introduction to fundamental analysis

Definition

In the currency market, there exist two basic types of analysis: fundamental analysis and technical analysis, which will be discussed in the next lesson. Fundamental analysis uses factors outside the currency market. It is impossible to consider all factors affecting the currency rate and for that reason fundamental analysts concentrate on only a few selected factors.

Fundamental Factors

News that has an impact on the economy both directly and indirectly is considered a fundamental factor. These fundamentals are separated into three major categories: economic factors, financial factors, and political factors which include crises.

Economic and financial factors have the biggest impact on currencies movements. The reason that economic and financial data releases are watched is the uncertainty concerning the release's outcome or results. The fundamental reports are kept under strict secrecy up to the time of the actual occurrence. Central banks, for example, change the discount rate confidentially and even though the markets closely watch these events, sometimes the outcomes do not coincide with the predictions. The deciding factor in whether a fundamental release will have an effect on the currency market is how closely the actual results come to economists' predictions. If the fundamental release matches predictions then it should have already been "priced in" to the market beforehand. However, if the release strays from the anticipated numbers, then it will have a bigger impact on the market.

The dates and times of economic data release are well known and are anticipated by the market. There are many resources available on the Internet concerning financial, and economic indicators. CMS provides an Economic Calendar for the dates of critical fundamental announcements and events.

Political factors can include elections, high level talks, and crises. Some political factors, such as a presidential election or a G-7 meeting are scheduled beforehand and can be anticipated. A political crises such as a nuclear test by a rouge nation such as N. Korea, or a terrorist attack such as 9/11 can have dramatic effects on the currency markets and are almost impossible to predict. However, only big political events that can affect the patterns of trade or working of an economy or group of economies will have an effect on the financial markets.

Next we will look at an example of a fundamental release and a political crisis.

Lets take one through an example of how to use a fundamental data release to trade Forex. Then we will show an example of a political crisis.

Release of a Fundamental Indicator (Non-Farm Employment Change):

On November 3rd, 2006, the United States Department of Labor released a monthly report called the Non Farm Payroll. This fundamental indicator (the term for a report or release) measures the change in employment in the United States for the previous month, excluding the farming sector.

For this release the figures came in above expectations of economists. As a result the Dollar strengthened that day as the data suggested that the labor sector of the US economy was doing better than expected.


This chart shows the EUR/USD pair, or the Euro vs the US Dollar. Each "candle" represents 30 minutes of market activity. When price moves upward it means the Euro is getting stronger, or that it takes more Dollars to buy one Euro (the numbers on the right hand side). When price moves downward it means that it now takes less Dollars to buy one Euro.
As you can see, on November 3rd, there was a huge surge as price moved downward from around 1.2770 to 1.2680, a move of 90 points, or "pips" in forex lingo. There aren't any other candles in the surrounding time period where price moves as much as the 30 minutes after the release of the Non Farm Employment data.

A Political Crisis:


This figure shows the USD/JPY pair where each candle represents 2 hours of market activity. When the price of the pair goes up on the chart it means the Dollar strengthened against the Yen and vice versa.
This chart shows the reaction of the currency market to a geopolitical crisis. In this crisis, North Korea detonated a nuclear weapon in a test of their nuclear capabilities. How a particular currency will respond to geopolitical dangers depends on many factors. Here, the Japanese Yen suffers because it is a neighbor of North Korea and because the two countries have tense relations they are opposed to each other militarily. Obviously, any attack by North Korea on Japan would damage the Japanese economy. When traders got wind of these developments on Friday, October 6th, they sold the Yen and bought the Dollar. The price changed around 100 pips, meaning the amount of Yen you needed to get one Dollar went up from 117.90 to 118.90. Or, in other words it now cost one more Yen to buy a US Dollar.

Safe Haven:

Since a nuclear test by North Korea is very Yen negative, the Dollar would do better since it's the opposite currency in this particular pair. The Yen's weakness withstanding, the Dollar would have still gained on this geopolitical event because it is considered a "safe haven" currency. During times of danger, investors will move their money out of riskier investments and put them into more stable ones. Since the US is the sole superpower left in the world, it naturally attracts those investors that want to park their money in a safer economy.

The US's "safe haven" status doesn't always work in times of danger in the world. If there is a geopolitical event that directly affects the United States, such as a terrorist attack, or something less immediate, such as military posturing against a state like Iran investors might sell the Dollar. Traders would be worried that the threats might come to action and there would be a war between the two countries. A war with Iran weakens the Dollar because the US economy is so tied to the oil market, of which a large proportion travels through the Persian Gulf. A military engagement against Iran would disrupt oil deliveries and cause hardship for the American economy in other ways. So, as we mentioned before, there are many factors to consider during a political crisis to see what effect it will have on a particular currency.

In the Forex market, traders are speculating on the health of countries' economies. In order to have an understanding of an economy's "fundamentals", one needs to look at how productive and vibrant the different sectors of the economy are. This involves looking at data on manufacturing, retail sales, housing construction and sales, consumer spending and confidence, and the status of the labor market. Data on these different sectors can be found in reports released by government agencies, academic institutions, and private firms.

Economic Fundamental Indicators

Gross Domestic Product (GDP)

Gross Domestic Product is one of the major economic indicators that generally reflect the state of the economy of the whole country. GDP measures an economy's total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. In particular, the GDP is the market value of all final goods and services produced within a country in a given period of time. The formula used to compute GDP is: GDP= Consumption spending + Investment spending + Government spending + Imports and Exports. GDP does not discriminate between those goods and services made by the people of that country or by foreigners. As long as the goods and services are made within that country's borders, it counts towards the GDP.

Gross National Product (GNP)

GNP is the total income earned by a nation's permanent residents. Whereas GDP is the total of all final goods and services made within an economy, GNP measures the goods and services made by a nation's residents throughout the world. If a Japanese car company opens a plant in Michigan, the value of the cars made and the money spent on investment, will count towards US GDP but also to Japanese GNP as they own the capital and profits. GNP and GDP are released every quarter, but preliminary measures come out in between those releases. The formula for GNP differs from GDP by including income that US citizens earn abroad and excluding income that foreigners earn within the US.

New Durable Goods Orders

Consumers primarily use these goods. New Durable Goods Orders measures the strength of manufacturing because durable goods are designed to last three years or more. These goods can include airplanes, machine parts for factories, cars and buses, cranes, appliances, etc... Since this fundamental indicator measures new orders, it will be an indication of how actual production will perform in the near future. Production firms will have to make the durable goods to fill all the new orders. New orders directly affect the level of both unfilled orders and inventories that firms monitor when making production decisions. The Conference Board attempts to take into account inflation when measuring. In the US, New Durable Goods Orders data uses price indexes constructed from various sources at the industry level and a chain-weighted aggregate price index formula to try and "deflate" the results.

Retail Sales Indicator

The retail sales indicator is released on a monthly basis and is important to the foreign exchange trader because it shows the overall strength of consumer spending and the success of retail stores. Retail Sales impart information on the economy because it measures the amount of shopping consumers are doing. If the consumers have enough income to purchase goods at stores, then more merchandise will be produced or imported. Retail Sales is a "seasonal" indicator, meaning that during certain months retail sales are always expected to be up, for example September (when kids are going back to school) and December (the holiday season). The Retail Sales indicator is particularly important in the US, where all business is aimed toward the consumer.

Building Permits, Construction Spending, Housing Starts, New Home Sales, Existing Home Sales

These indicators measure the vitality of an economy's housing sector. Building Permits, Construction Spending, and Housing Starts show respectively how many new homes are being planned to be constructed, how much construction is currently happening, and how many new homes have finished being built. New and Existing Home Sales show how the housing market is doing. If people are buying more homes, that means they have more money, and therefore the economy is doing better. When homes sales fall, the economy can weakens because housing is such a big sector. There are other indicators that deal with housing such as the change of prices of homes. Home price data is usually released side by side with home sales data.

Stock Prices

The stock market of a country reflects the price movements, and value of a country's biggest company's and firms. Increases (decreases) of a stock index can reflect both the general sentiments of investors and the movements of interest rates.

Interest rates and inflation are financial indicators, which are very important to future economic activity and to the foreign exchange market. We look at these indicators next.



Inflation

Inflation measures at what rate prices in an economy are rising. Inflation is tied directly to the purchasing power of a currency within its borders and affects its standing on the international markets. Prices of goods, houses, labor, production materials, etc., are all closely monitored to see if their prices are increasing or not, and at what speed. Inflation can come about for different reasons.

Very Fast Growth in an Economy

In one simple example, inflation can start rising as a result of unchecked growth in an economy. Fast economic growth increases the amount of money printed and circulated throughout the economy. Extra money is necessary because consumers are taking money out of their banks and purchasing products. If businesses and stores are bringing in larger revenue and profits, then it can be expected that workers' wages will increase as well. As wages increase, consumers go out and buy even more goods.

Businesses that did not benefit from the initial extra economic activity see that the consumers, with their extra wages, have more money. They purchase more of other goods now expanding the economic activity to other sectors. In order to keep up with the extra demand the businesses may choose to raise their prices.

If these cyclical prices changes are not contained, then it takes away from the actual economic growth of the economy, as on paper people have more money, but the money buys less goods due to higher prices. For example, a retired person with retirement funds in a bank will be adversely affected if prices start rising because that nest egg is not able to buy the same amount of goods prior to inflation.

Volatile Items
In a second example, inflation can be set off by an increase in the price of just one crucial item, such as energy. If the price of oil went up, many other items that use oil in their production process will increase in price. Not only that, but consumers and businesses have to spend more of their incomes and revenues to pay for the same amount of gasoline (a products that uses oil). Inflation erodes the purchasing power of their currency. Since an economy such as the US is heavily dependent on oil for its economic activity, a rapid rise in energy costs could begin a period of inflationary pressure.

Curbing Inflation
Inflation is troublesome. It is the job of the central bank of an economy to manage price stability. The main tool that central banks have is the power to set the country's base interest rate. If inflation is running high, a central bank would raise rates in order to cool economic activity, and hopefully stem inflation. If inflation is low and the central bank wants to stimulate economic growth, they might lower rates. Since inflation has such a direct impact on a country's interest rates policy it is very important in the currency markets.

Inflation Indicators

Consumer Price Index - The Consumer Price Index measures the average price level of a basket of goods and services that are purchased by consumers. Changes in the CPI represent the inflationary pressures surrounding the economy. The CPI figure is probably the most crucial indicator of inflation within the United States. Consumers buy goods and use services and the changes they experience in prices will reflect the inflation in the economy.


Producer Price Index - Producer Price Index measures the average price level for a fixed basket of capital, rent and materials needed for producers to manufacture consumer goods. Just as the CPI measures the prices from a consumer perspective, the PPI measures the prices at the producer level. PPI can show inflation before CPI because it will influence consumers next as they purchase these more expensive goods and services. Part of the inflation at the producer level is passed onto the consumers and therefore influences the CPI figure

Average Hourly Earnings - This indicator measures the change in worker's wages. It sheds light on consumers' disposable income and on the costs to firms for their labor. Changes in wages also highlight the tightness of the labor market, as firms will have to pay their skilled workers more to retain them.
Employment Indicators

Employment indicators reflect the overall health of an economy or business cycle. In order to understand how an economy is functioning, it is important to know how many jobs are being created, what percentage of the work force is actively working, and how many new people are claiming unemployment. We have already mentioned, on the previous page, that it is also important to monitor the speed at which wages are growing.

Unemployment Rate

The unemployment rate is released monthly and consists of surveys of both business firms and households. The business firms survey consists of the payroll, workweek, hourly earnings, and total hours of manufacturing, retail, government jobs, and others. The household survey shows the overall labor force, and the number of people employed and unemployed. A decrease in unemployment signifies a maturing business cycle while an increase in unemployment signals a bust cycle. The unemployment rate is slow to change however, so fundamental traders look at other indicators for more immediate insights.

Nonfarm Employment Change

One of those indicators, which is released at the same time as the unemployment rate is the Nonfarm Employment Change. It measures how many new jobs were created the previous month. It is an easier number than unemployment to gauge the latest changes for labor in the economy. The currency markets anticipate this release every month.

Average Weekly Initial Claims for Unemployment Insurance

This indicator is also more sensitive than the unemployment indicator. It becomes the flip side of the nonfarm payroll change as it shows when people are losing their jobs and need to apply for unemployment insurance. When employment conditions worsen, this will be one of the leading indicators to keep an eye on. It is released weekly, unlike most other indicators which are released monthly.

Average Weekly Hours

Average Weekly Hours is a sample of other employment indicators which are not as important, but can give clues to state of the economy. The average weekly hours put in by manufacturing workers, usually leads the business cycle since employers adjust work hours before changing the workforce.

There are many other indicators worth learning about and following in order to trade fundamental news and releases. We have presented just a few, and explained why they are important to the currency markets.

In our next lesson, we will discuss technical analysis.