WHAT ARE THE FUNDAMENTALS OF FOREX TRADING?
Many FX day traders pay little or no attention to fundamental analysis. Their view is that fundamentals can take a long time to filter through and influence currency pairs. So instead they focus on technical analysis to identify areas of support and resistance which will help them find buying and selling opportunities.
But not everyone who deals in FX is a day trader. There can be many reasons for buying or selling a particular currency and short-term speculation is only one of them. While technical analysis is vital when it comes to timing a trade (that is, choosing your open and closing levels) fundamental analysis can really help in establishing market direction over the medium to long-term. Often it can help a trader identify the foundation of an overall trend.
The fundamentals which drive FX markets are, on the face of it, quite different to those which move other financial instruments such as individual equities. Nevertheless, some traders find it helpful to consider a currency as the “stock price” of one country relative to another. So, whereas fundamental analysis on an individual company will include considering such factors as the management team, projected sales growth and P/E ratios, the corresponding FX analysis could look at a country’s political leadership and stability, growth prospects, and purchasing power parity. So let’s look at some of the fundamental factors that influence FX movements. This isn’t a definitive list, but it should highlight some important areas to consider.
FOREX TRADING FUNDAMENTALS: ECONOMIC DATA RELEASES
Firstly, it’s vitally important to know in advance which economic numbers are due to be published and when. Obviously, there are stacks of releases which vary in importance, but it is still worth knowing when data is due to be published. Keep an eye on the economic calendar: not only will this tell you which data releases are due out from which country, but also what the previous number was and what the consensus expectation is for the latest update. Spread Co’s economic calendar will also show you the relative importance to traders of each event or release.
Here are some key data releases which have the potential to move currencies dramatically, all other things being equal. There are employment reports such as US Non-Farm Payrolls and the Unemployment Rates for other countries, inflation numbers (such as CPI), Retail Sales, Manufacturing and Non-Manufacturing PMIs, Durable Goods, Industrial Production and Gross Domestic Product (GDP). It’s important to know how to use this data effectively. First of all, there is the data release itself. We can quickly establish if this is better or worse than the prior release. Then we need to know how the latest release compares to the consensus market expectation. Then there is the overall trend in the data series. We can look at prior releases to see if this has been improving or deteriorating over time, and how the latest release fits in with the overall trend. It could be that an unexpected number triggers a sharp initial reaction which unwinds quickly if traders decide that it is a “one off” or outlier which may be due to specific circumstances. There’s always the possibility that the market can move violently as a response to a particular release. For this reason, many traders prefer to avoid trading around important economic numbers.
It’s vital to remember that currencies trade in pairs, that is, you’re looking at how one currency fares in relation to another. So when you look at FX fundamentals you’re typically comparing the trend in the economic data of one country with another.
On top of this international trade flows can also influence supply and demand for a currency. Countries with a positive trade balance, that is ones that export more than they import, can see the demand for their currency increase. This is because foreign buyers have to exchange more of their own currency for the currency of the exporting country. This increases the demand for the currency and puts upside pressure on it. Typically, this in turn is deflationary for the exporting country as its stronger currency means that its imports cost less.
FOREX TRADING FUNDAMENTALS: MONETARY POLICY
Whereas fiscal policy (taxing and spending) is the purview of governments and policymakers, monetary policy is the domain of central banks such as the US Federal Reserve, the European Central Bank (ECB), Bank of Japan (BOJ) and Bank of England (BoE). The idea is that central banks use interest rates together with the purchase or sale of bonds to influence market liquidity. The value of a free-floating currency is based on supply and demand. So if a central bank buys its own currency and holds it in reserve, this reduces the supply and should therefore boost the value of that currency. The central bank can devalue its currency relative to others by selling its reserves back to the market. This increases the supply of the currency and should lead to a decrease in valuation.
Depending on their mandates, central bankers work to ensure that the monetary conditions are right for the economy for which they have responsibility to prosper. This generally means ensuring price stability (controlling inflation) while promoting a sustainable level of growth. It can also mean (as in the case of the US Federal Reserve) working to ensure “maximum employment.”
Central banks regularly hold meetings to discuss and make changes to monetary policy. Typically this is achieved by raising or lowering key interest rates. However, we have also seen a number of major central banks engage in quantitative easing (QE), or money printing as it is often referred to. This is where the central bank creates money and introduces it into the market via financial institutions such as commercial banks. The central banks do this by purchasing bonds and other securities held by qualifying financial institutions as collateral for their normal business. The theory is that the financial institutions will lend out these extra funds in the wider market so adding liquidity and boosting economic activity.
As we’ve seen, central banks can tighten monetary policy by raising rates and reducing or even reversing their bond purchases. Typically this will see the relevant currency rise in value - all other factors being unchanged. Central banks loosen monetary policy by reducing interest rates or adding to their bond purchases. In effect, this adds to liquidity and therefore cheapens the relevant currency.
As a consequence, central bank meetings are extremely important events in the FX trader’s calendar. However, it is worth noting that central bankers often try to manage expectations ahead of key meetings. They do this through speeches and communications with the media. Quite often, it is a comment from a significant central banker ahead of a key meeting that can lead to the most dramatic market reaction. This is because it can signal a sudden change in outlook which catches investors unawares. Consequently, it’s vitally important to identify key members of every major developed world central bank and know in advance when they are due to deliver a speech or give an interview.
This Forex Trading Fundamentals guide is a short primer designed to highlight some of the most important fundamentals affecting currencies. It’s not fully comprehensive as one would have to write a book to cover everything. In addition, individual traders all have their own ideas concerning what is, and what isn’t, essential to watch when trading FX. It’s also necessary to remember that unexpected events can have a dramatic effect on currency movements, but the very fact that they are unpredictable makes these impossible to trade. One can only be lucky or unlucky in terms of positioning when something unexpected happens. It may go in your favour or against you. That is why it is vital to exercise strict money and risk management, and these topics are covered in greater detail in other blogs in our Trading Guides series.