Lecture 13

Fundamental analysis of foreign exchange market.

As it was mentioned earlier, the prediction of market behavior is based on two main branches of the analysis – fundamental and technical analyses. In our previous lectures we have paid attention to the technical analysis and now it’s time to get acquainted with the basics of the fundamental analysis.

A few indicators of the economy actively affect currencies course movement. The other indicators do not have a direct, immediate impact on this movement, they are more important to economists and other markets. They indirectly confirm (or not confirm) the supposed or known trends in the economy, which are out of concrete determining influence at the FOREX market and therefore they are simply absorbed by the market in its usual fluctuations. The fundamental analysis examines the economic situations in definite countries and the world all in all and their influence to each other on the basis of dozens of different reasons and economic indicators that suddenly took place or vice versa openly reported and published in advance of the known by various governmental, non-governmental and academic organizations from major world countries plan.

Any information which directly or indirectly may influence the economy can be regarded as fundamental. It all can be divided into 4 main categories – economic factors, financial factors, political events and crises.

  1. Economic factors (indicators) are different from others that their released data is known in advance, at least for the majority of the Largest Economies.
  2. Political factors are very diversified, some of them are previously known, such as the President elections; for example, a sharp change of government form will be a shock for all markets, regardless which methods of analysis they used – fundamental or technical.
  3. Financial factors often remain to be unpredictable and therefore they have a strong impact on state of FOREX. The most demonstrative example is the trend of interest rates by the Central Banks of the Largest Economies in the world. For example, by the U.S. Federal Reserve Bank (Federal Reserve). No one knows exactly whether the trend of interest rates will be done or not but even assumptions about it will have an intense impact on the market. Inside 2-3 weeks prior to the meeting of the Federal Reserve heads (FOMC – Federal Open Market Committee), who gather together in Washington for their meeting every 1.5 months, they accepted by the market very nervously, if the change of the interest rate was a sudden one, then the market literally became “nervous”, which leads to sharp changes of the exchange rate.
  4. Crises can have a strong impact on the market, according to their predictability, that is why the crisis in the Persian Gulf had a limited effect on FOREX market. But sometimes even fluffs in the officials’ speeches led to a sharp change of the course, as it was during the speech of the British Prime Minister Tony Blair concerning the Euro taking – over instead of the pound in 2001.

 

Indicators of fundamental analysis 

Economic indicators are important element of fundamental analysis. Dates of their publication are known beforehand. In the USA they are published monthly except of GDR (Gross Domestic Product) and GDPD (Gross Domestic Product Deflator) which are published quarterly.  Indicators which are published weekly usually do not influence the work on Forex and there is no sense for considering them. Knowledge of economic indicators’ date of publication is of the utmost importance for trader but it is easy to receive it now – information about the dates as well as analysis of these indicators’ influence regularly appear in the news of all firm-providers which provide Internet trading, and in many other resources of Internet.

Economy of the USA come up to 20,6% of global economy, so influences the most Forex market. With this aim, we will examine economic indicators of the USA and you can estimate the indicators of other countries on the analogy with account of their influence on the world economy in whole. All economic indicators consists of 2 parts: first part – figures for last month, and the second part – update information for the previous one.

The Gross National Product (GNP) is the most important economic indicator. It is calculated by formula:

GNP = C+I+G+T

where: Consumer Expenditures which depend on personal income and Consumer Confidence, i.e. on psychological factor, the result of which is decision of spending or saving money;

I – investments

G – Government spending, which influence much on different economic indicators and country’s economy in whole;

T – Trade balance of the country (Export (minus) Import).

GNP is published quarterly and shows total amount of goods and services provided by American companies in the USA and abroad for some period of time. During the GNP growth comparing with forecasts – US Dollar course is rising against other currencies and vice versa.

The Gross Domestic Product (GDP) – in distinction from GNP, GDP reflects the value of all goods and services produced on the territory of the USA by local and international companies. Relating to the US economy difference between GDP and GNP is small; however this index is more popular abroad than in the USA, then it is published in the United States of America only for making comparison other economies with American one easier.

Inflation Indexes – indicators showing the distribution of trend of price rising for goods and services; and traders closely follow the inflation processes development in the country because the main weapon of the Central Bank in the fight against inflation is interest rate rising, which increase the value of the local currency. Moreover, inflation level lower the interest rate till its real objective value which along with real data of GDP/GNP is the most objective tool of comparison of different countries economics for search of the best conditions for money making for traders and funds managers.

Producer Price Index (PPI) has been investigated since the XXth century and considers the average wholesale price changes for the raw products and utilities at all production stages. For This index information from the majority of branches of economy including production, extraction of raw materials and agricultural sector is processed. In general, price changes approximately at 3400 name of raw materials and goods produced only in the USA are taken into consideration. The most important groups of goods include: whole food – 24%, fuel – 7%, vehicles – 7%, clothes – 6%. Published monthly.

Consumer Price Index (CPI) examines average changes of retail prices at the special consumer basket which includes one and same goods and services constantly. It includes data about whole food prices – 19% of the index, house value – 38%, fuel – 8%, vehicles – 7%, and clothes, transportation charges and medical services which people pays for daily. It also includes imported goods. Published monthly. Both indexes PPI and CPI help to measure inflationary activity of the economy.

Commodity Research Bureau’s Futures Index (CRB Index) consists of equi-weighted futures prices for 21 type of commodities: precious metals (gold, silver, platinum), industrial commodities (oil, gasoline, diesel fuel, wood, cuprum, cotton), crops (corn, wheat, soybean, bean cake, soya oil), live cattle and meat (live stock, pork), import (coffee, cocoa, sugar), misc. (orange juice).

In spite of the fact that 13 positions of 21 refer to the whole foods which wrenches the real situation of the headline inflation, this index is rather popular during last 20 years among the professionals of FOREX.

The Journal of Commerce Industrial Price Index (JoC) consists of prices at 18 industrial goods being processed at the first stages of industrial production, building and electric-power production. This indicator is more accurate because it is projected to show inflationary changes before other inflationary indicators.

Balance-of-Payments consists of all international commercial and financial transactions of one country. Analysts value the real importance of this index by keeping the eye on the big picture of a county’s economy from the point of view of its competitive ability. It is derivative from the quantity of natural resources of industrial base, professional level of labor at the employment market and labor costs market. However this index is used meagrely by traders who work at the intraday operations.

Merchandise Trade Balance consists of difference between export and import of concrete country. It is one of the most important economic indicators.

It includes 6 categories of goods:

  1. Whole goods
  2. Raw materials and industrial semi-raw materials
  3. Consumer commodities
  4. Vehicles
  5. Large industrial goods
  6. All other commodities

If this index is greatly different from the forecasting one, then it can influence the US Dollar – if deficit is bigger than forecasting one, US Dollar is falling, if less – rising.

The USA-Japan Merchandise Trade Balance. While the deficit rises in trading with Japan, US Dollar usually falls.

INDICATOR OF INDUSTRIAL PRODUCTION

Industrial production is composed of production output of all the production, process plants and mines. From the fundamental point of view this indicator is very important; it reflects the real strength of economy and by it strength of concrete currency, so the higher index – the stronger US Dollar. Published monthly.

Capacity Utilization is correlation of total industrial output to the existent production capacities. Normal ration for good economy is 81, 5%. If this index is in these bounds, then does affect FOREX. But if this index reaches 85% and more, then it indicates that industrial production is “got heated”. i.e. economy is working at full capacity. This index, if it reaches 85%, forebodes the beginning of probable inflation which can lead to increase of Central Bank interest rate for avoiding the inflation of fighting against it.

National Association of the Purchasing Managers Index (NAPM) is deduced by the inquiry of 250 managers of the major industrial enterprises to study out how, in comparison with the last inquiry, the quantity of new orders of their production, total output, total volume of hire, quantity of produced goods stored in the warehouse and delivery speed of goods to the wholesaler have changed. If index is less than 45-50% it shows aggravating position of a country. It is the first of established and used till present indicator. It is not perfect because it is based upon the psychology more than facts and does not include the largest state California and, moreover, increase of industrial production not always means increase of customer demand. In case of changes, it is sometimes used for forecasting short-term fluctuations at the market.

Factory Goods Orders – total amount of orders for the durable, nondurable and single-use goods, i.e. for whole foods, light, simple industrial goods and accessory products and tools. It has weak impact on the prices at FOREX.

Durable Goods Orders takes into account orders for goods with period of use more than 3 years. Such commodities are divided into 4 major categories – hardware (including jewelry); mechanisms and goods working by mechanical drive; mechanisms and goods working by electric drive; transfer mechanisms and goods. This indicator divides the orders by military and unmilitary. It is very important for FOREX, because durable goods cost more and increase of their sales indicates rising consumers’ sentiment in their future and increasing possibility of spending money. So positive digits of this indicator lead to the US Dollar (or currency of any country releasing such indicators) rate appreciation.

Construction Data – information about housing. It is the most important economic indicator, included in the GDP. Starting from the postwar period it is housing which helps the USA to come out of the latest recession. It consists of 3 categories:

  • new houses building and building licenses;
  • sales of new and already existent one-family houses;
  • building expenses.

This indicator is cyclic and very sensitive to the interest rate of the Central Bank. The number of new houses sales 1.5 – 2 million per month shows that economic is strong, but when this number decreases to the 1 million per month, it is said that economic went into the recession. It is usually used for receiving the big picture of economic situation of the country.

Employment Indicators – indexes of the unemployment rate. They are of the utmost importance for analysis of situation in the economy in general, and as components of another economic indicators such as GNP and GDP.

Unemployment Rate is given in percentage terms. It consists of 2 separate parts:

  1. The Business Firms (Establishments) Survey which also consists of the following indicators:
    1. Payroll;
    2. Workweek;
    3. Hourly earnings;
    4. Total hours of employment in the non-farm sector
  2. The Household Survey which consists of:
    1. Unemployment rate in %;
    2. The overall labor force;
    3. Number of people employed

For traders working at market FOREX, indicators which are published monthly are important, because they show how the economy is strong and what position of business cycle it has – at the side of growth or at the side of recession. Among indicators appreciating the situation at the labor market, unemployment rate improves last of all. If the unemployment rate is decreasing, then US Dollar position will probably consolidate and vice versa.

Consumer Spending Indicators.

Retail Sales is very important for traders because it indicates the force of consumer demand and consumer confidence in the future which have vicarious impact on the strength of currency.  If consumer has enough income or credit for purchase, this can lead to the situation that more goods and services will be produced and imported. This indicator has seasonal nature, the most important months for traders – September, when purchases are made for children at school, and December – the month of Christmas purchases. The higher this indicators, the stronger US Dollar.

Consumer Sentiment is an inquiry of houses owners, created for clarification of tendencies at individual intension of the middle class for spending money. It is made by two organizations – by Michigan University and National Family Opinion for the Conference Board. It has some popularity among traders.

Auto Sales is the number auto sales. Despite of the importance for economy in whole, it rarely used for forecasting on FOREX.

Leading Indicators is composed indicator and consists of the following economic indicators:

  • Average workweek of production workers in manufacturing;
  • Average weekly claims for state unemployment;
  • New orders for consumer goods and materials;
  • Vendor Performance (companies receiving slower deliveries from suppliers);
  • Contract and orders for plant and equipment;
  • New building permits issued;
  • Change in manufacturers’ unfilled orders, durable goods;
  • Change in sensitive materials prices;
  • Index of stock prices (Dow, NASDAQ, S&P500, Russell 2000 etc.);
  • Money supply, adjusted for inflation;
  • Index of consumer expectations.

 

These indicators are developed for determination of economic development for the next 6-9 months. However this indicator is not that valuable for traders on FOREX.

MARKET ANALYSIS BY FINANCIAL, SOCIAL AND POLITICAL FACTORS

Financial factors

Financial factors, generally Interest Rates of the Central Bank, has a great impact on the rates of exchange. Many analysts consider this index as the main one in estimation of one currency “value” against another currency. It does not mean that in case of this percentage rate increase, the rate of national currency will grow automatically – probability of it is increasing, but other factors also play role in trading and they will be considered below.

Financial factors are the main ones in fundamental analysis. Changes in state monetary and taxation policy are made with the aim of positive results achievement in county’s economy and they are, for sure, reflected at the exchange rates. Sometimes it is necessary for Government to get involved to the international affairs with the aim of different obligations execution which the United States of America, or European Economic Community, incur to the world community. And financial factors are leverages of such interference. The major structure controlling such leverage is the Central Bank of a country – in the USA it is “Federal Reserve Bank” or “Fed”. The US Federal Reserve Bank plays the major part in price determination US Dollar against other world currencies. We will consider below in details how the Federal Reserve Bank sets its monetary policy, what it is aimed at and what leverages it uses.

FEDERAL RESERVE BANK

“Fed” has huge opportunities of influence on the economy of the country by the “key interest rates”, i.e. percentage which “Fed” allocates funds to the commercial banks for their reserves at, and at which they lend these reserves to other banks for a day. Such percentage is called “overnight federal funds rate”. By this percentage “Fed” influence on the slowdown or acceleration of the economy growth rate and decrease of the inflation processes. Let us consider now those financial factors which have the most impact on the exchange rate. They are: Money Supply and Interest Rate.

Money Supply consists of:

  • M1 – Notes and coins (currency) in circulation and in bank vaults
  • M2 – includes funds in the savings bank account;
  • M3 – consists of different banking financial instruments.

Information about Money Supply is released in the USA weekly on Thursdays.

Interest Rates are percentage at which Central Bank allocates funds to the commercial banks. This index is of utmost importance for rate of exchange assessment. The whole fundamental analysis starts with observation of “interest rates”. It is rather complicated process and Central Banks usually reluctantly change it and make it rarely (sometimes – once in several years), but frequency is directly depends on the economic situation in a country and in the world.

The main rule says: the higher the interest rate, the stronger the currency of a country. But in the rate of exchange always two currencies are involved, that is why it is important to look after the ratio of interest rates of these countries, which is called “Interest Rate Differential”. It is also one of the main factors which traders of Forex keep an eye at. So they should react to the change of this factor too and not only to the change of interest rate of one country.

Traders think of the “Interest Rate” the same as they treat other indicators – trading on the basis of rumors and estimates first, and then on the basis of real facts. So expected and predicted change of interest rate, occurred during the last meeting of the Central Bank governor, is often already devalued by the market and situation remains stable.

If changes of the interest rate occurred because of political reasons and not economic ones, then market can go against the Central Bank, rested upon the fundamental analysis in its estimates. However not only the change of interest rate is important but also how big the difference between the change and the anticipated magnitude is, and how this change will help the economy.

Social and political factors

Political events are the last category of fundamental factors which influence the global market of currency exchange. Those which are known before, such as presidential elections, are rather predictable and their influence is well-known. For instance, presidential elections in the USA lead to the short-time fall of the US Dollar. Elections in the European countries influence in a different way. If some socialist parties which are not usually supported by business, come to power, then exchange rate of the currency most likely temporally falls against US Dollar. If parties or politics who are supported by business and connected with some hopes for economic recovery, come power, then exchange rate of the currency rises.

But that was before euro, now situation is that socialists are in the government of many European countries. European Central Bank (ECB) is headed by Gan-Claude Triche, succeeded Wim Duisenberg, who is completely solid with the predecessor and the worth thing for him (and for 12 countries, where Euro was accepted) is threat of inflation, and his main task is not to allow its growth. Huge pressure is put upon the European Central Bank by the European politics of different ranks with the aim of making the interest rate lower, and this pressure was successful.

Besides the predictable political events, there are many unexpected events – military coups, wars, conflicts, murders of politicians which cannot be foreseen. Usually financial instruments, which are called “safe heaven” for investors, are used. During the last ten years “safe heaven” is US Dollar and Swiss Franc – their rates surge forward against all other currencies because everybody start buying them (it also concerns gold). Though not only these currencies can be “safe heaven”, sometimes British pound acts similar in the similar situations. In case instability of South-East Asia sharply increases by different reasons, for instance, threat of war from the side of North Korea, or in the regions of the Middle East, where in case of war extraction and cargo of oil to the world market decrease drastically, the rate of Japanese Yen slumps against the US Dollar.

If world oil price rises steeply, then usually the rate of British pound rises as well, because British economy directly depends on its oil extraction in the North Sea. In general, prices at the commodity markets, i.e. at the different raw materials, rise, then the rates of currencies of those counties which economies depend strongly upon the export of these materials. These countries are: Canada, Norway, Finland and others. Prices at raw materials are quoted in US Dollar so when price at raw materials rises, the US Dollar rate rises too.

In all cases, as we discuss above, when military events are imminent where the United States of America can take part, exchange rates of US Dollar and Swiss Franc rise sharply against other currencies (but in case of war in Yugoslavia, exchange rate of the only US Dollar rose steeply).

Fundamental analysis should take into account the great number of different factors, it is entire science. However factors clearly defined in the fundamental analysis, not always influence the market instantly – sometimes some days and even months can pass before the fundamental factors have an impact on the market. If by the time you cannot make your opinion regarding the situation at the market, then do not trade, wait until the market gives you more clear signals about direction of its movement.

Economic calendar containing description and approximate time and day of macroeconomic indicators’ publication, you can find here:

http://instaforex.com/calendar.php

 

Test questions: 

  1. Enumerate the employment indicators.
  2. Name the inflation indexes. What impact has inflation index advance on the market?
  3. The USA trade balance deficit increased more than it was predicted, what will happen to the US Dollar?
  4. What actions of the Central Banks have more impact on the exchange rate of the national currency?
  5. Give an example of impact on the market, which release (publication) of some indicator had. Point out concrete date of publication, name of index, absolute value of currency exchange rate movement.

The list of recommended literature: 

http://www.instafxeducation.com/en/basic_analysis.php

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