Fundamental Analysis in Forex Market: Basic

As you know, market movements forecasting is based on two types of analysis: technical and fundamental. We have already explored the methods of technical analysis in course of our preceding lectures; now it is time for fundamental analysis.

So, let’s get started. Only few economic factors can influence currency exchange rates. The rest of indicators are mainly used by economists or other markets. These factors confirm to some degree a possible or existing trend in the economy, which does not have a direct impact on the forex market. Therefore, such factors are just absorbed by usual market fluctuations. Fundamental analysis is a way to assess both economic growth in separate countries and the global economic situation, including their mutual influence, allowing for numerous economic indicators and factors. Some deciding events happen accidentally, others are published on a set schedule by government, non-government scientific research organizations.

Any kind of information that contributes to the economic well-being belongs to fundamental data. It can be divided into four major groups, including economic factors, financial factors, political events, and periods of crisis.

Economic factors (indicators) are set apart from others as their release date is usually known in advance in most industrialized countries.
Political events represent various influences on the global market.  Thus, president election can hardly reverse the market course, while a sudden change of a government system has every chance to shock market participants.

Financial factors can be referred to the group of events that are hard to be predicted. These factors have a considerable impact on the forex market. Changes in key rates of the world’s leading central banks, such as the US regulator, are an obvious example. No one could clearly foresee monetary policy reforms. There are only expectations available, which in their turn crucially influence the market. Usually, investors begin to express concern about one week before another US Fed’s meeting. The tension becomes almost unbearable in case of a sudden rate change that results in sharp fluctuations in the currency exchange rate.

Crisis can also play a role of a deciding factor in global markets. An impact it makes depends on the degree of predictability.  For example, the Persian Gulf Crisis produced a modest effect on Forex. However, sometimes a simple hint dropped by a senior official can cause huge volatility in the currency exchange market. Thus, UK Prime Minister Tony Blair sparked an immediate response from the market delivering the speech on adopting the euro as the currency to replace the British pound in 2001.

Fundamental analysis cannot be performed without economic indicators as they represent its instrumental part. As a rule, fundamental releases are scheduled in advance. In the US, economic indicators come in on a monthly basis except for the Gross Domestic Product (GDP) and the Gross Domestic Product Deflator (GDPD), which are published once in a quarter.

Meanwhile, weekly indicators do not make any significant impact on the market so they are not worth considering. Traders should be kept informed of every date when a particular economic report is due to be released. Especially since it is unlikely to cause any problem as all the relevant information on releases and analysis of their potential impact on the market can be found in news feeds from brokerage companies, which provide traders with services for trading online.  Besides, over ten other online sources deliver such data.

The US economy has the greatest influence on the forex market as it contributes 20.6% to the global GDP growth rate. To prove this fact, let’s explore the US economic indicators drawing an analogy with indicators of other countries according to their impact on the global economic health.   As a rule an economic indicator is comprised of two parts. The first one is its reading in the last month, and the second – revised data for the preceding period.

The Gross National Product (GNP) is one of the major economic indicators. The formula for calculating the GNP  is:

GNP = C + I + G + T

С is the consumption spending which depends on an amount of personal earnings and consumers’ estimates of their prospects in the future. In other words, this is a psychological factor that determines consumers’ decision whether to spend or save money;

I is for capital investments;

G is for government spendings. This data strongly influence other economic indicators and the whole economic situation in the country;

T is a trade balance (difference between exports and imports).

The GNP report comes out once a quarter measuring the sum of all goods and services produced by the United States residents, either within the country or abroad, for the reporting period. When the GNP readings top analysts’ forecast, the US dollar strengthens against the most majors and vice versa.

The Gross Domestic Product (GDP) efers to the sum of all goods and services produced in the United States, either by domestic or foreign companies. The difference between the GDP and GNP is nominal in the case of the United States economy. However, this economic indicator is more popular outside the United States rather than within the country. In the US it is mainly published in order to make it easier to compare the performances of different economies.

Inflation Indicators are indicators which detect trends in prices of consumer goods and services. These indicators are closely monitored by market participants. Raising the interest rate is the method of choice for central banks to control the inflation growth rate, and higher interest rates tend to support the local currency. The inflation rate limits the key interest to its objective level that, coupled with real GDP/GNP figures, helps traders and fund managers compare economic conditions in different countries and find the best opportunities for making profits.

Producer Price Index (PPI) has been published since the early twentieth century.  The indicator measures the average change in wholesale prices for raw materials and parts at all stages.  The indicator is calculated on a basis of reports from all of the physical goods-producing industries, including manufacturing sectors, raw materials extraction, and agriculture. It covers near 3,400 materials and goods produced in the territory of the US. The most major groups include food – 24%, fuel — 7%, auto — 7%, and clothing — 6%. The indicator is monthly released.

Consumer Price Index (CPI) measures an average change in  prices for items in a basket of consumer goods and services weighted according to their importance.  The most important categories in the consumer price index are food — 19% of the total weight, housing — 38%, fuels — 8%, automobiles — 7%. Besides, the index includes transport costs, healthcare, and closing.  Import goods are also measured by the indicator. The release comes in once a month. Both the PPI and CPI are used to assess the inflation growth rate in the country.

Commodity Research Bureau Futures Index (CRB Index) is comprised of the equally weighted futures prices of 21 commodities, including precious metals (gold, silver, platinum), industrials (crude, gasoline, heating oil, lumber, copper, cotton), grains (corn, wheat, soybeans, soy meal, soy oil), livestock and meat (cattle, pork bellies), imports (coffee, cocoa, sugar), miscellaneous (orange juice).

Thus, 13 of 21 commodities belong to food, which makes the indicator less reliable in terms of general inflation.  However, the indicator is recently gaining in popularity among professional traders.

The” Journal of Commerce” Industrial Price Index (JoC). The indicator consists of the prices of 18 industrial materials and supplies processed in the initial stages of manufacturing, construction, and energy production. It is one of the most sensitive indices as it was designed to signal changes in inflation at the initial stage. Other inflation indicators detect the same changes later.

Balance-of-Payments measures the total number of economic transactions of  a certain country with the rest of the world. Analysts assess the value of this indicator according to country’s long-term prospects of economic performance allowing for natural resources, industrial base, the level of professional training in the labor market, and labor costs. The indicator is rarely used by intraday traders.

Merchandise Trade Balance consists of the net difference between the exports and imports of a certain economy. It’s one of the most important economic indicators. The data cover six categories, including food, raw materials and industrial supplies, consumer goods, autos, capital goods, and other merchandise.

A significant difference between the indicator readings and analysts’ forecast puts the US dollar under pressure. In case of wider-than-expected deficit, the US national currency loses against the most majors and vice versa.

The USA-Japan Merchandise Trade Balance — is a separate indicator that belongs to this group. It shows the balance of trade between the US and Japan. The greenback, as a rule, declines on the back of growing deficit in the US-Japan trade balance.

Industrial Production is comprised of total output of nation’s plants, utilities, and mines.  This indicator is instrumental in fundamental analysis. The indicator reflects strength of economy, and by extrapolation strength of a national currency. Thus, the US dollar gains when the indicator reading posts a rise. This data is released every month.

Capacity Utilization indicator consists of total industrial output divided by total production capability. A normal reading for a steady economic growth rate is 81.5%. The indicator has a nominal impact on the market staying near this level. If the figure reads 85% or more, the data suggests that the industrial production is overheating and the economy is close to its full capacity. Besides, high capacity utilization rates precede new inflation developments. In its turn, a central bank can raise interest rates to fight the inflation growth or avoid it.

National Association of the Purchasing Managers Index(NAPM) is driven from a survey of 250 managers at the largest industrial companies. The survey unveils whether the performance of the manufacturing sector improves compared to the previous survey results, including changes in new orders, production output, employment, stock of finished products, and suppliers’ delivery times. A reading below 45-50 presents a contraction of the manufacturing sector in a certain country. 

The index was among first industrial sector indicators, so it can hardly be called perfect.  Responds are mostly based on psychology rather than statistics. Besides, the survey is not conducted in California, which is one of the US largest states.  Increasing production does not necessarily mean growing consumer demand. Traders rarely consider the indicator reading, only when the data changes. Meanwhile, the PPI helps forecast short-term developments in the market.

Factory Goods Orders reflects both durable and nondurable goods orders. A list comprises food, light industrial products, and products designed for the maintenance of durable goods. The report makes minimal impact on the forex market.

Durable Goods Orders. This indicator refers to products with a lifespan over three years. All durable goods can be divided into four major categories, including primary metals (jewelry), machinery, electrical machinery, and transportation. Besides, the orders can be broken down into two types - defense and nondefense.  The indicator strongly influences the market. As a rule, durable goods are more expensive than non-durable ones, and increasing sales reflect mounting consumer confidence and an advancing propensity to spend money. So, a strong indicator reading is generally bullish for the domestic currency.

Construction Data is one of the most major economic indicators. It is included in the GDP calculation. It is housing that pulled the US economy out of recession during the post-war period. Construction data is classified into the following:

housing starts and permits;

• new and existing one-family home sales;
  
• construction spending.
  
• Construction indicators are cyclical and partially depend on the key interest rate. When 1.5-2.0 million new houses are reported to be sold within a month, the economy is assumed to be growing. The report which reads less than 1 million houses sold suggests that the economy is slipping into recession. The indicator is mostly used to appraise the general economic situation in the country.
  

Employment Indicators measure the rate of unemployment in the country. The indicator plays an important role in assessing the general economic situation in the country. Besides, it is used for other economic indicators calculation.

Unemployment Rate is always released as a percentage. The indicator includes two groups of data.

The Business Firms (Establishments) Survey, which in its turn covers the following subjects:

• Payroll — the total amount of money paid by a company to the people it employs;
  
• Workweek — the average number of working hours per week;
  
• Hourly earnings —average earnings per hour
  
• Total hours of employment in the non-farm sector — the total amount of working hours in government, industrial sector, services sector, construction, mining, retail trade etc.
  

The Household Survey includes:

• Unemployment rate — a percentage-based level of unemployment
  
• The overall labor force — the total volume of  industrial labor force
  
• Number of people employed — the total number of employed people at the age of 16 and over
  
• As these indicators reflect the economic health of a country, traders should closely monitor any changes in readings, which are monthly released.  Employment indicators show whether the economy advance or live through the period of recession. The unemployment rate is the last economic indicator to rebound when the labor sector recovers. For this this reason, the national currency rise when unemployment contracts and vice versa.
  

Retail Sales he indicator plays a significant role in the forex market. It shows the strength of both consumer demand and consumer confidence, which influence the national currency. If consumers have enough money to make purchases, then the industrial sector will advance as well as imports. A seasonal aspect is important for this economic indicator. September and December are most carefully watched by traders as the first is a back-to-school month and the latter is a period of Christmas gifts purchase. A rise in retail sales figures causes an increase in the national currency.

Consumer Sentiment is a survey of households. It was created to reveal middle-income individuals’ intention of spending money. The survey is conducted by the University of Michigan and National Family Opinion for the Conference Board. The figures have a limited impact on the forex market.

Auto Sales reports automobiles sales. The indicator is important for the economy in general, but is rarely used in foreign exchange analysis.

Leading Indicators comprise the following economic indicators:
- Average workweek of production workers in manufacturing
- Average weekly claims for state unemployment
- New orders for consumer goods and materials
- Vendor performance (companies receiving slower deliveries from suppliers)
- Contract and orders for plant and equipment
- New building permits issued
- Change in manufacturers' unfilled orders, durable goods
- Change in sensitive materials prices
- Index of stock prices, including Dow, NASDAQ, S&P500, Russell 2000 etc.
- Money supply, adjusted for the inflation rate
- Index of consumer expectations