getting acquainted with the forex market, most people start by looking only at price charts. This is called technical analysis. Those who focus on technical analysis are often called chartists. But the study and analysis of what moves those charts is called fundamental analysis. The goal of Part I is to identify the components of fundamental analysis in regard to forex and then provide a recipe for developing your own fundamental analysis of a currency pair.
Chapter 1
The Fundamentals of Forex
We begin in this chapter with an exploration of the forces that move the prices: the fundamentals. The reader will learn why fundamentals are important to foreign exchange (forex) traders as well as what kinds of economic activity are most important in affecting price movements. These include interest rates, interest rate differentials, economic growth, and sentiment regarding the US dollar.
In many ways, forex trading is similar to playing a game. You have an opponent (the market). In games of chance, the key feature is that everyone faces the same odds and therefore the same level of information. In these games, no player can change the odds.
Playing forex, however, is not a game of odds. It might feel like gambling, but it is not gambling. In a fair game, like the roll of a dice, the person rolling the dice does not affect the outcome. Everyone has the same probabilities of winning. However, participants in forex trading do not share the same amount of information. Asymmetry of information results in advantages and disadvantages. Some players have more information than the others. In forex, information about fundamental aspects of economies does not arrive simultaneously to all participants. The important question is, what kind of knowledge and information can improve trading performance? The search for an edge starts with a fundamental understanding of the nature of the forex market. Having a foundation of knowledge in fundamentals is a first step in evolving into a winning trader.
Why take time to look at forex fundamentals? Why should fundamentals matter if a trade is done in a short-term time interval such as the five-minute chart? The short answer is that one cannot separate the fundamentals from the technical analysis without exposing oneself to great distortions in understanding the forex market and avoidable losses. The five-minute trader who is on the side of the longer trend is likely to be more profitable. Foreign exchange is by its nature both fundamental and technical and reflects the increased globalization of the world economy.
It is worthwhile to note the comments of the late, great Milton Friedman in a 2005 conversation with Dallas Fed president Richard Fisher:
The really remarkable thing about the world is how people cooperate together. How somebody in China makes a little bit of your television set. Or somebody in Malaysia produces some rubber. And that rubber is used by somebody in the United States to put on the tip of a pencil, or in some other way. What has happened has been an enormous expansion in the opportunities for cooperation. 1
Consider the following: Every transaction in the world settles in a currency. Whether it is a consumer purchase, an imported or exported item, an investment in an equity, or even cash under the mattress, the world's economic activity is essentially a flow of money. What makes forex fascinating as a market and as a trading vehicle is the fact that currencies provide an intimate linkage to the world economy. The currency trader by putting on a currency trade becomes a participant the world economy. The trader is participating as a speculator looking for a very short-term profit. The forex trader is riding on a global wave. The wave consists of economic, geopolitical, and emotional influences. Some will surf the waves, jumping on and off; others will stay in much longer and face the volatility. Forex trading becomes possible because the world is constantly assessing and reassessing the value of one currency against another. The forex currency trader is looking to tap into this stream of changing values.
The challenge is to find the right combination of tools that can assist the trader in finding high-probability profitable trades. In meeting this challenge, the first step is understanding what moves currencies over time. In putting together a recipe for successful forex trading, knowing the fundamental chemistry of forex is highly recommended. Anyone who doubts this should simply look at daily headlines that evoke names and places that are, and certainly need to be, part of the daily consciousness of a trader. These names should be familiar to all traders: Yellin, Draghi, Kuroda, Carney, Stevens, Poloz, Jordan, and Zhou Xiaochuan.
Notice, these aforementioned names are the current heads of the major central banks in the world. The fact is that the words and decisions of these central bankers of the United States, the Bank of Japan, the European Central Bank, Bank of England, Reserve Bank of Australia, Bank of Canada, Swiss National Bank, and the Bank of China alert the trader to interest rate and monetary policy and news that affect sentiment about the direction of the dollar. Mention the cities of Baghdad, Tehran, Crimea, and Gaza, and they evoke emotions of fear and crises. Detect news about retail giant Wal-Mart's sales, and one starts anticipating a potential reaction in the currency markets. These and other factors mix together and form the chemistry of forex, which results in shifts of sentiment regarding economic growth in the United States, Eurozone, Britain, China, and Japan. These shifts in sentiment cause price reactions and shift the balance between buyers and sellers. Let's look in more detail at these fundamental factors.
Interest rates are the “dough” of the fundamental forex pie. They are one of the most important factors that affect forex prices, as interest rates have been the most used tool that central banks use as a throttle or break on their economies. The central banks of the world do not hesitate to use this important tool. Before the great financial collapse of 2008, almost all of the central banks increased interest rates. The European Central Bank raised interest rates eight times from December 6, 2005, to June 13, 2007, to a level of 4.0 percent to guide a booming European economy to slow down and avoid too-high inflation. The US central bank – the Federal Reserve – increased interest rates 17 times between June 30, 2004, and August 2006, and then paused when it decided the economy no longer needed the brake of interest rate increases.
Then came the financial crisis of 2008. It was so great a collapse that statisticians remarked it was more than 12 standard deviations from the norm. In other words, no one saw it coming. Rather than focus here on the causes of the collapse, we simply need to note that the immediate consequence was a global shift to nearly a zero interest rate environment. That near-zero interest rate environment has prevailed since then, and as a result, central banks ran out of tools to stimulate economies and turned to quantitative easing (QE), which resulted in expanding the money supply in order to stimulate demand.
However, in late 2014, the world central banks began to see the end of a policy of lowering interest rates. The US Federal Reserve Bank ended its quantitative easing policy in October 2014 and put an increase in rates back on the agenda. The Bank of England (BOE) also has provided guidance that an increase in interest rates is due. In late 2014, only New Zealand, among the Western economies, increased rates. However, the world recovery from the collapse of 2008 has not been equal. The Eurozone faced deflationary fears and therefore remains sustaining low interest rates. The Bank of Japan also has remained in a quantitative easing policy, with an official target of reaching a 2 percent inflation rate.
In other words, the forex trader in 2015 and the years beyond will need to recognize that interest rate expectations, whether they are for remaining low or increasing, provide one of the most important fundamental forces moving currencies.
As the globe recovers in growth, the role of interest rate increases is to try to avoid excessive inflation. Inflation is itself a complex set of events. But for the forex trader, there are basically two kinds:
1. Demand inflation– consumer spending increasing pushes up prices.
2. Wage inflation– the lack of a supply of workers pushes up average wages.
Inflation in wages is increasingly a focus of central banks. In fact, a puzzle is emerging where expectations of wage inflation are increasing, but there is little evidence that it is occurring. The world is in a tectonic shift where economies are experiencing lower annualized growth