Understanding the Basics of Fundamental Analysis in the Forex Market
Traders typically approach financial markets in one of two ways: either through technical analysis or fundamental analysis. The reality is that history is full of traders who have had very successful careers as traders that employed both of these types of analyses.
As stated, successful traders throughout history have employed both technical and fundamental analysis. In this article we are going to break down the basic principles of fundamental analysis in the forex market.
Fundamental Analysis is commonly defined as a method of evaluating a specific security in order to determine its intrinsic value by analyzing a host of economic and financial data. In the foreign-exchange market, a security would be a currency. Market participants are continually analyzing the emerging fundamental from a country in order to determine the intrinsic value of the country's currency. There are several key economic indicators that every trader should understand on a basic level. Fluctuations in the data of these key indicators will generally cause the value of a currency to rise and fall.
Interest Rates
These are the single greatest driver of currency value over the long-term. Most Central Banks announce interest rates each month, and these decisions are watched very scrupulously by market participants. Interest rates are manipulated by Central Banks in order to control the money supply in an economy. If a Central Bank wants to increase the money supply, it lowers interest rates, and if it wants to decrease money supply it raises interest rates.
Gross Domestic Product (GDP)
GDP is the most important indicator of economic health in a country. A country's Central Bank has expected growth outlooks each year that determine how fast a country should grow as measured by GDP. When GDP falls below market expectations, currency values tend to fall and when GDP beats market expectations, currency values tend to rise.
Inflation
Inflation destroys the real purchasing power of a currency, and, therefore, inflation is very bad for the economy in most circumstances. Each year a normal rate of inflation between 2-3% is expected, but if inflation begins moving beyond the upward targets set by the Central Bank, a currency value will actually rise due to expectation of an imminent rate hike. Higher interest rates tend to fight off inflation.
Unemployment
We will discuss consumer demand in a moment, but people are basically what drive economic growth; therefore, unemployment is the backbone of economic growth. When unemployment levels increase, it has a devastating effect on economic growth; consequently, when the labor market contracts and unemployment increases, interest rates are often cut in an attempt to increase the money supply in the economy and stimulate economic growth.
Consumer Demand
As stated in the previous point, people are what drive economic growth; as a result, healthy consumer demand is essential to the normal, healthy functioning of an economy. When consumers are demanding goods and services, the economy tends to move forward, but when consumers are not demanding goods and services, the economy falters.
Fundamentals of the USD
The US Dollar's Presence Globally
The US Dollar has maintained a
vital presence on the world stage for nearly a century. Most major governments
maintain some of their currency reserves held in USD, this means the ripple
effect of inflation and other valuation issues connected to the US Dollar have
far reaching consequences.
There are many economic
indicators pertinent to the US economy. Some of the relevant economic
indicators to the US Dollar are released directly through the Federal Reserve
(Fed), while others may be released from private data analysis firms. Each of
the economic indicators listed and described below have the potential to affect
the price and stability of the US Dollar upon their release. This is not a
complete list of economic indicators that have an impact on the US Dollar.
The reports are listed in
alphabetical order, for more on the report and its strength ranking take a look
at each individual indicator description below. For the date and time of the
next release for each report please browse our current economic calendar.
ADP Nonfarm Employment Change
The ADP (Automatic Data
Processing, Inc.) Nonfarm Employment Change is a measurement of the number of
new jobs created in the previous month (of course excluding farming related
employment). This report is said to be a precursor to the much more widely
followed Nonfarm Payroll Report, which of course is released two days later.
The ADP Nonfarm Employment Change report began in March of 2006, and though it
is said to offer insight into the pending Non Farm Payroll Report, its brief
history accounts for its lesser credibility with traders.
Average Hourly Earnings m/m
This indicator gathers numbers
relevant to wage inflation, specifically price increases in wages paid to
nonfarm employees. When corporations and businesses are forced to pay higher
wages this increased will soon be seen on the consumer end, thus wage inflation
is viewed as a preemptive look into consumer inflation. Higher trends seen in
this indicator tend to have a positive impact on a nation's currency, as wage
inflation leads to consumer inflation and consumer inflation is relative to a
strong economy.
Beige Book
The Beige Book gathers regional
information from Federal Reserve branches on the strength of the economy within
their own region. This information is collected two weeks prior to the FOMC‘s
(Federal Open Market Committee) monetary policy meetings. The FOMC will use the
Beige Book when considering the future of interest rates.
Chicago PMI
PMI stands for Purchasing
Managers Index. Measured in Chicago (essentially accounting for the Midwest
region of the United States) the Chicago PMI is conducted by the National
Association of Purchasing Managers (NAPM). Before the report is published purchasing
managers in the area are surveyed on the present situation of their firm,
specifically whether the firm's purchasing activity is lower than, higher than,
or equal to the previous month's activity. The word ‘activity' is meant in
reference to employment, inventories, prices, orders, output, etc. The
indicator uses a reading of 50 to measure expansion, or the lack thereof. A
reading above 50 would indicate economic expansion in the region.
Consumer Confidence
In a monthly survey respondents
are asked to measure and evaluate the future strength of the economy. Consumer
optimism will of course have a positive impact on the strength or weakness of
an economy, and ultimately the nation's currency; when consumer confidence is
high the purchase of goods and services tends to increase as well, thus
stimulating economic growth.
Consumer Sentiment
In a monthly survey conducted by
the University of Michigan 500 respondents are asked to measure and evaluate
both the present and the future strength of the economy. Consumer optimism will
of course have a positive impact on the strength or weakness of an economy, and
ultimately the nation's currency; when consumer confidence is high the purchase
of goods and services tends to increase as well, thus stimulating economic
growth.
Core Durable Goods Orders m/m
Core Durable Goods Orders
essentially reports the same data as does ‘Durable Goods Orders' minus data
including Transportation components. This is because purchase orders for
aircraft and automobile components often see rapid increases for brief periods
– such numbers weaken the clarity of the overall trend. As such, Core Durable
Goods Orders is typically more widely watched than is Durable Goods Orders.
Core Durable Goods Orders is a measurement of the total value of purchase
orders placed through manufacturers for products with a shelf life of more than
three years. This indicator is watched closely by traders primarily because of
what it has to say about the future of an economy. When the total value of purchase
orders is higher than previous months it can be expected that manufacturers
will be pressed to fill the pending orders, as such employment will likely see
an increase. When productivity and employment are expected to increase as a
direct result of increased purchase orders the coming months are more likely to
see an increased GDP (Gross Domestic Product).
Core PCE Price Index m/m
PCE stands for Personal
Consumption Expenditures; The Core PCE Price Index is a measurement of consumer
inflation rates, as seen when purchasing goods and services. Essentially, PCE
is very similar to CPI (Consumer Price Index), the subtle difference lies in
the fact that PCE gauges the level of price changes seen within consumer goods
and services, specifically those targeted towards individual consumers (as
opposed to production consumers). As is the case with other economic
indicators, Core PCE Price Index implies that certain statistics are left out
of what would be included in the normal indicator. In this case, Core PCE
excludes Food and Energy because month-to-month purchase volatility of such can
skew underlining consumer trends. The Federal Reserve tends to favor this
indicator for its clear look at consumer inflation, for this reason traders
watch the Core PCE closely.
Currency Manipulation Hearings
The US House Committee on Ways
and Means will conduct a hearing to examine possible evidence of potential
currency manipulation seen by countries in the Asian region. China and Japan
will be closely looked at. The committee will then recommend whether or not the
US should take action, and what the most plausible solution would be.
Durable Goods Orders m/m
Durable Goods Orders is a
measurement of the total value of purchase orders placed through manufacturers
for products with a shelf life of more than three years, i.e. automobiles and
parts, appliances, airplanes and parts, computers, etc. This indicator is
watched closely by traders primarily because of what it has to say about the
future of an economy. When the total value of purchase orders is higher than
previous months it can be expected that manufacturers will be pressed to fill
the pending orders, as such employment will likely see an increase. When
productivity and employment are expected to increase as a direct result of
increased purchase orders the coming months are more likely to see an increased
GDP (Gross Domestic Product).
ECI q/q
ECI stands for Employment Cost
Index, a measurement of inflation rates found within salaries, wages and
benefits paid to non-government employees. A rise in wage inflation rates are
seen as a positive for a nation's currency. This is because wage inflation is
directly linked to consumer inflation; when employers are forced to pay higher
wages prices seen by consumers will soon be increased in order to compensate.
Traders keep an eye on wage inflation as a means to gauge pending consumer
inflation, which will of course ultimately affect GDP (Gross Domestic Product).
Existing Home Sales
Each month the National
Association of Realtors releases a report measuring the number of homes sold in
the prior month. Existing Home Sales and New Home Sales have collectively
gained more respect from traders since the beginning of 2007, when sub-prime
lending in the US began to fall under scrutiny. Most traders view Existing Home
Sales as the report that carries the most weight between the two.
GDP Annualized q/q
This release is a quarterly look
at Gross Domestic Product, revisions will follow in next two months. Gross
Domestic Product is considered by most the broadest, most comprehensive
barometer of a country's overall economic condition. It measures the sum of all
market values on final goods and services produced in a country (domestically)
during a specific period of time. A rising trend seen in a country's GDP of
course indicates that the economy of said country is improving; as a result
foreign investors are more inclined to seek investment opportunities within
that nation's bond and stock markets. It is not uncommon to see interest rate
hikes as a follow-up to a rising GDP, as central banks will have an increased
confidence in their own growing economies. The combination of a rising GDP and
potentially higher interest rates can lead to an increase in demand for that
nation's currency on a global scale.
GDP is calculated and reported on
a quarterly basis as part of the National income and Product Accounts (NIPAs).
NIPAs were developed and are maintained today by the Commerce Department's
Bureau of Economic Analysis (BEA). NIPAs are the most comprehensive set of data
available regarding US national output, production, and the distribution of
income. Each GDP report contains the following:
Personal income and consumptions
expenditures
Corporate profits
National income
GDP Deflator Annualized q/q
Aside from basic GDP (Gross
Domestic Product) figures the government also releases GDP deflators. The GDP
Deflator report publishes the difference between nominal and actual GDP. The
report takes a measurement of annualized quarterly inflation rates as
applicable to all economic activity.
Interest Rate Statement
The Federal Open Market Committee
(FOMC), which is the governing body of the US central bank, publishes an
Interest Rate Statement eight times each year. Perhaps at the core of all
economic indicators are those that relate to interest rate decisions. In fact,
most would argue that other economic indicators are used by the average trader
as nothing more than a means to anticipate pending interest rate changes. The
bulk of the statement includes an explanation of the various economic factors
that influenced the change in rates (or lack thereof) for the nation's short
term interest rate, also referred to as the "fed funds rate". The
report will also include insight as to what the next interest rate decision
might be. Short term interest rates are of monumental importance to traders in
any of the major financial markets. This is due to the fact that high interest
rates attract foreign investors who are seeking the highest possible return in
exchange for the lowest possible risk. Central banks are most concerned with
price stability. If inflation rates are continually rising interest rates will
likely be increased in an effort to bring prices back down. Globally, increased
interest rates are said to entice foreign investment flows, which would of
course, in turn, increase the demand and the standing of a nation's currency on
a global scale. Seasoned economists understand the relationship between
inflation and interest rates, namely that inflation tends to precede higher
interest rates, which ultimately increases the global demand for a nation's
currency.
ISM Manufacturing Index
The ISM Manufacturing Index is a
monthly report released by the Institute of Supply Management that tracks the
amount of manufacturing activity that occurred the previous month. The values
for the index range between 0 and 100. If the index has a value below 50, due
to a decrease in activity, it tends to indicate an economic recession,
particularly if they trend continues over several months. A value substantially
over 50 likely indicates a time of economic growth.
ISM Manufacturing Prices
This manufacturing indicator,
conducted by the Institute of Supply Management, surveys 400 firms in an
attempt to gauge price inflation seen within the manufacturing sector. Firms
are asked whether or not there has been an increase seen in the prices of
materials and services.
ISM Non-Manufacturing Index
ISM stands for the Institute of
Supply Management. The NON-Manufacturing Index of course focuses on the
non-manufacturing portion of the services sector. In the US this Manufacturing
Index seems to be closely watched by traders in each of the major financial
markets. Before the report is published purchasing managers are surveyed on the
present situation of economic factors relevant to their position; factors such
as new orders, inventories, production, employment, etc. Traders tend to keep
an eye on this indicator because it tends to lead (leading indicator) into data
that will later be released. This is because purchasing managers have an early
view at the performance of their company. The indicator uses a reading of 50 to
measure expansion, or the lack thereof. A reading above 50 would indicate
economic expansion.
New Home Sales
New Home Sales reports the number
of new privately owned homes sold or for sale in a given period (generally
reported once a month). Economists note the correlation between changing
mortgage rates and new home sales; namely that new home sales numbers tend to
lag slowly behind changes made to mortgage rates. Also measured is the number
of homes for sale in relationship to current sales prices; these numbers of
course in turn will affect housing starts. Because the new home sales report is
often subject to large revisions monthly numbers are often seen as unreliable.
As a result this indicator's potential impact on the market is rather
inconsistent; instead traders tend to give more credence to the existing home
sales report which is released earlier in the month.
Nonfarm Employment Change
This indicator is a measurement
of the total number of non farming related new jobs created in America for the
previous month. It is perhaps the most important of all economic indicators in
terms of its potential for immediate impact upon the currency market. The
Nonfarm Employment Change (also referred to as the Nonfarm Payroll Report) is
so largely influential because of its implications concerning the strength, or
perhaps the weakness of the US economy. The number of new jobs created is
closely connected to consumer spending, which in turn plays into GDP (Gross
Domestic Product). This indicator is released on the first Friday of every
month and contains data for the month prior. The report is the first of its
kind (related to labor statistics) every month and is often regarded as an
indicator in which surprise figures are generally anticipated. Traders in every
major financial market watch this release very closely and are often forced to
adjust trading strategies because of its immediate impact on the market.
Nonfarm Productivity q/q
This indicator takes a look at
quarterly growth (annualized) in the non farming sector. Essentially labor
efficiency for the production of goods and services is analyzed. This report is
watched closely by traders because it tends to give a glimpse into the
potential for inflation; as manufacturers may be forced to raise prices.
Personal Spending m/m
Personal spending is a simple
measurement of the total amount spent by consumers in a given period (month) on
goods and services. As consumer spending has far reaching implications into the
overall picture of an economy, and considering that it accounts for more than
half of GDP (Gross Domestic Product) a rise seen in the trends of this indicator
should have a positive effect on a nation's currency.
Unemployment Rate
The Unemployment Rate, as one
might presume, measures the total number of Americans that are unemployed and
who are presently seeking employment. Because consumer spending is such a large
part of economic health, and those who are employed tend to spend more than
those who are not, a downtrend seen in this indicator will have a positive
effect on a nation's overall economic strength. The Unemployment Report is
considered by traders a lagging indicator, meaning that its insight offers
little in the way of future projections. As such, this indicator is not as
heavily regarded as perhaps its name would suggest.
Unit Labor Costs q/q
This indicator is a measurement
that calculates output per hour minus inflation, or in other words the
correlation between productivity per hour and compensation per hour. An
increase in hourly compensation will of course increase unit labor costs; the
only way to offset this cost is to facilitate higher labor productivity per
hour. Higher trends seen in this indicator should positively affect a nation's
economy and thus their currency as well. This is because when companies are
forced to pay more for labor (wage inflation) consumers will soon see an increase
in cost as well (consumer inflation). This indicator is important to traders,
as wage inflation is often a precursor to consumer inflation, which will in
turn affect Gross Domestic Product, interest rates, etc.
Fundamentals of the EUR
The Euro's Presence Globally
The Euro finds itself in an
interesting position globally. Because the Euro is used by many countries
across Europe its global economic impact is substantial. Listed in alphabetical
order the Euro is the official currency of the following countries: Austria,
Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,
Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain – these
countries comprise what is known as the Eurozone. The economic standing of any
of the aforementioned countries can potentially impact the stability and price
direction of the Euro. That said, traders dealing in Euro must pay close
attention to political factors, and the various economic indicators of each
country in the Eurozone.
Some of the relevant economic
indicators to the Euro are released directly through the European Central Bank
(ECB), while others are released from private data analysis firms. Each of the
economic indicators listed and described below have the potential to affect the
price and stability of the Euro upon their release. There are other indicators
that are directly relevant to the Euro, but that have been excluded from the
list below.
Some of the below reports are
commonly released by most economic powers around the globe, others are specific
only to countries within the Eurozone. The reports are listed in alphabetical
order, for more on the report and its strength ranking take a look at each
individual indicator description below. For the date and time of the next
release for each report please browse our current economic calendar.
French GDP
Gross Domestic Product is
considered by most the broadest, most comprehensive barometer of a country's
overall economic condition. It measures the sum of all market values on final
goods and services produced in a country (domestically) during a specific
period of time. A rising trend seen in a country's GDP of course indicates that
the economy of said country is improving; as a result foreign investors are
more inclined to seek investment opportunities within that nation's bond and
stock markets. It is not uncommon to see interest rate hikes as a follow-up to
a rising GDP, as central banks will have an increased confidence in their own
growing economies. The combination of a rising GDP and potentially higher
interest rates can lead to an increase in demand for that nation's currency on
a global scale.
French Nonfarm Employment
Nonfarm Employment Change is a
measurement of the number of new jobs created in the previous quarter (of
course excluding farming related employment). The number of new jobs seen in a
given economy is of course largely influential in regards to the strength of
that nation's currency; as the number of new jobs directly impacts consumer
spending. Consumer spending accounts for nearly half of Gross Domestic Product.
GDP is of course one of the most important economic indicators in terms of
driving economic progression and the increase of a nation's currency.
German CPI
CPI stands for Consumer Price
Index, a fundamental indicator that establishes the rate of price inflation or
price increase as seen by consumers when purchasing goods and services. The
Consumer Price Index is touted as a timely and detailed inflation indicator.
Typically, it is assumed that a rising trend in CPI will positively impact a
nation's currency. Central banks are most concerned with price stability. If
inflation rates are continually rising interest rates will likely be increased
in an effort to bring prices back down. Globally, increased interest rates are
said to entice foreign investment flows, which would of course, in turn,
increase the demand and the standing of a nation's currency on a global scale.
CPI is a well respected fundamental indicator and is ranked highly in terms of
its potential impact in the market.
German GDP
Gross Domestic Product is
considered by most the broadest, most comprehensive barometer of a country's
overall economic condition. It measures the sum of all market values on final
goods and services produced in a country (domestically) during a specific
period of time. A rising trend seen in a country's GDP of course indicates that
the economy of said country is improving; as a result foreign investors are
more inclined to seek investment opportunities within that nation's bond and
stock markets. It is not uncommon to see interest rate hikes as a follow-up to
a rising GDP, as central banks will have an increased confidence in their own
growing economies. The combination of a rising GDP and potentially higher
interest rates can lead to an increase in demand for that nation's currency on
a global scale.
German IFo Business Climate Index
The IFo (Information and
Forschung) Business Climate Index surveys manufacturing, wholesale, retail and
construction firms in an effort to measure economic confidence in the coming
months. Over 7,000 firms are said to participate in the survey which has become
a very key indication of economic confidence, or the lack thereof, in the
German economy.
German Industrial Production
Industrial production is a
measurement of the cumulative dollar amount of product produced by factories
and other industrial production facilities. Increased levels of production
would of course signify a strengthening economy, thus an increased trend seen
in this indicator should positively affect the position of a nation's currency.
Industrial production is closely tied with personal income, manufacturing
employment and average earnings in that its quick reaction to the business
cycle often allows for a pre-emptive leading look into these indicators.
German Manufacturing PMI
PMI stands for Purchasing
Managers Index. Before the report is published purchasing managers are surveyed
on the present situation of economic factors relevant to their position,
factors such as new orders, inventories, production, employment, etc. Traders
tend to keep an eye on this indicator because it tends to lead (leading
indicator) into data that will later be released. This is because purchasing
managers have an early view at the performance of their company. The indicator
uses a reading of 50 to measure expansion, or the lack thereof. A reading above
50 would indicate economic expansion.
German ZEW Economic Sentiment
ZEW stands for Zentrum fur
Europaische Wirtschaftsforschung; for non German speakers, probably an
irrelevant fact. At any rate, the ZEW Economic Sentiment takes a look at
investor sentiment on the institutional level. Participants in the gathering of
data state whether they feel optimistic or pessimistic concerning the state of
their investments and the health of the economy in the coming six months. The
indicator compares the percent of investors who feel positive about the pending
economy to those who feel negative and then factors the number of those who
expect no change. If 40% of investors feel optimistic concerning the pending
economy and 30% expect a falling economy, leaving a remaining 30% that expect
no change the reading would measure +10. Investor sentiment, particularly
investors on an institutional level, can largely impact overall economic
sentiment, thus a positive trend seen in this indicator should positively
impact the economy.
Industrial New Orders
Industrial New Orders is a simple
measurement of the number of new purchase orders as seen by domestic manufacturers
for either durable or non-durable goods in a given period of time.
Interest Rate Statement
The Governing Council of the
European Central Bank (ECB) publishes an Interest Rate Statement every month.
Perhaps at the core of all economic indicators are those that relate to
interest rate decisions. In fact, most would argue that other economic
indicators are used by the average trader as nothing more than a means to
anticipate pending interest rate changes. The bulk of the statement includes an
explanation of the various economic factors that influenced the change in rates
(or lack thereof) for the nation's short term interest rate, also referred to
as the "cash rate". The report will also include insight as to what
the next interest rate decision might be. Short term interest rates are of
monumental importance to traders in any of the major financial markets. This is
due to the fact that high interest rates attract foreign investors who are
seeking the highest possible return in exchange for the lowest possible risk.
Central banks are most concerned with price stability. If inflation rates are
continually rising interest rates will likely be increased in an effort to
bring prices back down. Globally, increased interest rates are said to entice
foreign investment flows, which would of course, in turn, increase the demand
and the standing of a nation's currency on a global scale. Seasoned economists
understand the relationship between inflation and interest rates, namely that
inflation tends to precede higher interest rates, which ultimately increases
the global demand for a nation's currency.
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