Forex Fundamental Analysis
In this section, we will discuss trading analysis and how it helps traders make investment decisions. The exchange rate of a currency is determined by a variety of factors—economic or political, domestic or international. However, fluctuations in exchange rates are not limited to the factors mentioned above; they can also be influenced by the beliefs of market participants. We call this intrinsic factor the “Market Psychology” of the Forex market.
This is one of the key factors behind market sentiment. Considering all the uncertainties in the market, how do Forex traders make their trading decisions? In order to formulate their trading strategies, traders analyze the market using tools like fundamental and technical analysis.
Fundamental Analysis
The key concept behind fundamental analysis is the idea that a positive economic outlook strengthens a country’s currency. When a country is politically stable and economically sound, it attracts foreign investment. Therefore, would-be investors have to purchase the country’s currency if they want to invest or start a business there. The surge in investment boosts the demand for a country’s currency and raises its value relative to other currencies.
Accordingly, any major news and announcements—economic developments, social upheavals, Central Bank policies governing interest rates, and the release of earnings reports—will affect the exchange rate of a country’s currency.
Major Economic Events
Let us look more closely at some of the main economic events that can drive Forex price fluctuations. Take a few moments to familiarize yourself with these terms, for you will come across them often as you trade Forex.
Gross Domestic Product
The Gross Domestic Product, or GDP, of a country is an indicator that measures how well the economy is doing. GDP calculates the total value of goods and services that were produced in the country over a period. Accordingly, any news about a country’s GDP is always keenly awaited by the financial markets.
Balance of Trade
A country’s balance of trade shows the relationship between its exports and imports. A trade surplus is indicated by a positive value; a trade deficit is indicated by a negative value. To put it in another way, a trade surplus means a country’s exports were more than sufficient to pay for its imports; a trade deficit means the opposite. The significance of this figure depends on whether we are looking at it from a short-term point of view or a long-term point of view.
Countries with faster GDP growth rates than their trading partners tend to incur trade deficits, as imports normally rise more than proportionally to the GDP growth rate. However, trade deficits only represent a problem to a country’s economy if they occur persistently, in which case the affected country will incur foreign debt and the ensuing interest rate payments. Should the debt be perceived as unsustainable, this will result in a currency crisis.
Consumer Price Index
The Consumer Price Index, or CPI, is the most commonly used indicator of inflation. It is used to measure the purchasing power of money. Inflation is not good for a country’s economy, as rising prices make it harder for consumers to buy goods.
The Producer Price Index
In addition to the CPI, the Producer Price Index, or PPI, is also taken into account when measuring the inflation rate. The PPI measures the price of goods that are received by domestic producers. Because the PPI measures prices at the production end, it is a good indicator of future inflation in certain industrial sectors.
Unemployment Rate
A country’s unemployment rate is another key indicator used in measuring the health of a country’s economy. The unemployment report shows the percentage of the country’s workforce that is unemployed, the number of jobs created, the average working hours per week, and the average earnings per hour. The release of this report usually causes the market to react significantly. This is because a drop in the unemployment rate is regarded as indicative of a strong economy. In Forex, a drop in unemployment means a stronger exchange rate.
Durable Goods Orders
The Durable Goods Orders, or “Advance Report on Durable Goods Manufacturers' Shipments and Orders,” measures the value of goods with a lifespan of three years or more. This helps to provide an indication of a country’s future industrial activity. A rising trend in durable goods orders is indicative of rising inflation, increased employment, increased corporate profits, and a higher interest rate. This ultimately results in a stronger currency.
Retail Sales Index
The Retail Sales Index represents goods that are sold within the retail sector. It is used as an indicator of consumer confidence. Due to the fact that retail sales form a large part of a country’s total GDP, a persistent drop in retail sales can mean that a recession is looming. For many traders in the Forex market, a positive consumer confidence indicates that the population is in a buying mood, which could lead to a higher interest rate and a stronger currency.
Real Estate Data
The “New Residential Construction Report” in the US is a report on homes built by the real estate sector. Forex traders follow this index closely, for the purchase of new homes is a good indication of consumers’ willingness to spend on other goods (appliances, furniture, household items, and garden supplies).
A hike in the interest rate will eventually slow growth in the real estate sector, as mortgages become more expensive. As a result of the fact that the real estate sector has a ripple effect on other sectors of the economy, sluggish sales are usually understood by Forex traders as a sign of a weak economy.
Interest Rates
Not surprisingly, Forex traders wait for any decision regarding the interest rate by the Central Bank. The reason for this is simple: A higher interest rate translates into more interest payment made on the invested currency (higher profits).
Nevertheless, one should always bear in mind that changes to the interest rate are an indirect result of the cumulative effect of the other majors indicators mentioned above. As such, it is sometimes possible to predict an interest rate decision by the Central Bank by closely monitoring the major announcements and analyzing the forecasts made by Forex market analysts.
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