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October 5, 2006

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First-ever
Futures Trading Summit
for active traders!

Fundamental Analysis

Name: Marilyn McDonald

Company: Interbank FX

Learn More About Today's Author
Favorite Movie: Anything by Miyazaki

Fundamental Analysis

Every time you hear someone talking about analyzing the Forex market they usually tout Technical and Fundamental Analysis. They talk about the need to use both in your analysis and then do very little to tell you how to do this.  And while most traders are familiar with Technical Analysis it is hard to pin down exactly what Fundamental Analysis consists of, particularly for the forex market.  Most traders are left with questions like… “I don’t get it… Is there a PE ratio of Japan??”  Well, sort of.  Fundamental Analysis differs for the Forex market just a bit but the same basic principles apply. 

Fundamental analysis for the Forex market examines the macroeconomic indicators, asset markets and political considerations of one nation’s currency as opposed to another. Macroeconomic indicators include things such as growth rates (Gross Domestic Product), interest rates, inflation, unemployment, money supply, foreign exchange reserves and productivity. Other macroeconomic indicators include the CPI – a measurement of the cost of living, and the PPI – a measurement of the cost of producing goods.  Asset markets are made up of stocks, bonds and real estate. Political considerations influence the level of confidence in a nation’s government, the climate of stability and level of certainty.

There is a basic rule of thumb that says a currency can become more valuable in two main ways: when the amount of currency available in the world market place is reduced (for example, when the US Fed increases the interest rates and causes a reduction in spending), or when there is an increase in the demand for that particular currency.  But there are also many little influences that can nudge the currencies value enough for the retail forex trader to make (or lose) a substantial amount.

Let’s take a moment to examine some of the Fundamental information that has the potential to move the forex market. 

Getting a birds-eye view

If you want a solid view of the economy driving the currency pair you are trading it is helpful to get a good overview of the currency you are looking to trade.  One way to perform a more complete fundamental breakdown of a currency pair it is useful to compile the following information:

Daily range
(past x days):

 

Average:

 

Median:

 

Weekly range
(past x weeks):

 

Average:

 

Median:

 

For each pair list:

 

52 week high/low:

 

Next Central Bank Meeting Date:

 

GDP (annualized growth):

 

Short term interest rate expectations:

 

How are inflation rates?

 

Unemployment rates:

 

By filling out this form will help you to examine the health of your chosen currency pairs.   

Checking out the Macros

An interesting number watch when you are checking out the macroeconomics of a country is the interest rate.  Be careful not to jump to any premature decisions however, interest rates work like a split-personality and can have both a strengthening and a weakening effect on your currency. On the negative side, investors will often sell off their holdings as interest rates increase because they believe that higher borrowing costs will adversely affect stock rates.  This can cause a downturn in the stock market as well as in the national economy.  However, high interest rates tend to attract foreign investments which strengthen the local currency.   

Another thing to keep your eye on is the International Trade Balance.  A trade balance which shows a deficit (more imports than exports) is usually a bad sign.  Deficits mean that money is flowing out of the country to purchase foreign made goods and this can have a devaluing effect on the currency.   It is important to remember that the market will generally dictate whether a trade deficit is bad news or not.  If the country routinely operates with a deficit it has probably already been factored into the currency price. Trade deficits will generally only affect a currency when they are reported higher than the market consensus. 

Nice Assets

The asset markets have an interesting tie to the value of a country’s currency.   For instance, in the past the USD has moved in line with the stock markets.  In fact, everywhere you look people are still touting that relationship.  However, if you look at the charts (yeah, the technicals… ) you will find that this doesn’t hold anymore.  If the stock markets are up, the USD is usually down.  This is possibly due to the fact that US companies have increasingly derived their revenues from outside the US.   You can also see the same sort of influences between the Japanese Yen and the Nikkei. 

Some currencies, however, are closely tied to commodity prices.  The four major currencies that are usually mentioned in conjunction with commodity prices are the Australian Dollar, the Canadian Dollar, the New Zealand Dollar, and the Swiss Franc.   Gold and oil, in particular, are the commodities that have the most influential relationship with the forex market and some tout them as leading indicators for forex trading.

Watching the price of gold can be very beneficial for forex traders, especially if you bear in mind that gold moves on inflationary scares.  If you know how your chosen currency pair reacts to gold you may have a fairly reliable predictor of price movement. 

For instance, the US is the world’s second largest producer of gold, after South Africa.  So the price of gold can have a strong impact on the US Dollar.  Remember though that gold normally does not move in line with the US Dollar, they tend to have an inverse relationship to each other.   Also, the Australian dollar also has strong correlations with gold because Australia is the world’s third largest exporter of gold.  Bearing these facts in mind it is easy to see why the AUDUSD pair tends to follow gold’s prices.

The other 800 pound commodity gorilla in the forex market is oil.  The Canadian Dollar is the currency most influenced by rising or falling oil prices.  If you have an eye for the USDCAD then it is interesting to watch oil related news.  For instance, several months ago there was a spike in oil prices due to the death of a former Iraqi ruler.  This spike translated to movements in the forex market. This was a classic example of using the price of oil as a leading indicator for forex prices.

It’s all about politics

Politics can play a strong role in the value of a currency.  Several words mis-spoken by a political leader can boost or drop that currencies value in a matter of seconds.  A general rule of thumb is the more volatile the politics, the more volatile the currency.  The political neutrality of the Swiss and the fact that a large amount of its currency reserves have traditionally been backed by gold translates to the Swiss Franc being hailed as a safe haven during periods of uncertainty. This means that the CHFUSD ends up having a strong positive correlation with gold prices.
Check the crosses & relative pairs

Currency pairs often move in correlation with each other, either in the same direction or the exact opposite.  Examples of pairs that tend to have a strong negative correlation are the EURUSD and the USDCHF.  An example of a pair that has a strong positive correlation with each other are the GBPJPY and the EURJPY.  Check the charts and watch for another pair that has a strong relationship to your chosen pair.  These can server either as a leading indicator or a confirmation depending on the relationship between the pairs.

What’s going on in the news??

Watching the news quickly becomes a consuming hobby for the fundamental trader.  Headlines like “Fed Futures Start to Price In Rate Cuts”, “4% Chance of Oct. Easing” and “Odds of 41% by Jan 31 as weak Philly Fed index spurs fear of big slowing” should make you sit up and take a look if you are trading a pair that is influenced by the USD.  This sort of news will typically impact the U.S. Stock Markets which will influence the forex market. 

Whereas headlines like “Energy Prices Keeping Cooling Off” should make you take a closer look at the Canadian Dollar, as its value fluctuates in correlation to oil.  In fact, let’s take it a step further.  Let’s say there is some political event that spikes (up or down) the price of oil.  This will have an impact on the Canadian dollar and most of the time there is a bit of a lag so there is a bit of time to take advantage of the movement. 

My Consensus

Fundamental information can be just as influential on your trading as technical analysis.  When you understand the information behind the news regarding your chosen currencies you will be able to trade more confidently when news and politics move the market.  Watch all signs with an open mind. My last nugget of advice is this…When you have a currency pair and commodity that move closely in line with each other, either one can lead - so you should be watching for moves in both.

About Today's Author

Marilyn has worked in the trading and financial services industry for a number of years, currently with Interbank FX and prior to that at Reuters working with MetaStock. She has a strong advertising and marketing background. She loves to travel and has lived in a number of different countries but now resides in Utah with her son, a tank full of fish and two cats.

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