is that it has become increasingly difficult to be a purist of either persuasion. Fundamentalists need to keep an eye on the various signals derived from the price action on charts, while few technicians can afford to completely ignore impending economic data, critical political decisions, or the myriad of societal issues that influence prices.
Bearing in mind that the financial underpinnings of any country, trading bloc, or multinational industry take into account many factors, including social, political, and economic influences, staying on top of an extremely fluid fundamental picture can be challenging. At the same time, you find that your knowledge and understanding of a dynamic global market increases immeasurably as you delve further and further into the complexities and subtleties of the fundamentals of the markets.
Fundamental analysis is an effective way to forecast economic conditions, but not necessarily exact market prices. For example, when analyzing an economist’s forecast of the upcoming GDP or employment report, you begin to get a fairly clear picture of the general health of the economy and the forces at work behind it. However, you need to come up with a precise method as to how best to translate this information into entry and exit points for a particular trading strategy.
A trader who studies the markets using fundamental analysis generally creates models to formulate a trading strategy. These models typically utilize a host of empirical data and attempt to forecast market behavior and estimate future values or prices by using past values of core economic indicators. These forecasts are then used to derive specific trades that best exploit this information.
Forecasting models are as numerous and varied as the traders and market buffs that create them. Two people can look at the same data and come up with two completely different conclusions about how the market will be influenced by it. Therefore it is important that before casting yourself into a particular mold regarding any aspect of market analysis, you study the fundamentals and see how they best fit your trading style and expectations.
Do not succumb to “paralysis by analysis.” Given the multitude of factors that fall under the heading of “The Fundamentals,” there is a distinct danger of information overload. Sometimes traders fall into this trap and are unable to pull the trigger on a trade. This is one of the reasons why many traders turn to technical analysis. To some, technical analysis is seen as a way to transform all of the fundamental factors that influence the markets into one simple tool: prices. However, trading a particular market without knowing a great deal about the exact nature of its underlying elements is like fishing without bait. You might get lucky and snare a few on occasion, but it’s not the best approach over the long haul.
For FOREX traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors, and unforeseen events. Therefore, it is easier to get a handle on the most influential contributors to this diverse mix than it is to formulate a comprehensive list of all the fundamentals.
Economic indicators are snippets of financial and economic data published by various agencies of the government or private sector. These statistics, which are made public on a regularly scheduled basis, help market observers monitor the pulse of the economy. Therefore, they are religiously followed by almost everyone in the financial markets. With so many people poised to react to the same information, economic indicators in general have tremendous potential to generate volume and to move prices in the markets. While on the surface it might seem that an advanced degree in economics would come in handy to analyze and then trade on the glut of information contained in these economic indicators, a few simple guidelines are all that is necessary to track, organize, and make trading decisions based on the data.
Know exactly when each economic indicator is due to be released. Keep a calendar on your desk or trading station that contains the date and time when each statistic will be made public. You can find these calendars on the New York Federal Reserve Bank web site using this link: www.ny.frb.org. Then search for “economic indicators.” The same information is also available from many other sources on the Web or from the broker you use to execute your trades. Chapter 13, “The FOREX Marketplace,” lists several web sites that monitor news releases.
Keeping track of the calendar of economic indicators will also help you make sense out of otherwise unanticipated price action in the market. Consider this scenario: It’s Monday morning and the U.S. Dollar has been in a tailspin for three weeks. As such, it is safe to assume that many traders are holding large short USD positions. However, the employment data for the United States is due to be released on Friday. It is likely that with this key piece of economic information soon to be made public, the USD could experience a short-term rally leading up to the data on Friday as traders pare down their short positions. The point here is that economic indicators can affect prices directly (following their release to the public) or indirectly (as traders massage their positions in anticipation of the data).
Understand which particular aspect of the economy is being revealed in the data. For example, you should know which indicators measure the growth of the economy (GDP) versus those that measure inflation (PPI, CPI) or employment (nonfarm payrolls). After you follow the data for a while, you will become very familiar with the nuances of each economic indicator and which part of the economy it measures.
Not all economic indicators are created equal. Well, they might have been created with equal importance but along the way, some have acquired much greater potential to move the markets than others. Market participants will place higher regard on one statistic versus another depending on the state of the economy.
Know which indicators the markets are keying on. For example, if prices (inflation) are not a crucial issue for a particular country, the markets will probably not as keenly anticipate or react to inflation data. However, if economic growth is a vexing problem, changes in employment data or GDP will be eagerly anticipated and could precipitate tremendous volatility following its release.
The data itself is not as important as whether it falls within market expectations. Besides knowing when all the data will hit the wires, it is vitally important that you know what economists and other market pundits are forecasting for each indicator. For example, knowing the economic consequences of an unexpected monthly rise of 0.3 percent in the producer price index (PPI) is not nearly as vital to your short-term trading decisions as it is to know that this month the market was looking for PPI to fall by 0.1 percent. As mentioned, you should know that PPI measures prices and that an unexpected rise could be a sign of inflation. But analyzing the longer-term ramifications of this unexpected monthly rise in prices can wait until after you have taken advantage of the trading opportunities presented by the data. Once again, market expectations for all economic releases are published on various sources on the Web and you should post these expectations on your calendar along with the release date of the indicator.
Do not get caught up in the headlines, however. Part of getting a handle on what the market is forecasting for various economic indicators is knowing the key aspects of each indicator. While your macroeconomics professor might have drilled the significance of the unemployment rate into your head, even junior traders can tell you that the headline figure is for amateurs and that the most closely watched detail in the payroll data is the nonfarm payrolls figure. Other economic indicators are similar because the headline figure is not nearly as closely watched as the finer points of the data. PPI, for example, measures changes in producer prices. But the statistic most closely watched by the markets is PPI, minus food and energy price changes. Traders know that the food and energy component of the data is much too volatile and subject to revisions on a month-to-month basis to provide an accurate reading on the changes in producer prices.
Speaking of revisions, do not be too quick to pull that trigger should a particular economic indicator fall outside of market expectations. Contained in each new economic indicator released to the public are revisions to previously released data. For example, if durable goods should rise by 0.5 percent in the current month, while the market is anticipating them to fall, the unexpected rise could be the result of a downward revision to the prior month. Look at revisions to older data because in this case, the previous month’s durable goods figure might have been originally reported as a rise of 0.5 percent but now, along with the new figures, it is being revised to indicate a rise of only 0.1 percent. Therefore, the unexpected rise in the current month is likely the result of a downward revision to the previous month’s data.
TIP: It is not uncommon for prices to surge one way immediately after a news announcement—only to quickly turn and head in the opposite direction. Give the markets time to talk before you decide what they are saying about the news.
Do not forget that there are two sides to a trade in the foreign exchange market. So, while you might have a handle on the complete package of economic indicators published in the United States or Europe, most other countries also publish similar economic data. The important thing to remember here is that not all countries are as efficient as the G8 in releasing this information. Once again, if you are going to trade the currency of a particular country, you need to find out the particulars about that country’s economic indicators. As mentioned earlier, not all of these indicators carry the same weight in the markets and not all of them are as accurate as others. Do your homework so you will not be caught off guard.
When it comes to focusing exclusively on the impact that economic indicators have on price action in a particular market, the foreign exchange markets are the most challenging. Therefore, they have the greatest potential for profits of any market. Obviously, factors other than economic indicators move prices and as such make other markets more or less potentially profitable. But since a currency is a proxy for the country it represents, the economic health of that country is priced into the currency. One important way to measure the health of an economy is through economic indicators. The challenge comes in diligently keeping track of the nuts and bolts of each country’s particular economic information package. Here are a few general comments about economic indicators and some of the more closely watched data.
Most economic indicators can be divided into leading and lagging indicators. Leading indicators are economic factors that change before the economy starts to follow a particular pattern or trend. Leading indicators are used to predict changes in the economy. Lagging indicators are economic factors that change after the economy has already begun to follow a particular pattern or trend.
The problem with fundamental analysis is that it is difficult to convert the “qualitative” information into a specific price prediction. With FOREX leverage being what it is, it is seldom enough to know that a report is “bullish” for a currency without being able to attach specific values.
Econometric analysis attempts to quantify the often qualitative fundamental factors into a mathematical model. These models can become enormously complex. The problems with econometric analysis are twofold: It is difficult to objectively quantify qualitative information such as a news announcement. The interactions and specific weights of each factor are constantly in flux and the relationships between them are almost certainly nonlinear. Relationships that hold today are invalid tomorrow.
Chapter 4: Fundamental Analysis Recap
Fundamental analysis is a very deep well. It is important to understand the basic fundamentals that drive currency prices, even though most traders use technical analysis to make specific day-to-day trading decisions.
Fundamentals can be extremely powerful and useful to the trader. But they have a much steeper learning curve to use effectively than do technicals.
Even if you opt for a technical analysis trading approach, as most traders do, do not completely ignore the fundamentals. Use a new service to do a daily take on what is happening. Remember: Be aware of pending reports and statistical releases. They often will cause a violent market reaction one way or the other. The impact of fundamental information is more important than the information itself.
Leave a Comment:
Comments:
No comments yet. Be the first to comment!