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Fundamental Analysis: Using the News to Trade Smarter
07/01/2015 9:00 am EST
One of the foundations for success when trading forex is analysis—both fundamental and technical—so the staff at PrimePair.com breaks down fundamental analysis, highlights the leading fundamental economic indicators, and emphasizes their importance in trading forex.
Proper analysis of the marketplace is one of the foundations for success when trading forex. Market analysis can be divided into two equally important categories; technical and fundamental. In this post, we will be discussing fundamental analysis, including investor risk appetite, some of the different kinds of economic news events traders will want to examine in order to better understand what is going on in the marketplace, and how they can use this information to increase their profit potential.
What Is Fundamental Analysis?
Fundamental analysis consists of examining macroeconomic news and determining its impact on a specific currency pair. This news is typically, but not always, an indicator of the economic health of a country, like GDP, employment data, or a retail sales figure. Other types of news that could impact the forex market include significant weather events, government elections, or war. When conducting a proper fundamental analysis, traders need to consider not only the effect that the news event will have on the currency associated with the country releasing the news, but also on the second currency in the pair. For example, when analyzing the latest unemployment report out of the United States, traders need to determine what the impact will have on both the US dollar and the currency the dollar is paired with, whether it is the Japanese yen, British pound, euro, or anything else.
Knowing which news to follow and which to ignore is extremely important for fundamental traders. While economic calendars can provide a good indication of the significant news traders can expect to see in the future, there are several economic indicators that we will be going over that typically lead to market volatility, and which, traders would be wise to familiarize themselves with. First, we will be discussing how risk appetite in the marketplace can impact currencies.
Investor Risk Appetite and the Forex Market
When analyzing the forex market, traders will often come across phrases like “risky assets” and “safe haven currencies.” These terms are directly linked to risk appetite among investors, an important concept for all forex traders to understand. Currencies can be divided up into two categories; safe haven and risky. Safe havens include the US dollar, Japanese yen, and Swiss franc. These currencies come from countries with relatively stable economies and low interest rates and typically see less volatility than their risky counterparts. Currencies like the euro, Australian and New Zealand dollars are all considered to be risky due to their high levels of volatility and comparatively higher yields.
During times of economic stability and prosperity, risky currencies are likely to be more in demand, as they provide higher yields and are significantly more volatile than the safe havens.
Conversely, when investors are pessimistic about the state of the global economy, safe haven currencies will be in higher demand. This concept can become confusing, especially when a disappointing news event out of a country will actually result in that country’s currency increasing in value simply because it is considered a safe haven. This concept was evident during the global economic crisis of 2008. While economic indicators were showing the American economy getting progressively worse and worse, the US dollar actually strengthened against some of its higher yielding currency rivals. This was because investors—anxious about the direction the global economy was taking—still looked to the stability of the dollar.
NEXT PAGE: Central Banks and Interest Rates|pagebreak|
The Leading Fundamental Economic Indicators
Interest Rate Decisions
What are interest rates?
Interest rates are the base rate that a country’s central bank lends at. They are a direct reflection of the overall state of that country’s economy, and as such, directly impact the value of its currency. As a rule, a change or even the prospect of a change to a country’s interest rate is enough to create significant volatility in the marketplace. Furthermore, the higher a country’s interest rate is, the more a carry trade is worth to a trader who holds a position overnight. That means that the higher the interest rate, the more demand there is for that country’s currency among investors, thereby increasing its value.
How do they correlate with a country’s currency?
Typically when an interest rate is left unchanged, that country’s currency will see little movement as a result. That being said, a surprise rate hike or cut can easily throw the market into a flux and affect any number of currencies. The important thing to remember is how to trade immediately after a surprise interest rate change. As a rule of thumb, when a country increases its interest rate, their currency will increase in value. Conversely, if a country decreases its interest rate, its currency will decrease in value.
Central Bank Statements
What do central banks discuss in statements?
Central bank statements, typically released once a month, offer investors valuable hints about future changes in a country’s or region’s (as in the case of the European Union), monetary policy. While the statements can cover a number of different topics, investors typically pay attention to signs of an upcoming change in interest rates. It is not uncommon for even a subtle hint of an upcoming change in interest rates to set off massive volatility in the forex marketplace. In addition, if a country’s currency is particularly overvalued, as has been in the case in Japan a number of times, the head of a central bank may issue a statement about plans to intervene in the marketplace to bring its value down. Statements like these have also been known to dramatically affect the forex marketplace.
How are the statements connected to interest rate decisions?
Central bank statements are directly related to interest rate decisions. The main job of a central bank is to promote economic growth while making sure their currency is stable. In order to do so, it must make sure that inflation is kept at a reasonable level. One of the key ways for any central bank to promote economic growth without letting inflation get out of control is through control of interest rates. The statements are the primary way a central bank communicates with the public about any changes in economic policy. For forex traders, it is important to pay close attention to these statements, as the wording can often times be vague and non-committal. That being said, when a definitive statement is released, the markets are sure to respond.
NEXT PAGE: Inflation, Employment, and NFP|pagebreak|
What is inflation?
Inflation occurs when the value of a currency increases to such a level that the cost of goods and services increase as a result. Inflation data is important for forex traders because it is a direct measurement of the strength of a country’s currency. The value of a currency impacts everything in that country’s economy, from wages, to trade, to the all-important interest rate level. In order to curb inflation, central banks will often raise interest rates. This makes it more difficult to borrow from banks, which results in less spending. As was noted earlier, any change in interest rates has an immediate impact on the forex market.
Which reports measure inflation?
Traders want to pay attention to the Consumer Price Index (CPI) and Producer Price Index (PPI). Both are considered accurate measurements of inflation, with the CPI measuring the change in price of good and services from the perspective of the consumer and the PPI measuring the change in price of goods and services from the perspective of the seller.
Generally speaking, higher than expected inflation figures indicate that a central bank is more likely to increase interest rates, meaning that the currency should increase in value. That being said, this is not always the case, and traders will always want to pay attention to the overall investor mood and risk appetite before deciding how to place a trade.
Why does employment data matter to forex traders?
Employment data speaks volumes about the current economic state of a country. Broadly speaking, an increase in a country’s employment rate leads to an increased level of purchasing power among its people, which contributes to economic growth. For forex traders, this data is relevant because of the impact employment can have on interest rates.
An increase in consumer spending as a result of positive employment data can lead to increased inflation. High inflation could lead to speculation that a central bank will take action by increasing interest rates, which would in turn boost the value of that country’s currency.
While this may seem like a long chain of events before a country’s currency feels the impact of the data, in actuality, investors typically price in this information immediately after a significant employment figure is released.
The All-important US Non-farm Payrolls
When discussing employment data, no economic indicator is as significant to forex traders as the US Non-Farm Payrolls (NFP). Released on the first Friday of every month, the NFP measures the number of jobs added to US payrolls during the previous month. As the leading global economy, employment data out of the US has an immediate impact not just on USD pairs, but the entire marketplace from currencies, to commodities, to stocks and CFDs.
The sheer amount of market volatility that surrounds the NFP can make it difficult to know what trades to place once the report has been released. Traders will want to pay attention to not only the expected result vs. the actual result of the report, but also to the overall level of risk appetite in the marketplace prior to its release.
If the NFP comes in above the expected result, it can be taken as a sign that the US economy is expanding and that interest rates may be increased to curb inflation. As a result, the value of the US dollar could increase vs. its main currency rivals, with the opposite effect occurring if the NFP comes in below expectations. Still, as we mentioned during our discussion on investor risk appetite, a lower than expected result could lead to investors buying up the US dollar due to its status as a safe-haven. As such, it is critical for all traders to pay attention to the mood in the marketplace before the news is released.
This article was originally published on PrimePair—Forex Information Portal
By the Staff of PrimePair.com
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