Anyone who wants to trade in Forex market needs to understand the exact nature of the market and its potential for profits. Fundamental analysis takes into consideration various economic indicators that show the strength of the economy, the political climate prevailing in the country and how they impact the movement of currency price in the Forex market. The analysis of economic indicators, social factors and government policy of a business cycle can forecast price movement and trends of the market. The fundamentals of any country lie in the combination of factors like social, political and economic influences. It is possible to predict the conditions of the economy but unlikely the market prices by using fundamental analysis. From these, it should help traders to develop a certain plan of action concerning the ways of using the information as entry and exit spots in a certain strategy of trading. The economic conditions in the currency of native country along with a number of other factors are the obligatory elements of these fundamental criterias.
The activity of the economy is explained by a periodic business cycle. The business cycle consists of four stages: recovery (or expansion), peak, contraction (or recession), and trough.
The growth of business activity, increase in demand and production as well as the expansion of employment can be observed in the expansion phase. The interest rates usually rise during this phase due to money borrowing by businesses and consumers for their expansion.
At the state of business cycle peaks, the amounts of goods on demand are getting higher than the supply offer. Consequently, it is then reasonably followed by the increase in prices and causes inflation. This lowers the customer’s ability to purchase.
Because of the increase in prices, the demands then decline and lower the economy. This process is entering into the recessionary phase.
During deflation period, the economical activities are low. The unemployment rate is boosted to increase and thus lowering the demand. This is normally followed by price reduction that turn into deflation. The trough phase comes after that. Deflation is characterized as a process of strong and prolonged prices reduction. Eventually, the demands will start to rise again which are caused by low prices and the conditions for the economy to enter the expansion phase is created.
Another important aspect of fundamental analysis is the economic calendar. This is a creation of economists who forecast economic statistics and values according to previous month’s historical data. Upcoming economic figures are predicted before they are announced and once announced the figures are compared to the consensus forecast. Economic calendar uses GMT time zone as it standardizes time and it consists of most of the major economic indicators for the well-known traded currencies. In the economic calendar, each events announcement has an importance factor. The market will be more volatile immediately after the news release if the data has higher importance. The volatility is dependent on how positive or negative the actual data are when compared to the forecast data.
In other words, the market expectation of an indicator is also a significant thing in economic calendar. When certain new information is announced, it will has a large impact on the market only if it is different than expected. In particular, the economic data regarding US indicators tend to have the greatest impact on market as the US dollar is involved in 80% of all the Forex trades.
As a result, a trader must be ready to react when a figure is published. Therefore, trader should take into account the upcoming economic news announcements and analyze how they could affect his/her trades. Models incorporating empirical data are good strategy in here. It models what will probably happen when certain economic announcements are made. By using this method, trader can recognize how the news may influence his/her trade and then attempts to reduce the short term impact by the correct use of entry and exit points.
Macroeconomic indicators are important economic reports published at fixed time interval that illustrate the detail of a country’s economic performance whether it has improved or reduced. Some of the list of macroeconomic indicators that have the most significant impacts on the market as well as always available in the calendar are:
- Gross Domestic Product (GDP)
- Gross National Product (GNP)
- Non-farm Payrolls / Employment rate
- Inflation report
- Trade balance
- Housing Data
This quarterly report is a measure of a country’s overall economic output. It is the market value of all final goods and services made within the borders of a country. It is often positively correlated with the standard of living. Gross domestic product comes under the heading of national accounts, which is a subject in macroeconomics. Hence, it is a good indicator of the country’s economic strength. This indicator consists of the sum of consumption spending, investment spending, government spending, and net trade (exports – imports).
In a global context, GDP and GNP are equivalent terms. The only difference is that GDP defines its scope according to location, while GNP defines its scope according to ownership. GNP is goods and services produced by enterprises owned by a country’s citizens. Gross National Product is then also one of the key indicators of the economic activity. It is also released on quarterly basis.
This is an influential monthly statistic that is released that reveals how much payroll was issued in the country for positions that do not involve agricultural industries. This monthly report also includes estimates on the average work week and the average weekly earnings of all non-farm employees. This is a good indicator of the strength of a country’s economy. This statistic is released on the first Friday of every month. If you are trading the market, you will want to be very cautious about trading whenever this news announcement is released.
Inflation is the rate of rise in the general level of prices of goods and services in an economy over a period of time. It has direct relation to the purchasing power of a country within its borders and the country’s standing on the international markets because when the general price level rises, each unit of currency buys fewer goods and services. Thus, this is one of the closely followed indices by Forex traders. The examples of economic data that measures inflation are Customer Price Index (CPI), Producer Price Index (PPI), and so on.
The CPI is based on the consideration of a price level of goods and services used by consumers. The products considered do not include the food and energy sectors as they are too volatile. The index is prepared on a monthly basis and is a good guide of the inflation levels of the country.
The PPI measures the average price level for capital, rent and materials required for producers to manufacture their goods. The PPI measures the price at producer level while the CPI measures the price from customer point of view.
Inflation’s effects on an economy can be simultaneously positive and negative. The tool of easing inflation is raising the interest rates and the higher interest rates tend to support the local currency. However, the increase price of important raw material such as crude oil may bring higher productive cost pressure to the industry and will then lower down the productivity output of an economy.
Inflation reduces the real value of money and other items with an underlying monetary nature (e.g. loans and bonds). However, inflation has no effect on the real value of non-monetary items, (e.g. gold, and etc)
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation’s imports and exports. Items that are traded may include food, raw material, industrial supplies, purchaser goods and other merchandise. A positive balance of trade is known as a trade surplus since it consists of exporting more than is imported; a negative balance is referred to as a trade deficit. A trade deficit generally means that the currency is weak.
In addition, the merchandise trade balance is interrelated to the changes in foreign exchange market. Exporter will lose competitive advantages in the international market if its currency rate is high. Thus, the currency rate may be devalued by the adjustment made by central bank.
Housing information can be a good measurement of a country’s economy. If housing data is excellent, it shows that the value of the currency is going to increase as well. Housing data is regularly released in the form of a news announcement. From housing data, it is possible to know the amount of new houses that have been built and the existing homes that have been sold or are under contract.
The currency movements are based on economic, political, environmental, other relevant factors and statistics that will affect the basic supply and demand. Accordingly, a basic understanding of supply and demand is essential since it provides information on how political and economical events influence the currency market. The Forex fundamental analyst identifies factors that determine the intrinsic value of a financial instrument. The market supply and demand balance forms the currencies prices. If there is a decrease in supply but the level of demand remains the same, then there will be an increase in market prices. An increase in supply produces the opposite effect. The interest rates and the overall economy strength are the two key factors that influence the supply-demand balance.
Financial circumstances are vital to fundamental research. Changes in a government’s monetary or fiscal policies are bound to generate changes in the economy, and will be reflected in the exchange rates.
The control of money and credit supply within the economy is the general aim of the monetary policy. The interest rates are affected by these processes. The monetary policy is mainly interested in the control of inflation. When the inflation is up, central banks try to keep it low by leveraging interest rates. When interest rates are up, then the currency is supported. The central banks are the most influential player in this case as the central banks set the interest rates.
Stock traders evaluate the intrinsic financial value of a publicly-traded company by examining its balance sheet, indebtedness and cash flow statistics. However, most of the Forex traders focus on such things as central bank interest rate differentials (which is the difference between the borrowing interest rates as decided by the central banks of different countries). Furthermore, an interest rate increase in a country would strengthen its domestic currency.
Both global and local news are major forces which impact the currency markets. Although news from the financial sector, such as, interest rates and GDP have the firmest impact, but other key events can impact the markets too and non-financial news could be a complete surprise as well as having a large impact on the markets.
Political circumstances also impacts the Forex market especially an emergency that strikes suddenly and is unplanned. A currency may depreciate its value when its country general election is coming due to high political uncertainty and difficulty to forecast. Traders need to adjust their reaction relative to each event.
Natural disasters like the destruction caused by Hurricane Katrina or the incident of 2010 Gulf of Mexico oil spill are also considered as unexpected events which may impact the foreign currency exchange rates.
Even a planned event such as a major international conference in a particular country may help boost up the local currency too because of increase in investor confidence.