Fundamental analysis of Forex: a primer

Forex market analysis is divided into technical and fundamental. Technical analysis relies solely on the price chart and shows what is and has been happening in the market. Fundamental analysis explains what fundamental or, in other words, economic factors cause the movement of the exchange rate. Traders who want more than "buy on the green and sell on the red" must understand these factors.

We will begin our master class with a general overview of the fundamentals. In the next issues you will learn how to use them in trading with maximum efficiency.


Economic indicators

In the general case, a currency can rise in value for two reasons - if its supply (volume in circulation) in the world market decreases, or if the demand for it increases. In a particular case, the demand and supply of currencies and, as a consequence, their rates are simultaneously influenced by many factors. In the short term, the dynamics of currencies depend on how market participants perceive these factors. For your convenience, we have systematized all these numerous factors, dividing them into groups and describing their influence on the exchange rate.

  • Release Indicators: WFP growth rate, industrial production, retail sales - An increase in these indicators means economic growth and leads to an appreciation of the national currency.
  • Sentiment indicators: indicators of consumer and business sentiment - the higher these indicators, the more optimistic economic agents are, the more they spend and invest, the stronger the national economy and currency.
  • Labor market indicators: unemployment rate, changes in the number of unemployed/employed, number of claims for unemployment benefits - the higher the employment, the better for the national currency (the opposite is true for unemployment).
  • Indicators of the real estate market: Number of building permits/concerts/approvals, housing starts, new home sales, existing home sales, pending home sales - A vibrant real estate market is a sign of the health of a national economy and has a positive effect on the currency.
  • Inflation: indices of consumer, producer, wholesale and retail prices - In the short term, higher inflation increases the likelihood of a tightening of the Central Bank policy, which has a positive impact on the exchange rate of the national currency; in the long term, higher inflation depreciates the national currency.
  • Balance of trade (country's total exports minus total imports; >0 - surplus, <0 - deficit). In the case of a surplus, foreign demand for the country's currency increases and the national currency exchange rate rises. In the case of a deficit, on the contrary, the supply of the country's currency increases and its exchange rate tends to decrease.
  • Balance of payments (a balance reflecting the ratio of all payments between the country and abroad; >0 - surplus, <0 - deficit). A deficit means that the country owes more to foreigners than they do, and it needs to borrow capital abroad to make up the deficit, so the effect on the national currency exchange rate is negative. A surplus, on the other hand, has a positive effect on the exchange rate of the national currency.

Monetary policy of major central banks

I would like to draw special attention to monetary policy of central banks. In our opinion, it is the fundamental one in the fundamental analysis of the Forex market. A "soft" policy (low rates and unconventional monetary measures) leads to a decline in the currency, while a "hard" one (high rates) leads to its strengthening. For example, in 2012/13 the Japanese yen made the strongest fall on the background of aggressive monetary stimulus conducted by the Bank of Japan.

  • Interest rates. All central banks set the refinancing rate. There are two types of monetary policy: easing (lowering the interest rate during periods of economic weakness and low inflation - negative effect on the national currency) and tightening (increasing the interest rate in times of a strong economy and high inflation - positive effect on the national currency). In the table below we have collected data on the monetary policy of the leading central banks of the world and the prospects for its change (data as of 26.03.14).
Fig. 1. Monetary policy indicators of the world's leading central banks.
Fig. 1. Monetary policy indicators of the world's leading central banks.
  • Buying bonds. During a weakening economy, central banks can also conduct massive buybacks of government bonds, increasing the supply of money and making credit cheaper. In this case, the national currency will weaken. Unsterilized bond buying is called "quantitative easing" (QE). When the Central Bank rolls back QE, the national currency strengthens.
  • Interventions. When the exchange rate of the national currency is approaching some critical levels, the regulator may resort to currency intervention - buy/sell the national currency against foreign currencies in order to reduce/increase its supply and, accordingly, to raise/decrease its exchange rate. In addition, there are verbal interventions - comments of the country's leadership and monetary authorities, which can cause strong movements in the market. Such policies can be criticized by the G20, as this country forum promotes market-based exchange rates. To learn about the risk of intervention, it is necessary to follow market news and analysis.

The Fiscal State of Government

  • Budget Balance and Government Debt. Countries with high levels of government debt are usually less attractive to investors, as high debt increases inflation. In addition, the large amount of government debt can make the situation worse if market participants believe that the country is in danger of defaulting.

News Feed

  • Political and social news.
  • Economic forecasts of the IMF, OECD, World Bank and other organizations.
  • Moody's, Fitch, S&P, etc. review the credit ratings of countries.
  • Media articles.

We've looked at the general factors that are relevant to all currencies. Next time, we'll talk about the specifics of particular currencies and currency pairs traded on the Forex market. 

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