Section I: Introduction
There are basically two ways to approach the markets: technical and fundamental analysis.
Technical Analysis: studies the past behavior of price of any given instrument as an attempt to forecast its future behavior.
Fundamental Analysis: the focus of which is to study the economic, social and political forces that drive the supply and demand of currencies.
Which one is the best approach?
There has been an ongoing debate on which approach is better. Sometimes technicals nail it down, but for some others the fundamentals do it. The truth is, there is no clear answer to this question. And I would say that the answer lies within each one of us. That is, use the one that fits you, the one that works better for you.
If you are a short term trader, you will probably prefer the technical approach, since it concentrates on price behavior. On the other hand, fundamental changes take longer to be visible in the charts so it will be better to adopt a fundamental approach.
Today, many traders and investors use both approaches, so they can have a clearer picture of any given situation.
In this lesson we will go through Fundamental Analysis.
The topics covered in this lesson are:
Section II: What Moves the Forex Market: We will try to explain what makes currency pairs fluctuate; we will see several theories about how currency pairs are valued.
Section III: Fundamentals by Country: A list of the important news announcements for each country (majors), how important they are to the market, effects they produce on some currency pairs etc.
Section IV: Other Economic Indicators: In this section we will review other (not so important) economic indicators that under some circumstances can have a larger than usual impact to the Forex market.
Section V: Other Fundamental Factors that Influence the FX Market: We will explain the role of political and social crisis, and the statements of important people in the FX Market.
Section VI: Gold and Oil and their Relationship to the Forex Market: Getting to know how each of these two commodities are related to the Forex market can help you make better decisions.
Section VII: Common Practices Used by Fundamentalists: We will mention some practices used fairly often by fundamental traders.
Section VIII: Some Thought on News and Event Trading: “Trading the news” has become a very popular style of trading in the last few years; we will analyze its advantages and disadvantages.
Section II: What moves the Forex Market?
Currency movements, as in any other market, are driven by two main forces: supply and demand.
Think for instance of the car selling business in a small village. At first there will be just a few car vendors. As the village grows, more and more people will need cars to satisfy their needs, pushing up the demand for cars. At this point the demand for cars is greater than the quantity supplied, pushing prices up. As people realize selling cars is such a great business opportunity, more people will be attracted the car business and will start selling cars. As this happens, more and more cars will be available, pushing up the supply of cars. At some point, the supply will be greater than the demand of cars. If car vendors don't lower their prices, they won’t be able to sell their cars, so they are forced to lower them.
The same goes for currencies, when a currency increases its value, the demand is greater than its supply. When a currency decreases its value, its supply is greater than its demand.
What factors influence the supply and demand of one currency?
The two main factors that influence the movements in one exchange rate are:
1. The capital flows
2. The trade flows
These two components constitute what economics call balance of payments. The main purpose of the balance of payments is to quantify the demand and supply for a currency of one country, over a period of time.
Balance of Payments = Capital Flows + Trade Flows
A negative balance of payments indicates that the capital leaving the country is greater than the capital entering the country (not much demand)
A positive balance of payments means that the capital entering the economy is greater than the capital leaving the economy (increasing demand of the domestic currency)
Theoretically, a balance of payments equal to zero indicates the right value of one currency.
Capital Flows
Capital flows is the net quantity of currency traded (bought or sold) through capital investments.
The capital flow can be divided into: physical flows and portfolio investments.
Physical Flows - They happen when foreign entities sell their local currency and buy foreign currency to make foreign direct investments (for joint ventures, acquisitions, etc.) When the volume of this kind of investment increases, it reflects the good shape and health of the economy where it is invested.
Portfolio investments - These are investments made on global markets, variable and fixed income market investments (Forex, stocks, T-bills, etc.) An example of portfolio investments is when a hedge fund in Japan invests in the US equity markets.
Trade Flows
Trade flows measure the net exports and imports of a given country. These two components (exports and imports) constitute what economists call the current account.
Countries that have a positive current account (exports greater than imports) are more likely to depreciate their currency; this way the consumer abroad will perceive the foreign currency to be cheaper (and can purchase more goods and services). A good example is Japan.
On the other hand, countries that have a negative current account (imports greater than exports) are more likely to appreciate their currency since they need to sell the local currency and buy foreign currency in order to purchase goods and services. United States is an example of a net importer country.
Purchasing Power Parity (PPP)
This theory states that exchange rates are determined by the relative prices of a similar basket of goods in different countries. In other words, the ratio of prices of a basket with similar goods of two countries should be similar to the exchange rate.
If a Personal Computer in Australia costs AU$1,500, and the same PC in United States costs US$1,200. According to the PPP, the exchange rate AUD/USD would be 1.2500 (1,500/1,200).
If the exchange rate was at 1.3000 (or above 1.2500) it states that in the long run it will decrease its value until 1.2500 is reached. On the other hand, if the exchange rate was at 1.0500 (or below 1.2500) the exchange rate in the long run will increase its value until 1.2500 is reached.
This example is just illustrative, in the real world it is not just one good, but a basket of goods.
The major weakness of this theory is that it assumes that there are no costs related to the trade of goods (tariffs, taxes, etc). Another weakness is that it does not consider other factors that might influence the exchange rate (i.e. interest rates etc)
Modern monetary theories include the capital markets to the PPP theory arguing that capital markets have less costs of trading.
Interest Rate Theory
This theory states that interest rates differentials neutralize the increase or decrease of any currency against another currency. Therefore there are no arbitrage opportunities.
For instance if the interest rate of Australia is 6.25% and the interest rate of United States is 3.5%, then the AUD should depreciate against the USD, so that there are no arbitrage opportunities.
There are also other theories that try to explain the value of a currency pair. But as with every theory, they are based on assumptions that may or may not be present in the real world.
Section III: Important Economic Indicators by Country
In this section we will give you a quick overview of the economy of each of the Major currency pairs and the most important fundamentals releases for each one of them.
Note however, that this list is provided “as is” and may not reflect what happens in the real world. Use this only for informational purposes and on your own risk.
European Economy and Monetary Union (EMU) – EUR
EMU Quick Economic Facts
- The EMU (European Economic and Monetary Union) consists of 16 member countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, Slovenia, Spain, Sweden, Norway and The United Kingdom. However, Sweden, Norway and The United Kingdom have not entered the last stage of the EMU where they adopt the Euro as their currency; they still use their own currency.
- Eurozone is a common term used for those countries that have adopted the Euro as their Currency.
Eurozone Countries and their GDP
[Table 1]
Source: International Monetary Fund (2006)
- According to the International Monetary Fund, if the European Union (EU) was a country, it would be the only one in the world with a largest GDP than the US with 14.5 trillion USD.
- Aside from a common currency, Eurozone countries share a single monetary policy dictated by the European Central Bank (ECB). The ECB has established strict rules for every member country which main focus are:
- Stability of Prices
- Low Inflation per country (below 1.5% of the average of the best three performing countries)
- Low deficit
- Growth
- The importance of the EUR has grown considerably as more and more countries in the world switch their reserves from USD to EUR.
Important Economic Indicators for the EMU
Here is a list of the most important economic indicators for the Eurozone:
European Interest Rate Announcement
Interest rates are a measurement of “the cost of money. The European Central Bank uses Interest rates as a tool to accomplish their most important goals: inflation, growth and stability of prices.
When the ECB lower (tightens up) their interest rates, the Euro tends to depreciate against other currencies as it yields lower returns (i.e. investors sell their Euros to buy other currencies with higher returns, increasing the offer of Euros thus prices go down).
When the ECB hikes their interest rates, the Euro tends to appreciate against other currencies as it yields higher returns (i.e. investors sell their local currency to buy increasing its demand thus prices go up).
NOTE: As we already know the EU consists of various countries and each one of them has its own figure, although its important to have an idea of the overall performance, for the following economic indicators it’s more important to monitor the performance of the top three or four countries of the EU (refer to the GDP per country in the Eurozone above).
Gross Domestic Product (GDP) from Germany and the Eurozone
The GDP of the EU is the value of services and Products produced within the borders of the EU. A good GDP reflects a healthy economy.
A good GDP figure indicates the economy is growing and the Euro tends to appreciate against other currencies.
In a bad GDP figure, the Euro tends to lose value against other currencies.
Brain Feeder 1 – What is a good or/and a bad or good figure or number? In the GDP we saw (as we will see in future economic indicators) a good GDP tends to appreciate the value of the Euro, what does “good” mean? A value above zero? Or perhaps a number larger than 50? Think on it and try to come to an answer. Once you think you have got it please go to the Summary Report where you will find the answer to this feeder.
Harmonised Consumer Price Index (HCPI) from Europe
HCPI is what the EU uses as a measurement for inflation and stability of prices. As we already explained above, the ECB has some rules for its members and one of the most important is that each country’s inflation should not deviate more than 1.5% of the average of the best three performing members.
Usually for the EU:
When a low HIPC number is released the Euro tends to gain value against other currencies.
When a high HIPC number is released the Euro tends to lose value against other currencies.
Brain Feeder 2 – How is the European HCPI different from what other countries use as a measurement of inflation (like the US uses CPI)?
Unemployment Data from Germany and Europe
Employment is always a good indicator of the shape of the economy of all countries. Usually when unemployment numbers are low it reflects an economy in good shape (and vice versa).
Usually for the EU:
A low unemployment number tends to appreciate the value of the Euro against other currencies
A high unemployment data tends to depreciate the value of the Euro against other currencies.
Trade Balance from Europe
The Trade Balance in the Eurozone measures the amount of services and products purchased (imports) against those sold to other countries (exports). Trade Balance of each country of the Eurozone is divided in two: Intra-Eurozone and Extra-Eurozone. Intra-Eurozone is the balance of each country of the Eurozone against the Eurozone and Extra-Eurozone is the balance between each country of the Eurozone against non-Eurozone countries.
Usually Intra-Eurozone data does not affect the currency market while Extra-Eurozone tends to affect the currency market.
A good trade balance number usually appreciates the value of the Euro against other currencies.
A bad trade balance number usually depreciates the value of the Euro against other currencies.
Most investors focus on the Trade Balance of Germany as it is the leading economy of the Eurozone.
Industrial Production (German and European)
Industrial production of the Eurozone measures the total output of the manufacturing and energy sector. Sometimes the Industrial Production is used as a proxy variable to measure the GDP of any country.
Usually:
With a good number the Euro will gain value against other currencies
With a bad number the Euro will lose value against other currencies.
Most investors focus on Industrial Production of Germany as it is the leading economy of the Eurozone.
ANOTHER NOTE: For the following economic indicators its ok to focus on the performance of Germany as it is the leading economy of the Eurozone.
IFO Business Climate Survey (Germany)
The IFO Survey is one of the most important sentiment indicators for the Euro Zone. This survey is conducted on over 7,000 enterprises of Germany and it is divided into two main areas: their current assessment of business climate and their expectations for the future business conditions. It is an index where 100 is the centerline between good and bad conditions.
Usually:
A good number (above 100) tends to appreciate the Euro against other currencies.
A bad number (below 100) tends to depreciate the Euro against other currencies.
This survey is conducted monthly.
ZEW Survey (Germany)
This is survey is conducted by experts throughout Europe on their assessment about Germany’s economic expectation: inflation, growth, stock market and exchange rate over a medium term period (6 months) and their assessment of the current conditions.
With a good number, the Euro tends to gain value against other currencies.
With a bad number, the Euro tends to lose value against other currencies.
What is the difference between the IFO and ZEW surveys?
The IFO survey is conducted by enterprises and business owners while the ZEW survey is conducted by experts in the area.
10-Year German Bund
Long term securities (governmental) are always a good indicator for future performance of any country. In fact, if you do some research, you will see that very few under-development countries have in fact 10-Year securities (because very few investors would invest in any long term security due to its uncertainty).
In this case, the 10-year Bund is a good indicator for the future performance of the Euro. When compared to the US 10-Year Bond:
If the Bund rates are higher and the differential increases: bull Euro sentiment
If the Bund rates are higher and the differential decreases: bear Euro sentiment
United States - USD
US Quick Economic Facts
- Currently United States is the leading economic power in the world with a nominal GDP of 13.25 trillion USD, 3 times greater than Japan (which is the second in the world).
- US has a very large trade deficit (the US is the largest trading partner for most countries in the world).
- According to the Bank of International Settlements the USD is involved in 89% of all currency deals
- The Federal Reserve (Central Bank of US) has two main economic goals: Price stability and Sustainable growth
- The USD is perceived as one of the strongest and most stable currencies in the world and as a result many countries (mostly under-developed) peg their local currencies to the USD.
Important Economic Indicators for the USD
Non-farm Payrolls Report – “NFP” (US)
The NFP report is probably in the top three market movers in today’s markets.
The NFP shows the number of jobs created for a given month outside the agricultural industry and government agencies. It is a major indicator of the labor market strength, and the labor market is commonly tracked as an important domestic economy diagnosis.
A strong number indicates a healthy economy. Resultantly the USD could appreciate against other currencies
A weaker number indicates a lesser level of health in the economy. Resultantly the USD could depreciate against other currencies.
This report comes along with other data such as: the unemployment rate, which is the percentage of people actively looking for a job, but were not able to find one.
This report is commonly released on the first Friday of every month.
Interest Rate Decision (US FED)
Interest rates are a measure of “the cost of money”. Central banks use interest rates as a tool to accomplish certain goals and objectives- such as inflation, growth, etc.
An increase in US interest rates (hike) will typically increase the demand for the US Dollar, as foreign entities will sell their local currency and buy the USD to take advantage of the higher interest rate, pushing up the value of the USD.
Tightening interest rates (cut) will decrease the demand for USD, as foreign entities will buy back their local currency and sell USD, bringing back down its value.
Unchanged Interest rates could be bearish or bullish for the USD depending on the circumstances, unchanged interest rates after a period of tightening is perceived as USD bearishness and after a hiking cycle it could be perceived as USD bullishness.
This report is released 8 times a year.
Trade Balance from US
This measures the net exports and imports of goods and services of the US. This is the trade flows component of the balance of payments, which measures the demand and supply of one currency as explained before.
US has a negative trade balance against almost all countries in the world.
With a good number the USD is more likely to appreciate.
With a bad number the USD is more likely to depreciate
This report is released every two months (middle of the month following the reporting period.)
US Consumer Price Index
It is an index designed to measure the change in price of a fixed basket of basic goods and services (inflation). It is intended to measure pure price changes while leaving out the changes in quality of goods and services.
If the CPI increases, the purchasing power of the currency decreases.
If the CPI decreases, the purchasing power of the currency increases.
This report is commonly released the second week of each month.
Core CPI excludes food and energy which are two of the most volatile components in the CPI measurement. This indicator shows a more stable version of price changes.
Brain Feeder 3 – Is there a good Inflation number for all countries?
Consumer Confidence Index from US
The CCI is a survey conducted over 5000 consumers. They are asked questions about how they perceive the economy, current business conditions, what they expect for the future, etc. It measures how confident the consumers are in a given month.
A good CCI number indicates that the economy is in good shape, and the USD appreciates.
A bad number indicates something is wrong with the domestic economy, therefore USD depreciates.
In a CCI release day, the average range for the EUR/USD is 129 pips.
Release date: close to the end of each month.
US Retail Sales
Retail Sales is an indicator of consumer expenditure. It measures the sales of retail stores (including durable and non-durable goods), and excludes services (major weakness of this indicator).
A high number indicates favorable economic conditions, and the currency tends to increase its value.
A low number indicates non favorable economic conditions, and the currency tends to decrease its value.
Release date: near the middle of each month.
Gross Domestic Product from US
Measures the value of goods and services (total production) produced within the borders of the United States. GDP includes: consumption, private investments, government expenditure and exports less imports.
The most important component of this announcement is the change (in GDP) between the actual month and the same month of the previous year.
A good number indicates a strong economy, currency tends to increase its value.
A bad number indicates a weak economy, currency tends to decrease its value.
ISM Manufacturing Index from US
ISM stands for “Institute of Management Suppliers”. It is a survey conducted over business executives on their assessment for future business conditions. This indicator it’s important because the ISM is usually the first indicator that turns around after a period of recession or constant growth.
The ISM values range around 50, where values above 50 mean an “expansion” or good expectation; and values below 20 mean “contraction” or bad expectations for the near future.
Minutes of FOMC (FED)
Minutes of the Federal Open Market Committee (FOMC) give some insight about the monetary policy decision (three weeks after their actual monetary policy decision).
Usually investors and traders focus on key elements of how the Federal Reserve see current economic conditions, what they expect for the future and general commentaries on market indicators such as inflation.
The market reaction to the FOMC Minutes varies as the information is already priced, but when they give evidence of a “Hawkish” outlook interest rates hikes are more likely, on the other hand if they give evidence of a “Dovish” outlook, interest rates cuts are most likely.
Japan - JPY
Japan Quick Economic Facts
- Japan is the world’s second largest economy by nominal GDP with 4.4 trillion USD.
- Japan is one of the Worlds largest exporters in the world. A good percentage of their GDP accounts for exports (close to 15%).
- The Bank of Japan is the responsible for handling the monetary policy of Japan. The Bank of Japan is very active in the Forex markets. It is known that when the USDJPY approaches to 100.00 the B of J tends to intervene in the market pushing the prices up. It’s important to remember that Japan is a net exporter so it is in their best interests to have a cheaper currency than other majors; this way foreigners can buy more Japanese goods and services for less of their local currency.
- From the Major Currencies, the JPY is the currency with the lowest interest rate. This makes JPY crosses (such as GBPJPY or EURJPY) interesting for carry traders (those who look to profit from interest rate differentials via rollover).
- Although the Minister of Finance no longer officially dictates monetary policy, they still have some influence in exchange rates and monetary policy.
Important Economic Indicators for the JPY
Japanese Interest Rate Announcement
The Bank of Japan is responsible for the monetary policy of Japan. Currently, Japan is the country with the lowest interest rates (from the majors). The BoJ meets once per month to announce possible changes in their current monetary policy and economic outlook.
An increase in Japan’s interest rates might lead to JPY appreciation
A decrease in interest rates might lead to JPY depreciation.
Gross Domestic Product - GDP from Japan
GDP is the sum of all goods and services produced within the borders of Japan. Consumption, private investments, government expenditure and exports less imports are the elements of GDP or growth.
With a good number the JPY might gain value
With a bad number the JPY might lose value
Tankan Survey (Japan)
As other sentiment indexes, the Tankan survey is conducted on companies which are queried about their overall economic outlook (including business conditions).
This report is very important for both foreign investors and the Bank of Japan as it gives a picture of the current and the near future economic conditions. This helps investors allocate their capital or the BoJ to determine its policy.
A positive number means a good outlook while a negative number means a negative outlook.
A better than expected number usually helps the JPY gain value.
A worse than expected number usually makes the JPY lose value.
Trade Balance (and Merchandise Trade Balance) from Japan
The trade balance measures the difference between exports vs. Imports. Japan is widely known as a net exporter country so the bigger this number the better for its economy.
A positive number indicates a surplus while a negative number indicates a deficit.
A better than expected number tends to appreciate the JPY
A worse than expected number tends to depreciate the JPY.
Merchandise Trade Balance is a similar economic indicator but only takes into accounts tangible goods such as those of the car and electronic industries (two of the most important industries for Japan).
Japan’s Employment Situation
This report is an analysis of the current and future conditions for the labor market in Japan. As always, the labor conditions are a very good indicator for the overall economy health and activity.
Japan’s Employment Situation Report unusually incorporates other important data such as consumer consumption data, increase/decrease of wages, inflationary pressures, etc.
With a good number the JPY tends to gain value
With a bad number the JPY tends to lose value
National Consumer Price Index (NCPI) from Japan
The NCPI is the most important indicator for inflation in Japan.
Unusually, Japan suffers from deflation (indicative of slow domestic activity) so a low number might not be good for the JPY.
On the other hand, a high number might be good for the JPY as it indicates a more dynamic period for its domestic economy.
BoJ Policy Minutes (BoJ)
This report usually comes a month later after the actual monetary policy decision. It clearly explains the reasons or why the BoJ hiked interest rates, cut interest rates, left them unchanged or other decisions.
Traders and investors try to focus on key elements that will give them evidence about how the policy makers see the economy in the near future to make their trading decision.
United Kingdom - GBP
UK Quick Economic Facts
- The United Kingdom has the 5th largest economy in the world with a nominal GDP valued at over 2.3 trillion USD.
- As with other leading economies in the world, the UK is a service oriented economy (mostly financial services: insurance and banking).
- The UK has a very strong relationship with the Eurozone as imports and exports between both of them are around 50% of all UK’s trade balance.
- The Bank of England (BoE) is responsible for the monetary policy in the UK. Bank of England’s main concern is to keep inflation at comfortable levels.
- There has been an ongoing debate on whether or not the UK should join the Eurozone (countries adopting the Euro as their currency). Argument against: currently UK’s policies are doing well in the new global economy, they will no longer have control over their monetary policies and arguments in favor are: the power of the European Central Bank will increase dramatically.
- The GBP is amongst the most liquid currencies in the world and due its high interest, traders and investors are interested in this currency to perform carry trades even when other currencies have higher interest rates.
Important Economic Indicators for the GBP
UK’s Interest Rate Announcement
The Bank of England meets monthly to announce their interest rate decision. Currently, the GBP is the best choice for carry traders (even when there are other majors with higher interest rates) because of its liquidity (the most important being the GBP/JPY and the GBP/USD). For this reason traders and investors watch closely Bank of England’s decision.
An increase in interest rates tends to appreciate the GBP value
A decrease in interest rates tends to depreciate the GBP value
Unchanged interest rates can be bullish or bearish depending on the circumstances.
Gross Domestic Product (GDP) of the UK
The GDP shows the overall growth of the economy of United Kingdom.
With a good number the GBP tends to gain value.
With a bad number the GBP tends to lose value.
Sometimes excessive growth can lead to periods of high inflation which can lead to further interest rates hikes.
UK’s Trade Balance
Trade balance measures the difference from exports and imports of the United Kingdom. The first trading partner for the UK is the Eurozone, but still on an individual basis, US remains the first one.
With a good number the GBP tends to gain value
With a bad number the GBP tends to gain value.
Another important trade balance announcement is the NON-EU Trade balance which measures the difference between exports and imports of non European countries.
Consumer Price Index (CPI) from the UK
Consumer Price Index is the key element of inflation. This is how most investors and traders measure inflation and thus the increase/decrease of their purchasing power.
For the UK commonly:
A low number tends to increase the value of the GBP
A high number tends to decrease the value of the GBP
Another measure of the CPI for the UK is the Core CPI which excludes food and energy, two of its most volatile components.
Minutes of BoE Meeting (BoE)
In the Minutes of the BoE Meeting policy makers share their views and the reasons why they made any change to the interest rate or indeed left it unchanged.
Most of the times traders and investors focus on the outlook for the future as the rate decision was already occurred. They try to find evidence as to whether or not a future increase/decrease is likely to happen in the next interest rate announcement.
For instance: if they mention “the housing market is in a clear expansion” it might create inflationary pressure which might lead policy makers to increase interest rates.
Canada - CAD
Canada Quick Economic Facts
- Canada is currently the 8th largest economy in the world with a nominal GDP valued at 1.3 trillion USD.
- Canada’s economy is highly dependant on its trade balance especially with the US who imports around three quarters of Canadian exports.
- The Canadian Dollar has a very tight relationship (positive correlation) with commodities such as gold and oil.
- The Bank of Canada is responsible for the monetary policy. BoC primary objective is price stability. Changes in policies can be made at any time as their councils meet almost every day.
Important Economic Indicators for the CAD
Interest Rate Decision of Canada
As in other countries rate decisions, it is of major importance to its exchange rate.
Typically an increase in interest rates might increase the demand for CAD increasing its value. Whilst an interest rate cut will reduce the demand for CAD decreasing its value.
Because of the interest rate announcement is a highly expected and anticipated announcement, traders and investors are more focused on the wording policy makers use to collect evidence about future economic conditions.
Canada’s International Merchandise Trade
This indicator measures the difference between exports and imports (excluding services). Canada’s major trade partner is the US which imports about 75% of Canada Exports.
Typically in a good number the CAD will gain value
And in a bad number the CAD will lose value against other majors.
Gross Domestic Product (GDP) of Canada
The Canadian GDP measures the total production (and consumption) of goods and services produced within the Canadian borders.
A good number usually makes the CAD gain value
A bad number usually makes the CAD lose some value
GDP includes: Private consumption and investments, government expenditure and exports less imports.
Ivey Purchasing Managers Index (PMI)
175 corporate executives across Canada are queried about their purchases for the current month comparing them to the one previously.
With a good number the CAD might gain value
With a bad number the CAD might lose value against other majors.
A PMI value above 50 indicates expansion (better outlook) while a value below 50 indicates contraction (worse outlook).
Consumer Price Index (CPI) of Canada
As with other countries, the CPI measures price stability among a basket of goods and services. It intends to measure inflation for a given period. An increase of inflation reduces the purchasing power of the CAD while a decrease of it increases its purchasing power.
A good number tends to appreciate the CAD
A bad number tends to appreciate the CAD
Change in Canada’s Employment
Employment data is always a good measurement of the health of the economy. This announcement is the net change in the number of people employed from one period to another.
A good number could make the CAD gain some value
A bad number could make the CAD lose some value.
Australia - AUD
Australia Quick Economic Facts
- Around 80% of Australia’s GDP come from services industries such as insurance, financial services and real state
- The Reserve Bank of Australia (RBA) is responsible for the monetary policy. RBA main objectives are to: control inflation, stability of the exchange rate and low unemployment. Each month its members meet to discuss possible changes to the monetary policy.
- The AUD has a very strong relationship (positive correlated) to commodities, especially gold prices.
- Currently amongst the Majors, Australia has the highest interest rate at 6.75% (as of late 2007) making this currency interesting for carry traders.
Important Economic Indicators for the AUD
Interest Rate Decision of Australia
The Reserve Bank of Australia (RBA) is Australia’s Central Bank and is responsible for changes in monetary policy including interest rates.
From the major currencies Australia is the country with the highest interest rate valued at 6.75% (as of late 2007). The RBA normally meets nine times a year to discuss monetary policy and make possible changes.
An interest rate hike generally increases the demand for AUD increasing its value
An interest rate cut generally decreases the demand for AUD decreasing its value.
Australian Gross Domestic Product (GDP)
The GDP measures the final value of all goods and services produced within Australia’s borders during a specific period of time. GDP includes: private consumption, private investment, government expenditure and exports less imports.
During periods of constant growth inflation might become a problem for Australia’s economy.
With a good number, the AUD tends to gain value
With a bad number, the AUD tends to lose value.
Employment Change for Australia
This figure is the change of employment over a specified period of time. Usually traders and investors track employment data as a measure of the overall economy.
With a good number the AUD tends to appreciate
With a bad number the AUD tends to depreciate.
Consumer Price Index (CPI) of Australia
The CPI is the key element of inflation measurement. Basically inflation is the change in the purchasing power of one currency. Extreme inflation levels are no good for any economy, usually Central Banks tend to target values in-between.
A good CPI number tends to appreciate the AUD
A bad CPI number tends to depreciate the AUD
Trade Balance of Australia
The Trade Balance of Australia measures the difference between exports and imports of Australia and their foreign trading partners. When this number is on the negative side, it means that imports are greater than exports, conversely when this figure is in the positive side, it means that exports are greater than exports.
With a good number the AUD tends to gain value against other currencies.
With a bad number the AUD tends to lose value against other currencies.
Switzerland - CHF
Switzerland Quick Economic Facts
- Switzerland is the 19th largest economic power of the world with a GDP valued at over 380 USD billion. But on a per-capita basis, Switzerland is the 5th wealthiest country in the world.
- The service industry, specially the banking, insurance and investment industries are very well developed and employ more than 60% of its population. These industries represent around 70% of the total GDP.
- The Swiss National Bank (SNB) is responsible for the monetary policy in Switzerland. As other Central Banks, all decisions taken by the SNB are voted.
- One difference between the SNB and other central banks is that monetary policy changes can be done at anytime. The SNB inflation target is below 3%.
- Another difference is that the SNB doesn’t set an official interest rate target but a range target (i.e. 2.5%-3.00%) for their 3-month LIBOR rate.
- The USDCHF has a very strong negative correlation (close to -1.0) with the EURUSD. So they both act as a mirror, when the EURUSD goes up, the USDCHF goes down and vice versa.
- Switzerland is considered a safe-heaven.
Important Economic Indicators for the CHF
Interest Rate Announcement
As we already mentioned, the SNB doesn’t have a target rate but a target range for their 3-month LIBOR rate. The SNB mainly changes its target range to have some influence over inflationary pressure.
When the interest rate range is increased, the CHF tends to gain value.
When the interest rate range is decreased, the CHF tends to lose value.
Gross Domestic Product (GDP) of Switzerland
Swiss GDP refers to all final goods and services produced within the national borders. The GDP growth in any economy is used to measure the overall health of the economy.
As a result of a good number the CHF might gain some value.
As a result of a bad number the CHF might lose some value.
It’s important to mention that if growth rates are high and consistent it might create inflationary pressure that can lead the SNB to increase the interest rate range. If GDP growth rates are low in the other hand, the SNB might respond lowering their target range.
Trade Balance
The Swiss trade balance measures exports less imports. When the country’s exports are larger than its imports the trade balance has a positive value. The first trading partner for Switzerland is the Eurozone followed by United States.
As a result of a good number, the CHF tends to gain value.
As a result of a bad number, the CHF tends to lose value.
CPI
The CPI is the key element of inflation. Basically when the inflation rate grows the purchasing power of the CHF decreases and vice versa.
The SNB inflation target is below 3%
As a result of a good number the CHF tends to appreciate against other currencies.
As a result of a bad number the CHF tends to depreciate against other currencies.
Monetary Policy Assessment
Members of the SNB share their views of the current and future economic conditions.
Traders and investors tend to focus on key elements such as possible increases or decreases in the interest range target, inflation or growth.
Section IV: Other Economic Indicators and Events
This is a list of other economic indicators or events that normally don’t have a great impact in the forex market but under some circumstances the market could react to these indicators.
For instance, in the US with the recently mortgage crisis (Q3 2007) construction indicators could turn into very important indicators and therefore have a major impact in the market.
Another example would be oil prices, as they are near the all time high (and have been reaching new highs in the past months) investors and traders tend to focus on oil prices.
Economic Data
Industrial production (world) - This report consists of the total (and change in) production of factories, mines and utilities within one nation. This indicator is commonly used as a proxy variable for economic growth.
Producer price index (world) - Index designed to measure the change in price (as the CPI) from the seller perspective. Goods and services producers use for production.
Capacity utilization (world) - Refers to the total industrial output divided by the total production capability, measures the degree to which all factories are being used.
Business inventories (world) - This report consists of all items produced over a specific period of time, but were never sold and are held for future sales.
UBS Consumption Indicator (Switzerland) – This index measures the domestic demand in Switzerland. This index is calculated using other economic indicators such as: new car sales, overnight hotel stays, credit card transactions and others.
Durable goods (US) - Total sales of goods that have a greater life than 3 years. This indicator shows the propensity to spend and the consumer confidence over a period of time.
Productivity (world) - Measures the change of goods and services produced per unit of input. This indicator is an important component of growth.
Factory orders (US) - This report refers to the total orders of durable goods and non-durable goods. This report shows the pace of factories for the coming months.
Employment cost index (US) - Measures the changes in wages, salaries and inflation, as well as other benefits in non-agricultural industries.
Construction and housing indicators (world) - All indicators related to the construction area. These indicators are seen as an important catalyst for any economy as well as an overall growth indication:
- Housing starts and building permits
- Construction spending
- New home sales
Leading economic indicator index (world) - This index consists of 10 different indicators, including: vendor performance, change in sensitive material prices, average work week, weekly jobless claims, new orders for consumer goods and materials, business permits and others. All indicators are equally weighted since all of them are relevant to the economy.
Jobless claims (US) - An indicator that shows the number of unemployment claims reported. This indicator is released every Thursday of the week.
Tertiary Industry Index (Japan) – Measures the performance of the service sector in Japan’s economy. The Service sector is more indicative of the domestic economic activity than the manufacturing industry as the later are mainly exports.
TIC Data (US) - Amount of US treasuries and USD denominations foreigners are holding.
G7 meeting (world) - Is a meeting in which the 7 most important economies in the world (plus other important economies) discuss global issues including currency issues, such as Yuan revaluation.
Oil prices (world) - This economic indicator has a strong negative correlation with the USD and has become very popular in the Forex market. As the oil prices go up, the USD usually go down, the opposite is also true.
Surveys
Michigan consumer sentiment index (US) - Survey conducted by the University of Michigan on consumers. It gives investors and traders a general idea of the feeling of consumers.
Empire State Manufacturing Survey (US) – This is a survey conducted on New York manufacturing executives. Although NY is a pretty small sample is has shown to be of good correlation to the overall manufacturing industry in the US.
Philadelphia FED Survey (US) - Regional index that measures changes in the business growth of the manufacturing industry. When this index is above zero it indicates expansion, when at zero indicates no change, and below zero indicates contraction.
GFK consumer confidence (GER & UK) - Survey conducted on consumers on their assessment of current market conditions.
Section V: Other Factors that Influence the Forex Market
Many other factors have an important impact on a country’s currency.
These include ---
Political issues, political crises, social factors and statements of important people.
Political issues are discounted as the time passes by. It means that the nature of this problems are known to everyone, so little by little investors and traders take the appropriate actions (i.e. selling their positions as the issue gets worse and worse). Impacts of these factors are not violent in the Forex market.
On the other hand, political crises are not known until they happen. They can have violent and significant impact over the exchange rates.
Social factors can have important effects in the Forex market, especially if they are unexpected. Major strikes or terrorists attacks are example of social factors.
Statements of important people like monetary and treasury officials are also important factors. They can have significant impact on currencies.
Amongst the most influential people are:
Ben Bernanke, Chairman of the Federal Reserve
[Image 1]
Henry Paulson, US Secretary of Treasury
[Image 2]
Jean-Claude Trichet, President of the European Central Bank
[Image 3]
Peer Steinbrück, Finance Minister of Germany
[Image 4]
Toshihiko Fukui, Governor of the Bank of Japan
[Image 5]
Fukushiro Nukaga, Finance Minister of Japan
[Image 6]
Mervyn King, Governor of the Bank of England
Images: WikiPedia
Section VI: Gold and Oil
Gold and Oil have an important relationship with the Forex market. Often these two commodities are used as a leading indicator in making trading decisions in the Forex market.
Gold
Ok, before going through some analysis let’s take a look at the following table:
Gold Production by Country
[Table 2]
Source: http://www.goldsheetlinks.com/production.htm
Why would gold have a negative or inverse relationship with the USD if United States is the second larger producer of Gold (out-placed Australia in 2006)?
The answer is simple (or maybe not)...
The obvious reason behind this inverse relationship is that gold is always priced against the USD: naturally a strong dollar will buy more ounces of gold (and a weak dollar will buy less ounces of gold).
But there is also another less evident reason of this inverse relationship: decades ago, during periods of uncertainty investors tend to migrate away their capital from USD to gold as a safe-haven.
Ok, to check some numbers: The USD has fallen to historic lows against some currencies including: EUR, CHF and CAD while gold (XAUUSD) has reached all time highs.
Majors that have a positive or direct relationship with gold are the Canadian dollar and the Australian dollar.
AUD - Australia is the third largest producer of gold in the world and as a result, the correlation coefficient of the AUD and Gold prices is close to 80%. So the AUD always benefits from rising gold prices and it also decreases when gold prices decline.
CAD - Canada is the third world largest exporter of the commodity. This makes the CAD and Gold move in the same direction, although its correlation coefficient isn’t as large as the AUD and Gold.
What would be the case for the EUR or other major currencies where there is no relationship (at least not a clear one)?
Other majors will have a direct relationship with gold because both of them (majors and gold) are priced in USD.
Oil Prices
Generally speaking an increase in the price of oil results in increasing costs of transportation, utility and heating costs as well as the cost of practically every finished product (particularly in oil-dependent economies such as the US, China India and other developed countries).
Arguments in favor of an indirect relationship between oil and the USD:
- US accounts for only 5% of the world’s population but it consumes 25% of the world's fossil fuel-based energy.
- US imports about 75% of its oil, but owns only 2 percent of world reserves.
Because of this dependency on both oil and foreign suppliers, any increases in price or supply disruptions will negatively influence the US economy (hence the USD) to a greater degree than any other nation.
Canada is one of the few developed countries who are net exporters of energy (i.e. oil). Canada has the second largest oil reserves in the world (only behind Saudi Arabia). For this reason the Canadian dollar has a very tight positive relationship with oil prices.
Where is oil heading?
Oil experts adopted Hubbert’s Curve to forecast oil production for the following decades:
[Image 1]
According to their prediction, world oil production was to peak sometime around the second half between 2000 and 2010 (like now?). Right now the oil barrel is pretty close to US$100, but what could happen to if this prediction is true? It will probably keep going that way for a few more hundreds...
Brain Feeder 4 – Recently a few presidents from large oil producer countries have announced their concerns about the weak US dollar and have declared they would be willing to change the oil pricing in Euros instead of US dollars. What to you think could happen to the USD if they price their oil barrels in Euros instead of US dollars?
Section VII: Common Practices Used by Fundamentalists
Important note: This section is not intended to show fundamental systems, but a part of a given strategy.
Figure Deviation
A common practice used by short term fundamental traders (or more accurately news and event traders) is trading based on the deviation of an economic indicator actual figure vs. the expected figure.
When economic figures are to be announced, usually 3 numbers are shown:
Previous, expected (also called consensus or forecast) and actual figures.
Previous Figure: The actual figure of the previous period (usually the previous month).
Expected Figure: What experts think the figure should come out as. Usually and average is made between say forecasts of 20 experts on the field.
Actual Figure: The actual number of the figure.
What news and event traders focus on is on the last two figures: the expected and the actual figure. The more the deviation the actual figure has from the expected value the more the impact it should have in the exchange rate.
Carry Trades
Most fundamentalists trade the currency market for the long term. This is because most of the time changes in supply and demand take longer to be reflected in the charts.
Carry Trades or Rolling over is a common practice that consists of taking advantage of the interest rate differentials between two currency pairs. Most of these trades have a long-term span. Aside from taking advantage in the currency pair movements, they also benefit from buying a high yield currency and simultaneously selling a low yield currency or selling a low yield currency and simultaneously buying a high yield currency. This way, traders are paid an interest or roll over.
The pairs and cross-pairs most commonly used for this practice are:
(INCLUDE LONG OR SHORT)
[Table 1]
Equity Market Correlation
When a given equity market offers greater returns than other equity markets, it is common that fundamentalists buy the currency of the equity market that offers greater returns.
This is because investors around the world will see benefits by investing in that country. As the sentiment gets better, that currency will increase its demand, pushing its price up.
Section VIII: Some Thought on News and Event Trading
News and event trading has become a very popular trading style in these days. The reason behind it lies in the huge profit potential made in just a few minutes - with no effort at all.
Take for instance the first Friday of the month, when the non-farm payrolls report is released. The price of the EUR/USD can move around 150 pips in less than 10 minutes. That is US$1,500 (trade based in only one standard lot).
What traders fail to realize are all the risks involved in such practices. What if those 150 pips go against you? Even with a stop loss order, sometimes your broker won’t be able to honor it, because the price gaps (values between prices are not printed). In these cases, your broker won’t take the loss, so he will give you the closest printed price, meaning 70, 100, or 150 pips against you. That amount of pips could mean a margin call or a huge loss. In how much time again? …10 minutes.
The important thing here is that your job as a trader is to make sure you are going to be able to trade the next day, week, and years to come. Taking these kinds of risks won’t help much.
Other traders instead of using market orders to get in the market use stop and limit orders. But the same happens there, it is too risky, the market could again gap and your broker won’t be able to honor your stop. Traders that use this kind of strategy are taking uncalculated risks, risks that could cost them their trading account, and probably their trading careers.
Also, price movements are not always steady in one direction. It could go up and trigger some orders just to go back to the other extreme, then trigger the other side orders and then come back to where it all started.
The truth is, there is no possible way to forecast price movements in such circumstances. As we already know, the price moves based on traders and investors expectations. This is the combination of all traders perceptions on where price should be. To possibly know where the price is heading we need to ask every single trader and investor around the world what their intentions are during such announcements (something impossible to do). To go a little further, sometimes as the news report comes out, nothing happens, or worse, the price goes against the fundamentals.
Take for instance a day of interest rate announcement. It is rumored that there will be an interest rate cut. In this case, the currency will go short before the actual decision. Once the interest cut is announced, it is possible that the currency will be bought back, as all traders that could have shorted the currency, had already been short days or weeks ago. So there is no one else to short the currency. In this case, the price could be pushed up, against the fundamentals.
The point I want to make here is, trading itself is risky, and there are risks that you just cannot avoid, like the possibility to lose one trade. There are however some other risks that traders must avoid, as in event trading. The more you control your risks, the better results you will have. Take care of your risks; your profits will take care of themselves.
We consider trading the news announcements to be very risky.
Is there a system based solely on fundamental trading?
I am sure there is. But as with every system, it should have rules and setups that have to be present in order to get in the market, as well as money management controls etc.
Summary Report
Ok, now that you have read the lesson material please make sure you completely understand and/or do the following:
Even when we forex traders don’t trade fundamental announcements, we always get questioned about economic aspects, so we always need to be prepared to answer those questions accurately. But this is not the main reason why we should study fundamentals, the main reason is to really understand what kind of indicators there are and the effect that each one of them could have on any currency pair we are involved with, as well as other relationships with commodities such as gold and oil.
This lesson is important for novice and advanced students alike with no prior economic studies.
Make sure you understand the following:
- What each economic indicator measures and the effect on currency pairs
- Difference between political issues and crisis as well as what could be the impact in the currency market of social factors and statements of important people
- These days the oil price has become very important to currency traders so it is important to understand the effects of oil price changes in the currency market.
- Risks involved while trading during important news announcements
- Techniques used by fundamental traders (or news and event traders).
Here are the Brain Feeders:
Brain Feeder 1 – We were asked about what is a good or/and a bad figure or number in fundamental releases?
What we mean by “good” or “bad” number is how close or apart is the actual figure from the consensus or expected figure. For instance, if we expect the US economy to have created 50,000 jobs in November and the actual figure is 45,000, it is a bad number because it was worst than expected although 45,000 is still a positive numbers and it means the economy has created that amount of new jobs. On the other side if the actual figure is 60,000 then it is a good number because it was better than expected.
Brain Feeder 2 – In the second Brain Feeder we were asked how is the European HCPI different from what other countries use as a measurement of inflation (like the US uses CPI)?
Yeah I know, this Brain Feeder has nothing to do with thinking, its more like a research thing, anyway here is the answer:
According to WikiPedia the HCPI differs from the CPI in two aspects:
- The HCPI incorporates rural consumers (as well as urban consumers) while the CPI focuses only on urban consumers.
- The HCPI excludes “owner-occupied” from its scope while the CPI incorporates it.
Which one is better? Who knows...
Brain Feeder 3 – Is there a good Inflation number for all countries?
No, the effect of this announcement varies depending on the given circumstances. Most of the time: when a country suffers from high inflation, a high CPI number could have a negative impact on its currency value (this is the case for most developed countries). On the other hand, when a country suffers from low inflation or deflation (such as Japan), a low CPI number could have a negative impact on its currency value. Extreme values are no good for any economy; it is more likely that central banks try to find equilibrium in between.
Brain Feeder 4 – We were asked what do we think could happen to the USD if oil producer countries price their oil barrels in Euros instead of US dollars?
Excellent! You got this one right! The USD will plummet! That’s the only answer and of course the demand for Euros will increase.
Good luck!
