Definition and Economic forecasting
- Fundamental analysis can be defined as the study of country’s economic and financial performance in order to determine the fair market value and future direction of its currency.
- Fundamentals focus on factors that determine exchange rates, such as countries’ economic health, political stability and environmental events.
- A popular way to gauge the health of countries’ economy is through looking at its economic indicators and data releases, which is why every trader should be familiar with them and how they influence the value of a currency.
- If the European economy is doing better/worse than American economy then we expect EURUSD price to go up/down.
- Our target is to evaluate how well the economies in question are doing, and find which currency will appreciate/depreciate.
- Interest Rates
- Gross Domestic Product – GDP
- Trade Balance
Pic 1 - Major Indicators which can move the currency pairs
- Interest rates are perhaps the most important indicator when it comes to determine currency’s long term value.
- Central banks usually announce interest rate every month and by adjusting interest rates, a central bank can control the supply of its currency, directly affecting its value.
- One of the key factors that influence a central bank’s interest rates is growth levels and inflation.
- If interest rate is increased/ decreased, borrowing from banks becomes expensive/cheap and saving becomes more attractive/ less attractive.
- Higher/lower interest rates tend to increase/decrease demand and value for the currency.
- Traders use announcement and economic indicators to understand central bank intention to changing rates. Markets may move in advance of anticipated rate changes and as a reaction to actual announcements.
- Inflation refers to the persistent increase in price levels over time.
- Common measures of inflation include the Consumer Price Index(CPI) and the Producer Price Index(PPI) , and are usually released on monthly basis.
- If Inflation is above/below expectations, the currency is likely to strengthen/weaken.
- Low interest rates and higher growth levels lead to higher prices, where high inflation levels calls for a high interest rates.
- A high Inflation erodes the value of currency and is considered bad for any economy in most circumstances. Central banks normally target inflation levels of around 2-3%, and if their target is exceeded, they usually take action to get back to desired levels.
- When Inflation is high, the market begins to expect that central bank may increase interest rates, which directly affects the strength of its currency.
- The expectation of interest rate hike alone, will cause the currency to strengthen, as the market price-in the anticipated change in an effort to benefit from an announcement before it is officially made.
Pic 2 - Good economic data means good economy and vice versa.
Gross Domestic Product- GDP
- A country’s Gross Domestic Product is the value of all goods and services produced within a country in given time period. It represents the health of a country’s economy.
- A change in GDP levels are used as a measure of economic growth and are usually expressed as a comparison to previous quarter or year.
- Rising GDP levels points towards a booming economy and a stronger currency but are accompanied by higher inflationary pressures, Declining GDP levels signals towards a recession and a weaker currency.
- GDP is a major news release and is used to reflect the strength and weakness of economies along with interest rate expectations.
- Unemployment is an important measure of health of an economy and the pace of its economic growth.
- Increasing unemployment has a negative effect on country’s economic growth, while decreasing unemployment is seen as positive impact for the economy.
- Rising unemployment signals a troubled economy, the market may expect the central bank to reduce interest rates in order to increase the supply of money and help boost economic activity and growth.
- Higher than expected unemployment normally causes the currency to weaken, while lower than expected unemployment (or higher than expected employment) usually results in stronger currency.
- The number represents the difference between the values of goods and services that a country exports and the value that it imports them at.
- A surplus occurs if the value of export is greater than the value of imports, and a deficit occurs if the value of imports is greater than the value of exports.
- It is in country’s interest to export more than it imports and thereby generate money that it can use to further its growth.
- A greater than expected figure tends to be good for the currency, while a lower data release tends to be bad for the currency.
Pic 3 - Markets does hit peak and trough based on economic data and the cycle continues
Economic Indicators: How to benefit
- Economic indicators help to consider trades in the context of economic events and understand price actions during these events.
- Advanced knowledge of economics is not required to make use of an economic calendar, as not every single data release must be analyzed in-depth.
- By following GDP indicators, for instance, or inflation and employment strength, we can anticipate market volatility and identify potential trading opportunities.
- Trading fundamentally or not, It is good to be aware of what and when is being announced, as news can act as a catalyst for price trends.
- We should also know which economic indicator have a greater impact in terms of trading.
- For Example, Leading indicators change before the economy start following the trend – they predict economic changes. E. g. Stock market, manufacturer new orders, consumer goods, business confidence, building permits.
- Lagging Indicator show change after the economy has already started following a new trend – they are used to confirm economic changes. E.g. Unemployment, GDP.
- Coincident indicators, as the name suggests, tends to coincide with changes in economic trends. E.g. NFP, Industrial Production, Manufacturing and Trade Sales.
News Moves the Market
- Monitoring the Economic calendar can help to keep us updated with the most important news announcements and press releases.
- Depending upon the current state of the economy, the relative importance of these releases may change.
- For example, unemployment may be more important this month than trade of interest rate decisions.
News Trading: How it works
- The proverb no news is good news is not applicable to markets as news moves the market. After news more chances of increased volatility in underlying pairs.
- News trading means we can anticipate or react and trade before the news or after the news gets published.
- After news we can expect underlying pairs to fluctuate either up or down. Trading news through currencies can be exciting due to volatility that can be triggered by the news event.
News trading: Proactively or Re-actively
- News releases provide fresh information on how an economy is performing and if data surprise is large enough, the market reaction can last for a few minutes, hours or sometimes even days.
- Economic releases can be traded proactively or re-actively.
- Trading proactively involves taking an educated guess on whether a piece of data will surprise to the upside or downside and placing a trade before announcement is made.
- Trading re-actively, involves placing a trade after the economic data is released. This removes the need to “guess” the economic data but can also remove any advantageous knee-jerk reactions.
Pic 4 - Make use of economic calendar for predictions based on data news
Follow the economic Indicator data calendar at ducascopy.com and make use of fundamental analysis approach trading.With some practice and observations we can make profitable trades.