Traders don’t take positions in the fx market without an informed opinion about where the market appears to be headed. They won’t go long without some kind of signal that prices are moving up, and they won’t go short without a signal that prices are headed down. They don’t operate blindly, and they don’t throw darts at a dart board to form an opinion about price movement. What are these signals? Where do they come from, and how do traders use them to form educated opinions?
The signals come from two very different kinds of research — the analysis of external events that affect the markets (fundamental analysis) and the analysis of historical patterns of price movements (technical analysis). Each approach has its followers among hedgers and speculators. While some people are purists who advocate one type of analysis over the other, many others engage in both.
Fundamental analysis focuses on cause and effect — causes external to the trading markets that are likely to affect prices in the market. These factors may include the interest rate differentials, monetary policy, government policies, economic indicators, trade balances and even how traders are likely to react to certain events. Of course, fundamentalists have to know what to look at and how to interpret the information available.
Suppose, for example, that you take a fundamentalist approach to buying a house in a certain area. You would start by looking at factors affecting prices in that area. You might discover there’s been too much new construction this season, and that there are also many older homes on the market because of cutbacks at a local corporation. You’d note that sales are sluggish compared to earlier years and that currently there are more houses available than buyers — supply is greater than demand. Your fundamental research tells you that homes in that area will be priced at value or possibly even under-priced, so you’re likely to get a good deal
Because fundamentalists hope to predict which way prices will move, they’re interested in identifying factors that are likely to affect supply and demand. When the supply of a currency increases and demand decreases or stays the same, the price falls. When supply decreases and demand increases or stays the same, the price of that currency rises. If the supply stays the same, changes in demand will cause prices to rise or fall.
This is what we call top-down analysis which is performed by professional traders to identify the long term supply and demand for a currency. For example, the fact that the monetary policy between Fed and ECB are so diverse, gives a hint to investors that for the long term the supply for euro will be going up and the demand will decrease so the currency will depreciate against the greenback. On the other hand, we cannot rely on the big image to trade the fx markets simply because the intraday trading is more complicated than that. What we need to confirm our trend is the technical analysis.
Fundamental Analysis Benefits
- Determining the intrinsic value of an investment
- Identifying long-term investment opportunities
Fundamental Analysis Drawbacks
- Too many macroeconomic indicators and indicator can confuse novice investors
The European Central Bank
The European Central Bank (ECB) is the central bank for the euro and administers the monetary policy of the Eurozone, which consists of 19 EU member states and is one of the largest currency areas in the world. It is one of the world's most important central banks and is one of the seven institutions of the European Union (EU) listed in the Treaty on European Union (TEU). As of 2013 the President of the ECB is Mario Draghi, former governor of the Bank of Italy. The bank is based in Frankfurt and its location in the city is fixed by the Treaty of Amsterdam. The primary objective of the European Central Bank, as mandated in Article 2 of the Statute of the ECB,is to maintain price stability within the Eurozone.
Federal Open Market Committee (FOMC)
The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System (the Fed), is charged under United States law with overseeing the nation's open market operations (i.e., the Fed's buying and selling of United States Treasury securities). It is this Federal Reserve committee which makes key decisions about interest rates and the growth of the United States money supply. It is the principal organ of United States national monetary policy. As of February 3, 2014 the Governor of Federal Reserve is Janet Yellen, Vice Chair of Fed.
The Committee sets monetary policy by specifying the short-term objective for the Fed's open market operations. The FOMC also directs operations undertaken by the Federal Reserve System in foreign exchange markets, although any intervention in foreign exchange markets is coordinated with the U.S. Treasury, which has responsibility for formulating U.S. policies regarding the exchange value of the dollar.
Since 1981, eight regularly scheduled meetings have been held each year at intervals of five to eight weeks. At each regularly scheduled meeting, the Committee votes on the policy to be carried out during the interval between meetings, requiring members to think ahead. Attendance at meetings is restricted because of the confidential nature of the information discussed and is limited to Committee members, non-member Reserve Bank presidents, staff officers, the Manager of the System Open Market Account, and a small number of Board and Reserve Bank staff.
Bank of England (BOE)
The Bank of England, formally the Governor and Company of the Bank of England, is the central bank of the United Kingdom and the model on which most modern central banks have been based. It was established to act as the English Government's banker, and is still the banker for HM Government. The Bank is one of eight banks authorised to issue banknotes in the United Kingdom, but has a monopoly on the issue of banknotes in England and Wales and regulates the issue of banknotes by commercial banks in Scotland and Northern Ireland. The Bank's Monetary Policy Committee has devolved responsibility for managing monetary policy.
The Bank's Financial Policy Committee held its first meeting in June 2011 as a macro prudential regulator to oversee regulation of the UK's financial sector. It is sometimes known by the metonym The Old Lady of Threadneedle Street or The Old Lady.
Mark Carney assumed the post of The Governor of the Bank of England on 1 July 2013. He succeeded Sir Mervyn King, who took over on 30 June 2003. Carney, a Canadian, will serve an initial five-year term rather than the typical eight, and will seek UK citizenship. He is the first non-Briton to hold the post. As of January 2014, the Bank also has three Deputy Governors.
Macroeconomic indicators are statistics that indicate the current status of the economy of a state depending on a particular area of the economy (industry, labour market, trade, etc.). They are published regularly at a certain time by governmental agencies and the private sector. X Station provides an Economic Calendar for the dates of critical fundamental announcements and events. When properly used, these indicators can be an invaluable resource for any Forex trader.
In truth, these statistics help Forex traders monitor the economy's pulse; thus it is not surprising that these are religiously followed by almost everyone in the financial markets.
After publication of these indicators we can observe volatility of the market. The degree of volatility is determined depending on the importance of an indicator. That is why it is important to understand which indicator is important and what it represents.
How we interpret the change of fundamentals into a currency move from one direction to another? Let’s suppose that we trade EUR/USD which currently quotes at 1.1550, and we listen to our live audio from xStation that Euro area inflation fell more than projected. This is of course bad news for the euro and supposing that we don’t have any news for the USD, we should see EUR/USD going downwards. What if we trade USD/CAD and the news are for the quoted currency (CAD)? If the news in a major macro are better than expected CAD will find short term buying opportunities and all else remain equal USD/CAD pair should trade lower.
Lets now see the main factors driving long term currency trends and the main macro that we should watch carefully from each country.
Interest Rates Announcement
Interest rates play the most important role in moving the prices of currencies in the foreign exchange market. As the institutions that set interest rates, central banks are therefore the most influential actors. Interest rates dictate flows of investment. Since currencies are the representations of a country’s economy, differences in interest rates affect the relative worth of currencies in relation to one another. When central banks change interest rates they cause the forex market to experience movement and volatility. In the realm of Forex trading, accurate speculation of central banks’ actions can enhance the trader's chances for a successful trade.
Gross Domestic Product (GDP)
The GDP is the broadest measure of a country's economy, and it represents the total market value of all goods and services produced in a country during a given year. Since the GDP figure itself is often considered a lagging indicator, most traders focus on the two reports that are issued in the months before the final GDP figures: the advance report and the preliminary report. Significant revisions between these reports can cause considerable volatility.
Consumer Price Index
The Consumer Price Index (CPI) is probably the most crucial indicator of inflation. It represents changes in the level of retail prices for the basic consumer basket. Inflation is tied directly to the purchasing power of a currency within its borders and affects its standing on the international markets. If the economy develops in normal conditions, the increase in CPI can lead to an increase in basic interest rates. This, in turn, leads to an increase in the attractiveness of a currency.
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 or destructed, what percentage of the work force is actively working, and how many new people are claiming unemployment. For inflation measurement, it is also important to monitor the speed at which wages are growing.
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. The report is particularly useful because it is a timely indicator of broad consumer spending patterns that is adjusted for seasonal variables. It can be used to predict the performance of more important lagging indicators, and to assess the immediate direction of an economy.
Balance of Payments
The Balance of Payments represents the ratio between the amount of payments received from abroad and the amount of payments going abroad. In other words, it shows the total foreign trade operations, trade balance, and balance between export and import, transfer payments. If coming payment exceeds payments to other countries and international organizations the balance of payments is positive. The surplus is a favourable factor for growth of the national currency.
Government Fiscal and Monetary policy
Stabilization of the economy (e.g., full employment, control of inflation, and an equitable balance of payments) is one of the goals that governments attempt to achieve through manipulation of fiscal and monetary policies. Fiscal policy relates to taxes and expenditures, monetary policy to financial markets and the supply of credit, money, and other financial assets.
Let’s see the most important indicators of the G10 currencies by country/region that play a crucial role in a continuation or reversal of a trend.
Us news are of major importance as the USD participates in almost 90% of the daily transactions. Let’s have a look at the most important:
Average Hourly Earnings: Average Hourly Earnings are expressed as absolute values and as an index relative to the previous period. It is an indicator of potential inflation related with the increase in labor costs. It has a significant impact on the market. With expectations of an increase in basic interest rates, the increase of the index leads to an increase in the rate of dollar.
Building Permits The indicator shows the number of issued permits for the construction of new homes. The indicator is very sensitive to changes in key interest rates, since the construction requires bank loans. These data are subject to seasonal fluctuations due to the character of the real estate market. Building is directly connected with the income of the population. Therefore, the increase in construction characterizes the improved well-being and healthy development of the economy. It has a limited impact on the market. Growth of this value has a positive impact on the currency.
Capacity Utilization: This indicator determines the degree of utilization of productive capacity of the country's economy. The level of 85% indicates a good balance between economic growth and inflation. Figures above this level cause inflation in the economy. It has a limited impact on the market. The growth of this index leads to growth of the national currency.
Chicago PMI Index: Chicago PMI Index is based on surveys of purchasing managers in Chicago. This index includes the status of production orders, the prices of manufactured products and inventories in warehouses. Figures below the 45-50 indicate a slowing economy.
The indicator is carefully watched, because it is published shortly before the release of ISM Index. It has a significant impact on the market because it can give an idea of what the ISM Index will be. Growth of the index leads to the growth of the dollar.
Consumer Confidence (CCI): This index is an attempt to measure consumer optimism. It is calculated since 1967. Its base value is 100. The index is calculated based on the monthly survey of 5,000 families for a number of questions:
- family's financial situation as compared to the previous period;
- The expected financial situation of the family during the year;
- assessment of business conditions in the economy during the year;
- estimate of the expected unemployment and economic recession;
- assessment of home shopping (clothes, furniture, etc.);
The index has a moderate impact on the market because it can fail to reflect the real state of the economy. However, it is traditionally used for predicting trends in employment and the general state of the economy. Growth of the index is a good factor for the national economy and leads to the growth of the dollar.
Consumer Price Index (CPI): CPI defines the change in retail prices for a basket of goods and services. CPI is considered more reliable if it does not take into account food and energy industries. When calculating this index prices for imported goods and services are taken into account. Consumer Price Index is the main indicator of inflation in the country. This index should be analyzed together with PPI (Producer Price Index). If the economy develops in normal conditions, the increase in CPI and PPI can lead to an increase in key interest rates in the country. This, in turn, leads to growth of the dollar because of the increasing attractiveness of investing in currencies with higher interest rates.
Durable Goods Orders: Durable Goods Orders (DGO) is an indicator of orders placed for relatively long lasting goods. Durable goods are expected to last more than three years, e.g.: cars, furniture, appliances, etc. This indicator is important for the market because it gives an idea of the consumers' confidence in the current economic situation. Since durable goods are expensive, the increase in the number of orders for them shows the willingness of consumers to spend their money on them. Thus, the growth of this indicator is a positive factor for economic development and leads to growth of the national currency.
Gross Domestic Product (GDP): Gross domestic product (GDP) is the market cost of goods and services produced within a certain period, regardless of the ethnicity of used factors of production. Income of U.S. citizens and corporations received from abroad are not taken into account for index calculation. GDP is a key indicator of the country's economic activity. Its main components are consumer spending, investment, net exports of goods and services, and government spending. GDP growth is accompanied by the rise of the economy and the dollar tends to strengthen.
Housing Starts: The indicator gages the number of new houses. The indicator is very sensitive to changes in key interest rates, since the construction requires bank loans. These data are subject to seasonal fluctuations due to the character of the real estate market. Building is directly connected with the income of the population. Therefore, the increase in construction characterizes the improved well-being and healthy development of the economy.
Industrial Production: The index of Industrial Production is one of the main indicators reflecting the state of the national economy. This index measures the change in industrial production and public services in the country. It has a significant impact on the market. Production growth leads to growth of the national currency.
ISM Index: ISM Index (Institute of Supply Management's index, former NAPM — National Association of Purchasing Managers) is the index of business activity. ISM figures above 50 are usually considered as an indicator of expansion, while values below 50 indicate contraction. Typically, when ISM approaches 60 investors begin to worry about possible economic overheating, inflation increase and the corresponding measures (raising rates) by the Federal Reserve Bank. Figures below 40 entail talks about recession. ISM is released just before unemployment data are announced, and is often used to refine data by Bureau of Labor Statistics.
Jobless Claims (Initial Claims): There are two types of Jobless Claims - Initial Claims, when a person applies for a benefit for the first time in five years, and the total number. Initial claims are more important. Both figures show weekly changes in the number of jobless claims. These figures do not always reflect the real state of events. They are sometimes distorted by short-term factors, such as federal or local holidays. This indicator can give an idea of what Non-farm payrolls will be next time. For example, if during a month the value of Jobless Claims consistently decreases, then it is likely that the value of Non-farm payrolls will be large. It has a limited impact on the market. Reducing of the number of jobless claims is a favorable factor for the growth of the dollar.
New Home Sales: This indicator measures sales of new houses for a year. This number tends to grow when the rate on loans secured by real estate, which is associated with the basic interest rates in the country, is growing. These data are subject to seasonal fluctuations due to the character of the real estate market. When analyzing the figure moving averages are used. It has a limited impact on the market. Growth of this value has a positive impact on the currency.
Non-farm Payrolls: Non-farm Payrolls is the assessment of the total number of employees recorded in payrolls. This is a very strong indicator that shows the change in employment in the country. The growth of this indicator characterizes the increase in employment and leads to the growth of the dollar. It is considered an indicator tending to move the market. There is a rule of thumb that an increase in its value by 200,000 per month equates to an increase in GDP by 3.0%.
Personal Spending: The index reflects the change in spending for meeting personal needs. The index includes three components: spending on durable goods, on nondurables and services. Retail Sales Index shows the consumption of durable and nondurable goods. The process of service consumption, in turn, changes with a relatively constant rate, so the value of this indicator is often predictable. Thus, only the significant deviation of this index from predicted values may influence the rate of national currency. It has a limited impact on the market. Growth of the index is a good factor for the national economy and leads to the growth of the dollar.
Philadelphia Fed Index: Philadelphia Fed Index is based on the results of survey questioning manufacturers in Philadelphia on their attitude towards the current economic situation. The figures below "0" are an indication of a slowing economy. This index has a medium impact on the market. This index is being carefully watched, because it is published prior to ISM Index and can give an idea of what it will be. Growth of the index leads to the growth of the dollar.
Producer Price Index: PPI measures changes in the price of the consumer basket produced in the industry. This index consists of two parts: the input prices (semi-finished products, components, etc.) and output prices (finished goods). The output price includes labor costs and gives an insight into inflation associated with changes in labor cost. PPI is considered more reliable if it does not take into account food and energy industries. When calculating this index prices for imported goods and services are not taken into account. It has a significant impact on the market. With expectations of an increase in basic interest rates, the increase of the index leads to an increase in the rate of dollar.
Retail Sales: The index shows the change in volume of sales in the retail trade. It characterizes consumer spending and demand. In the results of retail sales, the share of durable goods (from cars to household goods) is about 1/3 of consumer spending and about 2/3 is the share of nondurables. Growth of the index is a good factor for the national economy and leads to the growth of the dollar. It has a limited impact on the market (mainly in the medium and long term).
Unemployment Rate: Unemployment rate is the number of unemployed persons in relation to the working-age population. It is released simultaneously with non-farm payrolls. Typically, analysis of unemployment is carried out in the context of the figures reflecting the value of Non-farm payrolls. For example, the growth of Non-farm payrolls with an increase in the unemployment rate indicates an increase in unemployment in the agricultural sectors of the economy, etc. It has a significant impact on the market. With expectations of an increase in basic interest rates, the decrease of the index leads to an increase in the rate of dollar.
University of Michigan Consumer Confidence Index: University of Michigan Consumer Confidence Index is the survey of consumers' confidence in the current economic situation. The survey is conducted by the University of Michigan USA. It analyzes the desire of consumers to spend their money. The index is a leading indicator of consumer sentiment. It has a limited impact on the market. Growth of the index leads to the growth of the dollar.
Traders watch these macros carefully but they focus on German data simply because the euro is more dependent on the German economy. News coming from France, Italy or Spain is also very important.
Consumer Confidence Indicator (CCI): The index is the average of the balance of answers to four questions: evaluating the financial state of the family household, evaluating the general economic situation in the country in the past and opinion about its future, the acceptability of making large purchases at the moment. The survey is carried out in all segments of the population. Only unambiguous answers are allowed: "yes — no", "bad — good". The final figure is the difference between positive and negative responses. Thus, the value above zero indicates a greater number of positive responses.
Economic Sentiment Indicator: This indicator is the most important one in terms of assessing the prospects for economic growth. It is a composite indicator with complicated calculations. Its value is equally influenced by the Industrial Confidence Indicator and Consumer Confidence Indicator. In addition, construction confidence index and stock prices index are used for calculating; their influence is reduced due to the use of reduction factors.As an integral indicator for the majority of survey of indexes, it has a big impact on financial markets, and from this point of view it is the main survey index. High or rising values of the index indicates a healthy level of purchases, business expenses and investments which positively affects the economic situation and leads to strengthening of the euro.
Gross Domestic Product (GDP): GDP is considered in the three independent components:
- GDP as the sum in money for all goods and services produced by business entities, plus taxes, minus subsidies on production of certain goods and services.
- GDP as the amount of funds spent on consumption of goods and services produced, plus export, minus import of goods and services.
- GDP as the amount of the revenue the economy as a whole (i.e. salaries, taxes, balance profit of businesses, etc. ).
After obtaining the data on these parameters and checking their balance, the value of GDP is obtained, which is included in the official documents. It is important to track GDP. Its growth relates to the factors that contribute to strengthening of the national currency, but despite its importance, they rarely have a strong impact on foreign exchange markets.
Harmonized Index of Consumer Price (HICP): The indicator is taken into account by the market. During the cycle of interest rates growth, the index gains more importance, since its growth entails further tightening of monetary policy in the country, and therefore entails the growth of the national currency. Indices of consumer price inflation are more important than the index of industrial inflation. To compare the values of indexes for different periods, the index value for the base year 1996 equal to 100 is used.
IFO Business Climate: This survey is one of the key indicators of country's business sentiment. The survey is conducted monthly, querying German firms on the current German business climate as well as their expectations for the next six months. As the largest economy in the Euro-zone, Germany is responsible for approximately a quarter of the total Euro-Zone GDP. Consequently, the German IFO is a significant economic health indicator for the Euro-zone as a whole. The figures below 100 are an indicator of a slowing down economy, and are clearly regarded by the market as a negative factor. Values above 100 indicate growing optimism, which in turn causes the strengthening of the Euro. The survey presents two equally weighted sub-indices: Current Assessment and Business Expectations.
Industrial Confidence Indicator: This index is calculated similarly to Consumer Confidence Index. Heads of industrial enterprises evaluates the production prospects in general, as well as the prospects of orders growth and growth of shares of industrial firms.
PMI Services: This index reflects the business optimism in the service sector. The indicator is calculated based on interviewing of executives in Germany, France, Ireland, Italy and Spain. Together, these countries account for about 4/5 of all activity in the service sector of Eurozone. The indicator values about 50 points indicate that during the reporting period there was neither extension no reduction of the service sector. Values above 50 indicate growth in this sector. Figures below 50 may indicate deterioration in the service sector. Because 2/3 of GDP is created in the service sector, PMI Services is an important and timely indicator of health of economy. The index has a significant impact on the market.
PMI Manufacturing: This index assesses business conditions in the manufacturing sector. Because the manufacturing sector represents nearly a quarter of the total Eurozone GDP, the Eurozone PMI Manufacturing is a significant and timely indicator of business conditions and the general health of the economy. The indicator values about 50 points indicate that during the reporting period there was neither extension no reduction of the manufacturing sector. Values above 50 indicate growth in this sector. Figures below 50 may indicate deterioration in the manufacturing sector.
Purchasing Managers Index (PMI): The index is based on a survey of a large number of participants who answer questions like "Have the conditions improved for your business in terms of new orders, prices, labor market, the timing of orders, etc.?", while the respondent selects one of the three types of response: "No", "Yes" or "Not changed". Such indexes very effectively monitor the dynamics of the economic cycle being leading indicators.
When the index starts to fall after a period of growth, this predicts the transition of the business cycle from the growth stage to decline, while its turn upwards after the fall predicts the beginning of recovery. The indicator values about 50 points indicate that during the reporting period there was neither extension no reduction of the manufacturing sector. Values above 50 indicate growth in this sector. Figures below 50 may indicate deterioration in the industry. The index has a significant impact on the market.
Retail Trade Confidence Indicator: This index is calculated similarly to Consumer Confidence Index. Owners of retail businesses answer questions about the trading situation at the moment and estimate prospects for the future.
Unemployment Rate: The unemployment rate is the percentage of working-age population who are actively looking for a job but can't find it. A low or falling unemployment rate is associated with increased expenditure, given that more people are employed and have incoming wages. This is a significant indicator of economic activity in a region, particularly because it is released earlier than the GDP. However, it receives less attention, because the corresponding figures for member countries are released before the aggregate rate for the Eurozone.
ZEW Survey: A German firm, the Center for European Economic Research (ZEW), queries financial experts throughout Europe every month in order to make a medium-term forecast about Eurozone's economic situation. The results are calculation of the difference between positive and negative reviews.
There are two types of the indicator:
- ZEW Economic Expectations Index — this indicator is made up of assessments of expected events— the direction of inflation, interest rates and exchange rates over the next six months.
- Zew Current Situation — in contrast to the previous indicator, it assesses the current economic situation. Experts are invited to select one of the variants: "better", "worse" or "unchanged." The final figure is the difference between positive and negative rates.
High figures indicate a positive economic environment and good business climate in the Eurozone.