FUNDAMENTAL

Forex Fundamental Analysis

Fundamental analysis is the interpretation of statistical reports and economic indicators. Things like changes in interest rates, employment reports, and the latest inflation indicators all fall into the realm of fundamental analysis.
Forex traders must pay close attention to economic indicators which can have a direct – and to some degree, predictable – effect on the value of a nation's currency in the forex market.
Given the impact these indicators can have on exchange rates, it is important to know beforehand when they are due for release. It is also likely that exchange rate spreads will widen during the time leading up to the release of an important indicator and this could add considerably to the cost of your trade.
Therefore, you should regularly consult an economic calendar which lists the release date and time for each indicator. You can find economic calendars on Central Bank websites and also through most brokers.

The Role of Central Bank

Overview

• Most countries have some form of Central Bank serving as the principle authority for the nation's financial matters.
• Primary duties for a Central Bank include:
  • Implement a monetary policy that provides consistent growth and employment
  • Promote the stability of the country's financial system
  • Manage the production and distribution of the nation's currency
  • Inform the public of the overall state of the economy by publishing economic statistics

Fiscal and Monetary Policy

• Fiscal policy refers to the economic direction a government wishes to pursue regarding taxation, spending, and borrowing.
• Monetary policy is the set of actions a government or Central Bank takes to influence the economy in an attempt to achieve its fiscal policy.
• Central Banks have several options they can use to affect monetary policy, but the most powerful tool is their ability to set interest rates.

How Central Banks Use Interest Rates to Implement Fiscal Policy

• A primary role for most Central Banks is to supply operational capital to the country's commercial banks. This is done by offering loans to these banks for short time periods – usually on an overnight basis.
• This ensures the banking system has sufficient liquidity for businesses and individual consumers to borrow money, and the availability of credit has a direct impact on business and consumer spending.
• The Central Bank charges interest on the short-term loans it provides. The rate charged by the Central Bank affects the interest rate that the banks charge their customers as the banks must recover their cost (the interest they paid) plus earn a profit.
• Central Banks use the relationship between the short-term rates at which it offers loans, and the interest rate the banks charge, as a way to influence the cost for the public to borrow money.
• If the Central Bank feels that an increase in consumer spending is needed to stimulate the economy, it can lower short-term rates when providing loans to the commercial banks. This usually results in the banks lowering the interest they charge, making borrowing less costly for consumers which the Central Bank hopes will lead to an increase in overall spending.
• If a tightening of the economy is needed to slow inflation, the Central Bank can increase interest rates making loans more expensive to acquire, which could lead to an overall reduction in spending.

Supply and Demand of Currency

• Just like any commodity, the value of a free-floating currency is based on supply and demand.
• To increase a currency's value, the Central Bank can buy currency and hold it in its reserves. This reduces the supply of the currency available and could lead to an increase in valuation.
• To decrease a currency's value, the Central Bank can sell its reserves back to the market. This increases the supply of the currency and could lead to a decrease in valuation.
• International trade flows can also influence supply and demand for a currency. When a country exports more than it imports (a positive trade balance), foreign buyers must exchange more of their currency for the currency of the exporting country. This increases the demand for the currency.

Common Economic Indicators

Gross Domestic Product (GDP)

• One of the most influential of the economic indicators, GDP measures the total value of all goods and services produced by a country during the reporting period.
• An increase in GDP indicates a growing economy, and for this reason, GDP is used to measure the level of inflation within the economy.

Consumer Price Index (CPI)

• Measures the cost to buy a defined basket of goods and services. It is expressed as an index based on a starting value of 100.
• A CPI of 112 means that it now costs 12% more to buy the same basket of goods and services today than it did when the starting index value was first determined.
• By comparing results from one period to the next, it is possible to measure changes in consumer buying power and the effects of inflation.
• Inflation is a concern to currency traders as it affects the price of everything bought and sold within an economy, and this has a direct impact on the supply and demand for a country's currency.

Interest Rates

• Most Central Banks maintain a "benchmark" interest rate.
• Depending on the jurisdiction, the Central Bank rate serves as the guide for the rate at which the Central Bank and other commercial banks lend each other funds to meet short-term operational needs.
• Commercial lending rates are also affected by the Central Bank rate, and it is this linking of short-term rates to the commercial rates that makes interest rate policy the primary monetary tool for Central Banks.
• As noted earlier, the Central Bank can increase rates during periods of high growth (inflation) in a bid to reduce consumer spending which should help bring growth back to a more manageable level.
• If deflation is a problem and the economy needs a boost, Central Banks can lower interest rates to entice more consumer lending. The expected outcome is that overall consumer spending will increase as consumers have access to less costly loans.
• Forex traders in particular pay close attention to changes in interest rates as investors tend to seek out currencies offering higher returns and this demand can cause a currency to appreciate.
• Also, the greater the interest rate differential between two currencies, the greater the profit potential of a carry trade strategy. See Trading Strategies and Best Practices in Lesson 4 for more information on carry trades.

Yield Curve

• Yield is the interest on fixed-income securities which includes such investments as futures contracts and government bonds.
• Referred to as "fixed" income because the payment stream (the yield) remains constant until maturity.
• For example, a simple 5-year bond with a 3 percent annual yield, would pay $300 a year for the next five years on an initial $10,000 investment.
• The yield curve shows the relationship between the yield, and the time to maturity.
• When dealing with fixed-income securities, investors want to ensure that the fixed yield remains profitable right up until maturity.
• As an investor you may be happy with a 5 percent return when the basic lending rate is 2 percent. However, if short-term interest rates rise and the lending rate jumps to 6 percent, your 5 percent return is no longer so attractive, and there are probably other options that could generate more income for your investment.
• Liquidity spread is the term used to describe the difference between the yield and short-term rates.
• If short-term interest rates rise above the fixed yield, the bond holder is said to be in a position of negative liquidity spread.
• When plotted on a chart, the yield is represented along the y-axis, while time to maturity is charted vertically on the x-axis. This results in a yield curve shape that some investors suggest offers insight into future interest rates.
• Consider the following so-called "normal" yield shape:

Normal Yield Curve

The normal yield curve shifts upwards over time. This pattern indicates an increase in the yield (the y-axis) as time to maturity (the x-axis) increases. This follows the tenant of the Arbitrage Pricing Theory which states that the longer the term, the higher the yield. This is based on a practice that rewards investors willing to lock their money into long-term bonds, despite the increased risks associated with a diminishing liquidity spread.

Flat Yield Curve

A flat yield curve results when the yields are basically the same for all maturities. This indicates that investors are willing to accept yields on long-term instruments that do not include a premium above current short term yields. Investors would only accept this if they feel that the economy has little capacity for growth combined with the likelihood that short-term interest rates will remain stable.

Inverted Yield Curve

An inverted yield curve that slopes downwards over time indicates a negative outlook for the market in the future. This could suggest the onset of a prolonged economic downturn or possible recession. An inverted yield curve shows even greater long-term pessimism than a flat curve – so much so that long-term bond yields actually fall below short-term yields (negative liquidity spread). The implication is that investors believe that long-term will fall in the face of a worsening economy.

Humped Yield Curve

A humped curve occurs when both short and long-term yields are equal, but medium-term yields are higher. This could indicate an expectation that the economy may be entering a period of growth, but this growth is not expected to be sustainable over the long-term.

Institute of Supply Management (ISM)

• The ISM report is another inflation indicator. It measures the level of new orders and helps predict manufacturing activity for the upcoming period.
• It is expressed as an index based on 50. A number less than 50 means that manufacturing has contracted from the previous period, while a number greater than 50 indicates growth for the previous period.
• Because the ISM captures current factory production levels, it provides insight into the expected level of consumer demand for goods in the immediate future.

Retail Sales Report

• The Retail Sales Report tracks consumer spending patterns – items such as health care and education are not included.
• An increase in the Retail Sales Report is likely to be seen as positive for the currency as it suggests growing consumer confidence.

Industrial Production Index (IPI)

• Shows the monthly change in production for the major industrial sectors including mining, manufacturing, and public utilities.
• Considered an accurate assessment of employment in the manufacturing sectors, average earnings, and overall income levels.
• An increase in IPI suggests continued growth which is seen as a positive for the economy.

Commodity Price Index (CPI)

• Tracks the changes in the average value of commodity prices such as oil, minerals, and metals.
• This index is particularly relevant for countries like Canada and Australia (known as the "commodity dollars") that serve as major commodity exporters.
• For commodity exporters, an increase in this index suggests greater potential for earning higher prices from these exports.

Trade Balance

• Compares the total value of imports to the total value of exports for a reporting period.
• A negative value indicates that more goods were imported than were exported (a trade deficit) – while a positive trade balance means that exports exceeded imports (a trade surplus).
• If the balance of trade shows a surplus or declining deficit, then there may be an increased demand for the currency.
• If the report shows a growing deficit, then the increased supply – together with a decrease in demand for the exporting currency – could lead to a devaluation against other currencies.