In this article we delve deep into fundamental analysis in forex trading. The market for the six frequently traded currencies are mostly opened and free. Demand and supply determine exchange rates, and anyone who wants to join or leave the market is free to do so. It is reasonable to assume the market participants buy or sell currencies because it is in their economic interest to do so.
Indeed, one must take this assumption;otherwise, no currency forecasting is possible. This article will introduce you to the broad conditions that likely influence exchange rates. These conditions might be economic, financial or political. Collectively, these conditions are known as fundamentals.
Economic Fundamentals
We say mostly opened and free because national central banks are also market participants. Through direct transactions in the forex market, the imposition of capital controls, the setting of prohibitive interest rates or other emergency measures, these bodies can have a sizable impact on forex prices.
Furthermore, central banks are not profit-oriented. The objective of their actions is not to earn profits in currencies but to achieve some other economic or political outcome. Such steps are therefore notoriously challenging to predict.
Even when forex markets are populated solely by economically self-interested actors, one must bear in mind that their economic interest typically lies outside the forex market. For example, British tourists buy yen because they are eying profits in GBP/JPY.
American investors buy euros because they purse investment returns in Germany and not pips in EUR/USD. Hence, forecasting exchange rates involves predicting when conditions arise that will make such decisions likely.
Several theories exist to determine what exchange rate ought to prevail. The “fair value” calculated through such approaches reveals whether currencies are broadly expensive or cheap, and enable traders to act accordingly.
Purchasing Power Parity (PPP)
According to the theory, the price of a good( the Bog Mac is an example of a reference product favored by economists because its composition is identical everywhere in the world) should be the same in all countries- the law of one price.
If for example the good is cheaper in Berlin than in Birmingham, the British consumers will buy in Germany instead. The sales of pounds versus euro to make this possible should drive GBP/EUR down until the product price are identical.
The arguments underlying this theory are persuasive. In practice however, currencies have demonstrated the ability to distance themselves significantly from their purchasing power parties and to remain there for years at a time.
The theory, and the various modified versions of it are impractical for all but the most tenacious traders.
Theory Of Elasticities (fundamental analysis)
If one ignores the price of any particular good and considers the entire import-export relationship between two countries then, there ought to be some long term tendency towards equilibrium.
If for example, the UK import massively from the US, strong demand for the dollar relative to the pound ought to drive GBP/USD lower to a point where US goods become prohibitively expensive in the UK.
Sadly, evidence for stubborn trade deficits and surpluses tend to undermine the theory too. It appears demand for foreign made products is less sensitive to price change (price inelastic) than theorized.
When consumers want German luxury cars, California-designed smartphones or French sparking wines, there are most likely indifferent to the price. In the short term, at least demand for products determines forex rates, not vice versa.
Modern Monetary Theories On Short-Term Exchange Rate Volatility
One additional domestically-made product that foreigners might demand is the money itself. Cash and cash-like financial instruments are commodities too. When for example, domestic incomes are strong and stable, demand for cash (in the form of bank loans or credit card borrowing) ought to be high.
The supply of money in the system should rise. If the central bank responds to evidence of growth in the money supply by raising cash interest rates, the demand for cash should fail. Monetary conditions like this might explain why exchange rates are seemingly able to ignore their purchasing power parity.
currencies will react more swiftly to difference in short-term interest rates or money supply growth than it will do to difference in the prices of manufactured products. The mismatch might even be the source of considerable exchange rate volatility.
The Portfolio Balance Approach
The portfolio balance approach takes into consideration the demand for all financial assets within a country, not just the demand for money.
If financial assets like stocks, bonds, real estate etc have a higher yield in one country relative to another, international demand for those assets ought to cause the currency to appreciate until the expected return on investment is the same in both jurisdictions.
Synthesis Of Traditional And Morden Monetary Views.
Market participants might buy a currency (and sell another) for many reasons. They might be attracted by the intrinsic value like it’s higher interest rate, or the prospect that it might be in short supply in the future.
Alternatively, they might appreciate the things one can buy with it like consumer goods or high yield investments. However, not all of this effects coincide. People might be more willing to give up American bonds than Hollywood movies.
Similarly, central banks might not respond to money supply growth or money supply growth to rising interest rates in the same way. In short, forex markets are not bound to reflect the “fair value” over any time horizon that is meaningful for currency traders.
Economic Indicators (fundamental analysis)
Although exchange rates might not respond to broad economic developments in a timely and appropriate manner, they also tend to react to data releases concerning these developments.
Currency trading service providers make available a calendar of economic data releases. Although it might be impossible to take advantage of the price changes that immediately follow this data publications, it is prudent to consider them when planning entires, exits and stops
The Gross National Product (GNP)
The gross national product is the sum of all goods and services produced by a country. Whether the production takes place at home or abroad.
The Gross Domestic Product (GDP)
The gross domestic product is the sum of all goods and services produced within a country, whether those products are domestic or foreign. Market participants are more interested in GDP than GNP.
In the US, though, the government imposes taxes on its citizens wherever they are in the world, so GNP is understandably a more appropriate measure.
Consumption Spending (fundamental analysis)
Consumers ability and willingness to indulge in discretionary spending is an indirect measure of how they perceive their economic security.
Investment Spending
Investment spending measures business outgoings on fixed capital equipment and the building up of inventories. It indirectly reflects business confidence.
Government Spending
Government spends vast sums of money and so they have an outsized influence on economic outcomes
Industrial Production
Industrial production is the total output of a country’s factories, mines and other industrial sites. in most rich countries, service rather than industrial production makes up the bulk of GDP. Yet this figure remains a useful comparative indicator for the currency markets.
Capacity Utilization
Capacity Utilization is a measure of industrial output as a proportion of industrial capacity. Low levels of capacity utilization indicates slack in the economy ( for obsolete plants and equipment). High levels of capacity utilization suggest production bottlenecks, high prices, generalized inflation or even higher interest rates.
Factory Orders
Factory orders are the sum of durable (products whose lifespan is more than 3 years) and non-durable goods (products whose lifespan is less than 3 years) ordered but not yet delivered.
Durable Goods Orders (fundamental analysis)
Durable goods includes productions like cars, ,white’ kitchen appliances, and office equipments, it also includes military hardware. So to avoid the rare order of an aircraft carrier distorting the number, defense spending is listed separately.
Durable goods whether for household or businesses tend to be expensive. Hence, financial markets treat a high value of orders as a positive sign for the economy
Construction Indicators
The non-service sector in rich countries typically accounts for no more than a third of the economy. Yet within that third, construction spending is a significant economic driver. The data for the US economy I particular, command much global attention because of the link to wages, consumer confidence and interest rates.
The monthly numbers for housing starts, home sales and construction spending will invariably appear in traders calendars.
Inflation Indictors (fundamental analysis)
Estimating the rate of inflation is essential for two principal reasons.
- Making international comparisons of economic performance
- Anticipating the action of central banks
The central banks that issues the six most frequently traded currencies have an inflation mandate. At least one of their tasks is to maintain the level of domestic inflation at an acceptable level.
Evidence of inflation significantly above or below the mandated might be a precursor to a change in interest rates. Traders use GDP to judge relative economic performance. However, any reported growth in the money value of domestic output could be due to increased production or just to higher prices.
To strip out the effect of higher price rises, economists deflate the number using an inflation estimate. This operation permits valid year-on-year and country-by-country comparisons.
Producer Pice Index (PPI)
The producer price index attempts to measure inflation in wholesale prices. It examines price changes to a basket of goods that represent the inputs to manufacturing, mining and agricultural processes. These goods include items like food and fuel.
Consumer Price Index
The consumer price index attempts to measure inflation in retail prices by calculating the cost of a basket of goods and services consumed by a typical household. This basket too includes manufactured goods, food and fuel.
But, it also reflects other sizable consumer outgoings like housing and healthcare.
Gross National Product Implicit Deflator
It’s an inflation measure derived from a comparison of current prices with those in a specific base year. The concept of “base” period is common in economic analysis, especially for looking at inflation.
For instance, one might consider the price of a new car today and its price 10 years ago “in today’s money”. The relative difference between those two values is the deflator.
Financial And Sociopolitical Factors
When economic incentives are present, economic actors tend to behave predictably. Yet there are occasions when the predicted behaviors contradict the social and political goals of a government and central banks.
Here are some examples for better understanding:
-A country faces labor shortages, and the government fears a loss of competitiveness from excessive wage growth but it is hostile to immigration.
-A country faces high inflation, but an interest rate hike might drive the currency higher and widen the trade deficit the government promised to reduce.
-A I promised not to raise taxes but as the country is part of a monetary union, tax policy is the only tool available to combat high inflation.
-A country wants to maintain the external value of its currency through intervention but, this means selling its reserves of foreign currency of which it only has a limited quantity.
-A country already faces a housing bubble but the government wants to deliver on a promise of homeownership for low income households by loosening lending criteria.
There is a saying in the market, “that which is unsustainable will not be sustained”. Whenever actions by authorities seem to run counter to the fundamentals, traders must ask themselves whether they are sustainable.
The realization, sometimes sudden, that some measures are not, is the cause of market volatility.
Summary Of Fundamental Analysis On Forex Trading
Fundamentals reflect the collective impact of the independent decisions of millions of consumers, firms and investors acting in their self interest, all around the world.
Fundamentals are undeniable. Economic actors respond to international differences in:
1 Interest rates
2 Investment yields
3 Prices for products
4 Inflation rates
5 Real growth rates
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