Forex Fundamentals 101
Forex Fundamental Analysis provides the additional information to Technical Analysis to give the forex trader a full understanding of the Forex Market.
The forex traders’ job is to determine the direction of a particular currency, then to decide which currency pair to buy or sell. To identify this, it is important to understand the ‘Cause and Effect’ of the Forex Market. The ‘Cause’ can be found in the fundamental economics of a particular country and the actions of the central banks to manage that economy. The ‘Effect’ is the subsequent reaction of the traders to this information in the form of buying or selling that can be found on the charts i.e technical analysis. So using both Fundamental Analysis Plus Technical Analysis gives the forex trader an edge. If the US Dollar economy was weak and the European economy was strong then the trader would look to buy the EURUSD and use Technical Analysis to find the key entry points into the trade.
Whilst it is not crucial to have an economics degree, it is important to understand the basics. When a country has a good economic outlook or its economy is currently strong the currency is most likely to increase in value. In the forex market we trade in currency pairs so it is vital to understand that we are comparing the relative strength of one economy against another i.e If the US Economy was strong and European economy was weak, then we could expect the EURUSD to have a downwards trend.
But wait – remember because we are using currency pairs it is the relative strength of the economies – If the US economy was strong BUT the EURozone economy was stronger then the EURUSD would go up.
How does a country economy work?
Yes you might need an economics degree to fully grasp this, however we are lucky as forex traders we just need to know if an economy is strong or weak relative to another and what economic data dictates a strong or weak economy.
Strong Economy = Higher GDP, Lower Inflation, Higher Interest Rates, Greater Productivity, Good Political Stability
Weak Economy = Lower GDP, Higher Inflation, Lower Interest Rates, Lower Productivity, Weak Political Stability
Money Flow – Life blood of an economy
To ensure an economy can actually function it needs money, no money no economy. Money needs to flow in and out of the economy whilst maintaining a balanced level of money within the economy. The Central Banks of each country manage and control the flow and quantity of money in the economy to keep it healthy and sustainable. Think of the Central Bank as the heart of the economy ensuring money flows.
How is an economy managed?
Contrary to popular belief the economy is not managed by the government of that country, it is managed by its central bank, which is not influenced by government. The Central Banks have objectives and they are generally:
- Maintain a stability
- Provide sustainable growth
- Manage inflation
Each country may have specific objectives, however each Central Bank has its own ‘Monetary Policy’ that shows everyone in a transparent way how that bank is going to achieve its objectives in the economy. A Central bank will also have a ‘Fiscal Policy’ that controls the money flow within that economy.
The metrics and tools that the Central Bank have to manage the economy?
For the Central Banks to manage their economy they need to be able to influence and monitor the metrics of a strong or weak economy. To influence and change those metrics they need some tools to do so.
Let’s take a look at the major metrics (as found in the formulae at the beginning of this article) of an economy:
GDP – Gross Domestic Product – Economic Health Indicator
Released quarterly, this is the most important indicator of economic health and growth and is a Tier 1 Economic Data Release (ie any variance on the forecast will create a large change in price). It is the total amount of goods and services produced.
CPI – Consumer Price Index – Inflation Indicator
Released quarterly, this is the second most important metric and is also a Tier 1 Economic Data Release. It is a measurement of prices for a range of consumer goods and a good measurement of inflation.
Retail Sales – Inflation Indicator
Released monthly, this data release is monitored closely by traders as it may give an indication of what is to come in the next CPI as that is only released quarterly. The Retail Sales metric tracks the dollar value of merchandise sold within the retail trade.
Central banks use a ‘Monetary Policy’ that outlines the objectives of the Central Bank and how they are going to manage their particular country’s objectives. Basically there are two types of Monetary Policy, known as ‘Expansionary’ and ‘Contractionary’. If a Central Bank wants to reduce unemployment, boost private sector borrowing and consumer spending, and stimulate economic growth they ‘increase money flow and is reffered to as an Expansionary Policy’. If they want to control an increasing inflation rate then they reduce the money flow rate to slow the economy growth rate down, increase unemployment and put the brake on borrowing and spending by businesses and consumers, this is referred to as a Contractionary Policy.
Interest Rates – Manages Inflation
Most Central Banks have a target inflation band of 2-3%. Interest rates are used as a throttle and a brake to control inflation. If inflation drops below 2% then they will cut interest rates to stimulate economic activity. When it approaches or exceeds 3% they raise interest rates to slow the economy down.
Quantitative Easing – Alternative way to manage Inflation
When interest rates are approaching or zero and the economy needs a boost, under normal circumstances interest rates are reduced which encourages borrowing and spending which would boost the economy. When the Central Bank cannot reduce interest rates any more to encourage economic growth, the only thing they can do is introduce more money into the economy. Whilst they can print money, this is normally a last resort so the Central Banks introduce more money into the economy by buying Government bonds from the banks, this allows the banks to get more money into their account so they can lend more and effectively reduce interest rates, without the Central Bank having to do it.
How an Economy works
A country’s economy is a dynamic and constantly changing cycle of events. Those events are:
- Expansion and Growth
The economy is managed by the Central Bank of that country and they have essentially one tool to manage it – Interest Rates.
The Economic Cycle
- Expansion and Growth – The economy is strong and growing the GDP growth Rate is positive.
This means there is a good flow of money, businesses will grow, jobs and personal income will flourish.
- Peak – When the economy reaches between 3-4% then it has most likely hit its peak.
At that point the bubble bursts and economic growth stalls and the economy starts to contract.
- Contraction – The economy starts to slow down
Money is now expensive as Central Banks have risen interest rates.
- Trough – Prices fall as demand decreases.
Central banks now decrease interest rates to stimulate growth.
The Central Banks
At the core of Forex Fundaments are each of the Central Banks have specific problems and objectives that are specific to their country. If we know what those problems and objectives are then we can predict the effect on the currency when an important economic data metric is released. The Central Banks make this very clear and transparent in their ‘Monetary Policy’. They want traders to know what they are doing so they can control the value of their currency.
Let’s take a look at the most important one the US Federal Reserve often called the ‘Fed’.
US Federal Reserve
The Fed has three goals specified by congress (government)
- Maximum Employment
- Stable Prices
- Moderate Log-Term Interest Rates
Read more about Conducting Monetary Policy from the Fed.
- Labor Market continued to strengthen and economic activity rising at a steady rate
- Unemployment rate continued to decline
- Over 12 months inflation has been declining and is below 2%
- Economic Activity will continue to expand at a moderate rate and labor market to remain strong
- Inflation expected to remain just below 2% near term and to stabalise at 2% long term
- To encourage a return to 2% inflation the Fed Funds Interest rate was increased to 1.5%
The Fed’s current focus
The FED is clearly focussing on maximum employment and returning inflation back to 2% from 1.7% so from the information above the important economic data releases in the next few weeks would be Inflationary and employment figures which would include:
- GDP Growth Final (%)
- Unemployment Rate (%)
- Employment Wages
Any large variances from the predictions will cause a large movement.
Can you see why Forex Fundamentals 101 are the cause of the currency direction in the forex market, and why other Forex Educators on the internet steer well clear.