Part I. How the Economy Works?
FX traders should have a proper understanding of the trading and investment environment. This requires some understanding of the economy and how it operates. An economy moves in cycles. Each cycle includes a period of economic expansion leading to a peak, followed by a period of economic contraction leading to a trough. After economic activity has reached a trough and bottomed out, a new cycle begins again with economic recovery and expansion. A period of at least six consecutive months of economic contraction is generally called a recession and if the downturn is extremely severe, as in the early 1930s, it is called a depression. The price movements of the major currencies follow these economic circular trends, forming well-defined patterns that can be tracked and predicted by fundamental and technical analysis.
Theories Used to Analyze the Economy
Several theories are utilized as tools to analyze the economy. These include: the purchasing power parity theory, balance model, and asset model.
Purchasing Power Parity (PPP) The PPP theory asserts that exchange rates are determined by the relative prices of similar baskets of goods sold in different countries. It is expected that changes in inflation rates are to be offset by equal but opposite changes in the exchange rate.
For example, a can of Pepsi costs 1.5 euros in France and $1.25 in the U.S. Based on the PPP theory, the 1.5 (euros) divided by 1.25 (USD) equals to 1.2. If the current exchange rate for EUR/USD is more than 1.2, the exchange rate overstates current market values and should depreciate until it reaches to the PPP value, which is 1.2. On the other hand, if the current exchange rate is less than 1.2, the exchange rate understates current market values and should appreciate until it reaches the PPP value. Therefore, the theory postulates that the two currencies will eventually move towards the exchange rate at which one euro can buy 1.20 US dollar.
Every few years, the OECD (Organization for Economic Cooperation and Development) publishes PPP values for all currencies. These values, in turn, are used by traders to anticipate exchange rates. PPP is a long term indicator and does not take into account short term fluctuations based on market news or rumors. Another weakness is that it assumes goods are easily tradable with no costs to trade such as tariffs, quotas, or taxes.
In addition to ignoring the costs to trade, this theory only accounts for goods and neglects services, where room for value differentials is significant. From empirical evidence, we learn that PPP is only applicable to long- term (3-5 years) price movements, when prices eventually correct themselves towards parity.
Balance of Payments Model
This model suggests that a foreign exchange rate must be at its equilibrium level — the rate that produces a stable current account balance. The theory asserts that if a country has a trade deficit, its currency will
depreciate. The cheaper currency renders the nation’s goods (exports) more affordable in the global market while making imports more expensive. The combination over time, forces imports to decline and exports to rise thus stabilizing the trade balance and the currency towardf equilibrium. In other words, the Balance of Payment Model is hinged on the theory that a currency will move as a result of a nation’s global trading position. Those countries that run a trade deficit will have their currency decline, while those with a surplus will have their currency appreciate.
Critics of the Balance of Payment Model state that it does not take into consideration the flow of funds into financial assets, but focuses solely on the trade of goods and services from one country to another. This explains why a country like the United States, with a large trade deficit, did not have its currency suffer markedly in recent years.
Asset Market Model
The explosion in trading of financial assets has
reshaped the way analysts and traders view currencies.
The basic premise of this theory is that the flow of funds into other financial assets of a country (i.e. equities and
bonds) increases the demand for that nation’s currency.
Advocates point out that the proportion of foreign exchange transactions stemming from cross border- trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services through import and export. Since the asset market approach views currencies as asset prices traded in an efficient financial market, it asserts that currencies are increasingly demonstrating a strong correlation with asset markets.
This helps explain the currency phenomena during the 1990’s, when the Japanese stock market and yen depreciated while the U.S. stock market and US dollar appreciated — a condition that was contrary to what the previous theories suggest, given the low level of Japanese interest rates relative to U.S. rates. In this case, interest rates did not have a strong influence. The price of comparable goods did not drive the market prices. The factor that exerted the greatest influence over the market was the net flow of funds into the investment sector. It is this variable that affected the demand for currencies to be bought and sold, one over the other.
Factors that Affect the Economy Forex is a perfect market for applying trading strategies and disciplined methods of limiting risk while taking full advantage of favorable market conditions. A trader must learn how to analyze the market in order to be-come successful. There are a lot of factors that can cause a nation’s currency to fluctuate. The key concept is that the movement of currencies is based on supply and demand, which is influenced by both economic factors and confidence factors.
Economic Factors
Economic factors examine specific demand stemming from purchases, goods, services, or assets. Currencies are affected by changes in interest rates of a country, which in turn, affect inflation. If the currency value goes down, it costs more to import goods from another country; hence, the cost of living goes up, leading to inflation.
Confidence Factors
Confidence factors are general, and often non- quantitative, explanations for a past or prospective move. They include political events, market sentiment about the management of a country’s currency, or hunches concerning other players in the market.
Political events can fall under this category. For example, if the leader of a country is suddenly removed from office or, worse yet, assassinated, the world’s confidence in that country’s currency is, at least in the short-term, sure to suffer.
Approaches to Analyze the FX Market
There are two distinct methods to analyze financial markets: fundamental analysis and technical analysis.
Fundamental analysis is based on underlying economic conditions, while technical analysis uses historical prices to predict future movements. There is an ongoing debate as to which methodology is more successful.
Technical traders focus their strategies primarily on price action, while fundamental traders focus their efforts on determining a currency’s proper current and future valuation.
Part II. Fundamental Analysis Fundamental analysis focuses on the economic, political, and social forces that dictate supply and demand in the market. It is a method that attempts to predict price action and identify market trends by analyzing economic indicators, government policy, and societal factors within a business cycle framework.
Fundamental analysts pay close attention to the causes of currency movements by studying the various asset markets, growth rates, gross domestic product (GDP), interest rates, inflation, unemployment rates, political events, social developments, and macroeconomic indicators. Political events that impact the level of confidence in a nation’s government, the climate of stability, and the level of certainty have a great influ-ence on the FX market. All this information is combined to assess current and future market performance. Thus, fundamental analysts need to constantly stay current with news and announcements, as these can indicate
potential changes to the economic, political, and social environment. By studying reports and events,
fundamental analysts examine the underlying reasons for the fluctuation of the exchange rate, in either the past or the future, towards one direction or the other.
They endeavor to do this before the rest of the market participants, placing themselves in a good trading position to earn profits.
Two Main Factors in Fundamental Analysis
There are two main factors that impact exchange rate movements from a fundamental perspective: trade flows
and capital flows.
Trade Flows
One factor affecting exchange rates between two respective countries is the trade balance. Trade bal-ance shows the net differences between a nation’s im-ports and exim-ports. It is, by definition, the merchandise trade balance — the net difference between the value of merchandise being exported and imported into a particular country. When an economy’s imports are more than its exports, the trade balance is said to be in deficit. If an economy’s exports are more than its imports, the trade balance is in surplus. Trade balances are important as they indicate a redistribution of wealth among countries. Generally, trade deficits negatively impact the value of a currency by forcing money to flow out of the country. Conversely, positive trade balances cause appreciation in the country’s currency.
Capital Flows
Capital flows take the form of both physical and portfolio investments. They measure the net amount of a currency that is being purchased or sold in capital investments. This provides a recording for an
economy’s incoming and outgoing investment flows. A positive capital flow balance implies that foreign inflows into a country exceed outflows. A negative capital flow balance indicates that there are more physical or portfolio investments bought by domestic investors than foreign investors.
Physical Investments
Physical Investments are actual foreign direct investments by corporations, such as investments in manufacturing, real estates, and local acquisitions. All these transactions require foreign corporations to sell their local currency and purchase the foreign currency, which leads to movements in the Forex market. These movements represent the underlying changes in actual physical investment activity. Global corporate
acquisitions are extremely important to currency movements as they involve more cash than stock.
Portfolio Investments
As technology advances, investing in global equity markets has become increasingly feasible.
Subsequently, the dynamic stock market in any part of the world serves as an ideal potential for all, regardless of the, geographic location. As a result, a strong correlation has developed between a country’s equity market and its currency. If the equity market is rising, investment dollars enter the country to seize the opportunity. Conversely, if the equity market is falling, domestic investors sell their shares of local publicly traded firms and invest in other nations.
Part III. Factors Moving the FX Market Each week, economic statistics and indicators are released by various nations’ governments, professional organizations, and academic institutions. Economic indicators are snippets of financial and economic data published by various agencies of the government or private sector. These statistics, which are made public on regularly scheduled intervals, enable market observers to monitor the pulse of the economy. Hence, they are religiously followed by almost everyone in the financial markets. Since so many people are ready to react to the same information, economic indicators in general have tremendous potential to generate volume and to move prices in the markets.
Most economic indicators can be divided into two categories: leading and lagging indicators. Leading indicators are economic factors that change before the
economy starts to follow a particular pattern or trend.
They are used by traders to predict changes in the economy. Lagging indicators are economic factors that change after the economy has already begun to follow a particular pattern or trend.
Economic indicators may range from interest rates and central bank policies to natural disasters. The
fundamentals are a dynamic mix of distinct plans, er-ratic behaviors, and unforeseen events. Therefore, it is better to get a handle on the most influential contribu-tors to this diverse mix than it is to formulate a list that includes all of the indicators, as that is merely impossi-ble. Some indicators are more significant than others, with respect to their influence on the FX market, but most closely looked at is the data related to interest rates and international trade. Below is a brief overview of some of the major economic news, events, reports, and announcements that can have a significant effect on currency market movement:
G7 Meetings
There are periodic meetings of financial leaders from the United States, Great Britain, Germany, Japan, France, Italy, and Canada who gather to discuss world monetary policies. Recently, Russia has taken part in this forum as an ‘observer”; hence, this group is sometimes referred to as the G-8.
Inflation
Price index numbers are used to assess inflation.
Inflation is a rise in the general level of prices in an economy. When the price of goods rises, there is a general increase in prices, which constitutes inflation.
This price level increase has a direct impact on cur-rency exchange rates. If the general price level falls, it is called deflation. The currency of countries with low inflation will normally rise in value, while the currency of countries with high inflation will fall.
Gross Domestic Product (GDP) The Gross Domestic Product (GDP) is the sum of all goods and services produced by both domestic and foreign companies in the economy in a year. GDP is a good indicator for the pace at which a country’s
economy is growing or shrinking as it measures the country’s economic output and growth.
In order to measure the performance of an economy, economists are usually most interested in the real rate of change of GDP. Real GDP is calculated by adjusting nominal GDP for inflation or deflation. When real GDP increases from the previous year, the currency be-comes stronger.
Interest Rates
Interest rates are charged by various financial
institutions. For example, the Prime Rate is an interest rate charged by banks to reputable customers and the Federal Funds Rate is an inter-bank rate for borrowing reserves to meet margin requirements. If there is an uncertainty in the market in terms of interest rates, any developments regarding interest rates could have a direct affect on the currency markets. Generally, when a country raises its interest rates, the country’s currency will strengthen in relation to other currencies as assets are shifted to gain a higher return. The timing of interest rate moves is usually known in advance.
Nominal and Real Rate of Interest The rate of interest reflects the cost of borrowing money. Since the rate of inflation affects the purchasing power of money, the rate of interest is affected by it.
Just like GDP can be adjusted for the effects of infla-tion, interest rates can also be adjusted for inflation.
The rate of interest is categorized as nominal and as real rate of interest.
The nominal rate of interest is the rate of interest advertised or stated in a financial contract. The real rate of interest is the rate of interest that is adjusted for the loss in purchasing power due to inflation. To calculate the real rate of interest, subtract the rate of inflation from the nominal rate of interest.
Rate of Inflations - Nominal Rate of Interest = Real Rate of Interest
Producer Price Index (PPI)
The Producer Price Index (PPI) measures the average changes in selling price as indicated by domestic
producers for their output in various industries. The FX market tends to focus on the PPI for seasonally adjusted finished goods on a monthly, quarterly, semi- annual and annual basis. PPI is an accurate precursor of the important Consumer Prices Index (CPI) figure.
Consumer Price Index (CPI)
The Consumer Price Index (CPI) is a primary indicator of inflation that measures the average price for goods and services most commonly used by a typical household. By definition, it is a measure of the average price level paid by urban consumers (80% of
population) for a fixed basket of goods and services. It reports price changes in over 200 categories. Items included in the CPI reflect prices of food, clothing, shelter, fuel, transportation, health care and all other goods and services that people buy for day-to-day living. These items are divided into seven categories (housing, food, transportation, medical care, apparel, entertainment, and other), each of which is weighted by its relative importance. The CPI also includes various user fees and taxes directly associated with the prices of specific goods and services.
Personal Income and Personal Consumption Expenditures (PCE) The PCE, constituting the largest component of GDP, represents the change in the market value of all goods and services purchased by individuals. Personal in-come represents the change in compensation that indi-viduals receive from all sources including: wages and salaries, proprietors’ income, income from rents, divi-dends and interest, and transfer payments (Social Se-curity, unemployment, and welfare benefits). The re-lease of these two figures gives the savings rate, which is the difference between disposable income (personal income minus taxes) and consumption, divided by disposable income. The ever-declining savings rate has become a key indicator to watch as it signals consumer spending patterns.
Trade Deficits
When the export value is smaller than import value, the result is a trade deficit. This renders an outflow of currency, which in turn makes a currency weaker.
Industrial Production
Industrial Production is the quarterly measure of the change in the amount of goods and services produced per unit of input. It incorporates labor and capital inputs.
The unit cost of labor component is a useful indicator of any emerging wage pressures. The importance of productivity has grown over the past few years since the Federal Reserve has begun attributing its growth trend to relatively low levels of inflation. When this fig-ure increases, the currency becomes stronger.
Unemployment Rates
The unemployment rate is calculated with the number of people unemployed in the labor force — represented in a percentage. The labor force is the sum of people who are employed and those who are receiving unemployment benefits. Although it is a highly proclaimed figure (due to simplicity of the number and its political implications), the unemployment rate gets relatively less importance in the market because it is known to be a lagging.
Business Inventories
Business inventories and sales figures consist of data from other reports such as durable goods orders, factory orders, retail sales, and wholesale inventories and sales data. Inventories are an important component of the GDP report because they help distinguish which part of total output produced (GOP) remains unsold.
When inventories of unsold output are high, it means the economy is slowing down and the currency is becoming weaker.
Durable Goods Orders
Durable Goods Orders measures the new orders placed with domestic manufacturers for delivery of hard goods. A durable good is defined as a product that lasts an extended period of time (three years and over)
Durable Goods Orders measures the new orders placed with domestic manufacturers for delivery of hard goods. A durable good is defined as a product that lasts an extended period of time (three years and over)