Fundamental analysis by trading on Forex
Two types of analysis are used for market movements forecasting: fundamental, and technical (the chart study of past behavior of currencies prices). The fundamental one focuses on theoretical models of exchange rate determination and on major economic factors and their likelihood of affecting foreign exchange rates.
1. Theories of exchange rate determination
Purchasing power parity states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate—the law of one price. There are two versions of the purchasing power parity theory: the absolute version and the relative version. Under the absolute version, the exchange rate simply equals the ratio of the two countries' general price levels, which is the weighted average of all goods produced in a country. However, this version works only if it is possible to find two countries, which produce or consume the same goods. Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant. In reality, transportation costs are significant and dissimilar around the world. Trade barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence
costs and goods distribution. Finally, this version disregards the importance of brand names. For example, cars are chosen not only based on the best price for the same type of car, but also on the basis of the name ("You are what you drive").
Under the PPP relative version, the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level. The relative version of the PPP is also not free of problems: it is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as with the absolute version, different price index weighting and the inclusion of different products in the indexes make the comparison difficult and in the long term, countries' internal price ratios may change, causing the exchange rate to move away from the relative PPP. In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices. In the short run, the exchange rate is influenced by financial and not by commodity market
conditions.
Theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. In other words, the degree to which the rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change in price. For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods, and therefore less demand for its own currency. The elasticities approach is not problem-free because in the short term the exchange rate is more inelastic than it is in the long term and additional exchange rate variables arise continuously, changing the rules of the game.
Modern monetary theories on short-term exchange rate volatility take into consideration the short-term capital markets' role and the long-term impact of the commodity markets on foreign exchange. These theories hold that the divergence between the exchange rate and the purchasing power parity is due to the supply and demand for financial assets and the international capability. One of the modern monetary theories states that exchange rate volatility is triggered by a onetime domestic money supply increase, because this is assumed to raise expectations of higher future monetary growth. The purchasing power parity theory is extended to include the capital markets. If, in both countries whose currencies are exchanged, the demand for money is determined by the level of domestic income and domestic interest rates, then a higher income increases demand for transactions balances while a higher interest rate increases the opportunity cost of holding money, reducing the demand for money. Under a second approach, the exchange rate adjusts nstantaneously to maintain continuous interest rate parity, but only in the long run to maintain PPP. Volatility occurs because the commodity markets adjust more slowly than the inancial markets. This version is known as the dynamic monetary approach.
Synthesis of traditional and modern monetary views. In order to better suit the previous theories to the realities of the market, some of the more stringent conditions were adjusted into a synthesis of traditional and modern monetary theories. A short-term capital outflow induced by a monetary shock creates a payments imbalance that requires an exchange rate change to maintain balance of payments equilibrium. Speculative forces, commodity markets disturbances, and the existence of short-term capital mobility trigger the exchange rate volatility. The degree of change in the exchange rate is a function of consumers' elasticity of demand. Because the financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes and in the long term by commodities changes.
2. Economics for fundamental analysis
For fundamental analysis on Forex, just as on any goods market, traders use the information from analytical reviews of specialists published in newspapers as well as charts and tables of many numerical indicators serving this purpose. All fundamental indicators are generally released on a monthly basis, except for the Gross Domestic Product and the Employment Cost Index, which are eleased quarterly (See below). All economic indicators are released in pairs. The first number reflects the latest period. The second number is the revised figure for the month prior to the latest period. For instance, in July, economic data is released for the month of June, the latest period. In addition, the release includes the revision of the same economic indicator figure for the month of May. The reason for the revision is that the department in charge of economic statistics
compilation is in a better position to gather more information in a month's time. This feature is important for traders. If the figure for an economic indicator is better than expected by 0.4% for the past month, but the previous month's number is revised lower by 0.4%, then traders can draw a justified conclusion about the economy’s situation. Economic indicators are released at different times. In the United States, economic data is generally released at 8:30 and 10 AM ET. It is important to remember that the most significant data for foreign exchange is released at 8:30 AM ET. In order to allow time for last-minute adjustments, the United States currency futures markets open at 8:20 AM ET.
Sources of information. Information on upcoming economic indicators is published in all leading newspapers, such as the Wall Street Journal, the Financial Times, and the New York Times; and business magazines, such as Business Week. More often than not, traders use the monitor sources—Bridge Information Systems, Reuters, or Bloomberg — to gather information both from news publications and from the sources' own up-to-date information. Separate groups of
fundamental indicators are considered below in accordance with a generally accepted
classification.
Economic indicators
The Gross National Product (GNP) measures the economic performance of the whole economy. This indicator consists, at macro scale, of the sum of consumption spending, investment spending, government spending, and net trade. The gross national product refers to the sum of all goods and services produced by United States residents, either in the United States or abroad. The Gross Domestic Product (GDP) refers to the sum of all goods and services produced in the United States, either by domestic or foreign companies. The differences are nominal in the case of the economy of the United States. GDP figures are more popular outside the United States. In order to make it easier to compare the performances of different economies, the United States also releases GDP figures.
Consumption Spending is made possible by personal income and discretionary income. The decision by consumers to spend or to save is psychological in nature. Consumer confidence is also measured as an important indicator of the propensity of consumers who have discretionary income to switch from saving to buying.
Investment (or gross private domestic) Spending consists of fixed investment and inventories.
Government Spending is very influential in terms of both sheer size and its impact on other economic indicators, due to special expenditures. For instance, United States military expenditures had a significant role in total U.S. employment until 1990. The defense cuts that occurred at the time increased unemployment figures in the short run.
Net Trade is another major component of the GNP. Worldwide Internationalization and the economic and political developments since 1980 have had a sharp impact on the United States' to compete overseas. The U.S. trade deficit of the past decades has slowed down the GNP. GNP can be approached in two ways: flow of product and flow of cost.
Industrial sector indicators
Industrial Production indicator consists of the total output of a nation's plants, utilities, and mines. From a fundamental point of view, it is an important economic indicator that reflects the strength of the economy, and by extrapolation, the strength of a specific currency. Therefore, foreign exchange traders use this economic indicator as a potential trading signal.
Capacity utilization indicator consists of total industrial output divided by total production capability. The term refers to the maximum level of output a plant can generate under normal business conditions. In general, capacity utilization is not a major economic indicator for the foreign exchange market. However, there are instances when its economic implications are useful for fundamental analysis. A "normal" figure for a steady economy is 81.5 percent. If the figure reads 85 percent or more, the data suggests that the industrial production is overheating, that the economy is close to full capacity. High capacity utilization rates precede inflation, and expectation in the foreign exchange market is that the central bank will raise interest rates in order to avoid or fight inflation.
Factory orders refer to the total of durable and nondurable goods orders. Nondurable goods consist of food, clothing, light industrial products, and products designed for the maintenance of durable goods. Durable goods orders are discussed separately. The factory orders indicator has limited significance for foreign exchange traders. Durable goods orders consist of products with a life span of more than three years. Examples of
durable goods are autos, appliances, furniture, jewelry, and toys. They are divided into four major categories: primary metals, machinery, electrical machinery, and transportation. In order to eliminate the volatility pertinent to large military orders, the indicator includes a breakdown of the orders between defense and non-defense. This data is fairly important to foreign exchange markets because it gives a good indication of consumer confidence. Because durable goods cost more than nondurable, a high number in this indicator shows consumers' propensity to spend. Therefore, a good figure is generally bullish for the domestic currency.
Business inventories consist of items produced and held for future sale. The compilation of this information is facile and holds little surprise for the market. Moreover, financial management and computerization help control business inventories in unprecedented ways. Therefore, the importance of this indicator for foreign exchange traders is limited.
1. Theories of exchange rate determination
Purchasing power parity states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate—the law of one price. There are two versions of the purchasing power parity theory: the absolute version and the relative version. Under the absolute version, the exchange rate simply equals the ratio of the two countries' general price levels, which is the weighted average of all goods produced in a country. However, this version works only if it is possible to find two countries, which produce or consume the same goods. Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant. In reality, transportation costs are significant and dissimilar around the world. Trade barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence
costs and goods distribution. Finally, this version disregards the importance of brand names. For example, cars are chosen not only based on the best price for the same type of car, but also on the basis of the name ("You are what you drive").
Under the PPP relative version, the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level. The relative version of the PPP is also not free of problems: it is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as with the absolute version, different price index weighting and the inclusion of different products in the indexes make the comparison difficult and in the long term, countries' internal price ratios may change, causing the exchange rate to move away from the relative PPP. In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices. In the short run, the exchange rate is influenced by financial and not by commodity market
conditions.
Theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. In other words, the degree to which the rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change in price. For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods, and therefore less demand for its own currency. The elasticities approach is not problem-free because in the short term the exchange rate is more inelastic than it is in the long term and additional exchange rate variables arise continuously, changing the rules of the game.
Modern monetary theories on short-term exchange rate volatility take into consideration the short-term capital markets' role and the long-term impact of the commodity markets on foreign exchange. These theories hold that the divergence between the exchange rate and the purchasing power parity is due to the supply and demand for financial assets and the international capability. One of the modern monetary theories states that exchange rate volatility is triggered by a onetime domestic money supply increase, because this is assumed to raise expectations of higher future monetary growth. The purchasing power parity theory is extended to include the capital markets. If, in both countries whose currencies are exchanged, the demand for money is determined by the level of domestic income and domestic interest rates, then a higher income increases demand for transactions balances while a higher interest rate increases the opportunity cost of holding money, reducing the demand for money. Under a second approach, the exchange rate adjusts nstantaneously to maintain continuous interest rate parity, but only in the long run to maintain PPP. Volatility occurs because the commodity markets adjust more slowly than the inancial markets. This version is known as the dynamic monetary approach.
Synthesis of traditional and modern monetary views. In order to better suit the previous theories to the realities of the market, some of the more stringent conditions were adjusted into a synthesis of traditional and modern monetary theories. A short-term capital outflow induced by a monetary shock creates a payments imbalance that requires an exchange rate change to maintain balance of payments equilibrium. Speculative forces, commodity markets disturbances, and the existence of short-term capital mobility trigger the exchange rate volatility. The degree of change in the exchange rate is a function of consumers' elasticity of demand. Because the financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes and in the long term by commodities changes.
2. Economics for fundamental analysis
For fundamental analysis on Forex, just as on any goods market, traders use the information from analytical reviews of specialists published in newspapers as well as charts and tables of many numerical indicators serving this purpose. All fundamental indicators are generally released on a monthly basis, except for the Gross Domestic Product and the Employment Cost Index, which are eleased quarterly (See below). All economic indicators are released in pairs. The first number reflects the latest period. The second number is the revised figure for the month prior to the latest period. For instance, in July, economic data is released for the month of June, the latest period. In addition, the release includes the revision of the same economic indicator figure for the month of May. The reason for the revision is that the department in charge of economic statistics
compilation is in a better position to gather more information in a month's time. This feature is important for traders. If the figure for an economic indicator is better than expected by 0.4% for the past month, but the previous month's number is revised lower by 0.4%, then traders can draw a justified conclusion about the economy’s situation. Economic indicators are released at different times. In the United States, economic data is generally released at 8:30 and 10 AM ET. It is important to remember that the most significant data for foreign exchange is released at 8:30 AM ET. In order to allow time for last-minute adjustments, the United States currency futures markets open at 8:20 AM ET.
Sources of information. Information on upcoming economic indicators is published in all leading newspapers, such as the Wall Street Journal, the Financial Times, and the New York Times; and business magazines, such as Business Week. More often than not, traders use the monitor sources—Bridge Information Systems, Reuters, or Bloomberg — to gather information both from news publications and from the sources' own up-to-date information. Separate groups of
fundamental indicators are considered below in accordance with a generally accepted
classification.
Economic indicators
The Gross National Product (GNP) measures the economic performance of the whole economy. This indicator consists, at macro scale, of the sum of consumption spending, investment spending, government spending, and net trade. The gross national product refers to the sum of all goods and services produced by United States residents, either in the United States or abroad. The Gross Domestic Product (GDP) refers to the sum of all goods and services produced in the United States, either by domestic or foreign companies. The differences are nominal in the case of the economy of the United States. GDP figures are more popular outside the United States. In order to make it easier to compare the performances of different economies, the United States also releases GDP figures.
Consumption Spending is made possible by personal income and discretionary income. The decision by consumers to spend or to save is psychological in nature. Consumer confidence is also measured as an important indicator of the propensity of consumers who have discretionary income to switch from saving to buying.
Investment (or gross private domestic) Spending consists of fixed investment and inventories.
Government Spending is very influential in terms of both sheer size and its impact on other economic indicators, due to special expenditures. For instance, United States military expenditures had a significant role in total U.S. employment until 1990. The defense cuts that occurred at the time increased unemployment figures in the short run.
Net Trade is another major component of the GNP. Worldwide Internationalization and the economic and political developments since 1980 have had a sharp impact on the United States' to compete overseas. The U.S. trade deficit of the past decades has slowed down the GNP. GNP can be approached in two ways: flow of product and flow of cost.
Industrial sector indicators
Industrial Production indicator consists of the total output of a nation's plants, utilities, and mines. From a fundamental point of view, it is an important economic indicator that reflects the strength of the economy, and by extrapolation, the strength of a specific currency. Therefore, foreign exchange traders use this economic indicator as a potential trading signal.
Capacity utilization indicator consists of total industrial output divided by total production capability. The term refers to the maximum level of output a plant can generate under normal business conditions. In general, capacity utilization is not a major economic indicator for the foreign exchange market. However, there are instances when its economic implications are useful for fundamental analysis. A "normal" figure for a steady economy is 81.5 percent. If the figure reads 85 percent or more, the data suggests that the industrial production is overheating, that the economy is close to full capacity. High capacity utilization rates precede inflation, and expectation in the foreign exchange market is that the central bank will raise interest rates in order to avoid or fight inflation.
Factory orders refer to the total of durable and nondurable goods orders. Nondurable goods consist of food, clothing, light industrial products, and products designed for the maintenance of durable goods. Durable goods orders are discussed separately. The factory orders indicator has limited significance for foreign exchange traders. Durable goods orders consist of products with a life span of more than three years. Examples of
durable goods are autos, appliances, furniture, jewelry, and toys. They are divided into four major categories: primary metals, machinery, electrical machinery, and transportation. In order to eliminate the volatility pertinent to large military orders, the indicator includes a breakdown of the orders between defense and non-defense. This data is fairly important to foreign exchange markets because it gives a good indication of consumer confidence. Because durable goods cost more than nondurable, a high number in this indicator shows consumers' propensity to spend. Therefore, a good figure is generally bullish for the domestic currency.
Business inventories consist of items produced and held for future sale. The compilation of this information is facile and holds little surprise for the market. Moreover, financial management and computerization help control business inventories in unprecedented ways. Therefore, the importance of this indicator for foreign exchange traders is limited.
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