Analyzing Exchange Rates Based on Fundamental Factors

Fundamental Analysis

Analyzing Exchange Rates Based on Fundamental Factors

Fundamental analysis deals with the external factors that move currencies. These factors might be quantifiable, like those that fall under the umbrella of economics or finance. There are also numerous qualitative factors, such as investor sentiment, political developments, and crises of various kinds. As I explained in Chapter 3, all of these factors can influence exchange rates, and determining just how this takes place is the job of the fundamental analyst.

At the heart of the fundamental analysis is the notion of equilibrium. At any given time, a currency pair should trade at a particular rate that balances trade and investment flows. Of course, fluctuations in market risk appetite and unexpected developments may imply a rate that is well above or below what financial-economic conditions justify. If you accept the efficient market hypothesis in its weak form—the idea that all public information has already been priced into the exchange rate—then this isn’t a major concern.

Fundamental analysis is ultimately more art than science. As you’ll see from the pages that follow, competing narratives abound in the forex markets, and this makes fundamental analysis difficult even in the most stable market conditions. Still, those that are able to read the tea leaves correctly (and are able to develop good forecasts) will find fundamental analysis of exchange rates to be a rewarding pursuit.

Interest Rate Analysis

There are two overarching forces which describe how changes in central bank interest rates impact exchange rates: interest rate parity and the carry trade. Emerging (growth) currencies tend to trade in direct proportion to relative interest rate levels since higher rates attract speculative investors. Recall that investors in the carry trade seek to profit from positive interest rate differentials; hence, the higher the interest rate, the more attractive the corresponding currency. Currencies backed by stable (slow growth) economies generally fluctuate against one another so as to preserve interest rate parity, especially over the long term.

In other words, interest rate adjustments lead to inverse changes in the exchange rates between major currencies. For example, a hike in the US federal funds rate should cause the US dollar to fall against the British pound, unless the Bank of England takes similar action. Recall from Figure 3-5 in Chapter 3 that, from 2004 to the present, changes in the US/UK interest rate differential presaged corresponding changes in the GBP/USD rate. In order for interest rate parity to be maintained, a decline in US interest rates (relative to UK rates) should spur risk-averse investors away from the pound and toward the US dollar. The same logic can be applied to the Swiss franc, Japanese yen, euro, and Canadian dollar.

This relationship is not set in stone. The actual impact will depend on investor sentiment and the prevailing market narrative. When risk appetite is extremely high, for example, investors might treat major currencies like emerging currencies. In the early 2000s, when the carry trade came into vogue, the US dollar rose rapidly against the yen in conjunction with a series of federal rate hikes. Similarly, when the Federal Reserve Bank, or commonly, the Fed, began cutting rates in 2007, investors moved to unwind their carry trade positions and the US dollar plunged against the yen. As a result, the USD/JPY underwent a massive correction (Figure 5-1) and interest rate parity was restored.

Figure 5-1. USD/JPY response to changing interest rate differential

One way to conceptualize this is that, due to high appetite for risk, spot market traders were willing to violate covered interest rate parity in order to secure immediate short term profits. When risk appetite tanked (in the lead up to the 2008 credit crisis) and the US/Japan interest rate differential simultaneously narrowed, the short-term benefit of holding the US dollar against the Japanese yen was eliminated. Another way to understand this is that the spot market (which was betting on the dollar) fell out of equilibrium with the forward market (which implied a weaker dollar, in accordance with covered interest rate parity) and was only restored when speculators in the spot market retreated.

You can see from Figure 5-1 that both the long-term uptrend (from 2004 to 2007) in the USD/JPY and the long-term downtrend that followed (from 2007 to present) were preceded by changes in the interest rate differential. (To be fair, the downtrend was much due to the inception of the global financial crisis, and falling US interest rates were probably more of an effect than a cause. I will explore this idea later in greater detail.) A fundamental analyst, then, might have seen an opportunity to buy the USD/JPY in 2005 and a basis for selling in 2007.

In fact, the carry trade has become one of the most reliable trades in forex. When investors buy a high-yielding currency against a low-yielding one, they can capture an interest rate spread. Their expectation is that the underlying exchange rate will remain stable so that adverse changes don’t erode interest earnings. When market risk appetite is strong, a flood of speculative capital into carry trade strategies actually forces the underlying exchange rate to rise, and profits from currency appreciation become an added bonus for those seeking low-risk interest. When the tide turns, however, the whipsaw of money flowing out of carry trades can be just as ferocious. This is typically triggered by a change in risk appetite rather than a change in interest rate differentials.

Emerging market currencies represent the primary targets for carry traders since their corresponding short-term interest rates are perennially high. Their industrialized counterparts, on the flipside, are known for low rates and are better utilized on the short end of the carry trade as funding currencies. Of course, emerging market currencies are also plagued by higher volatility, monetary instability, lower liquidity, and logistical issues related to trading them. The benchmark interest rates of Angola and Kenya, for example, are perennially among the highest in the world, but, for many reasons, their currencies are not well suited for carry trading, let alone normal currency speculation.

Before we get ahead of ourselves, consider that there are in fact many different interest rates, depending on which entity is performing the calculation. For example, most central banks control a base interest rate that they determine outright or merely target (as in the case of the Federal Reserve Bank). The Fed has its federal funds rate and discount rate. The European Central Bank has its refinancing rate. The Bank of England uses a repo rate while the Bank of Japan prefers an overnight call rate. While the nuts and bolts of each country’s rate mechanism are slightly different, the objective is always the same: to achieve economic stability. For example, when an economy is expanding too quickly and price inflation picks up, the central bank will raise its benchmark interest rate in order to make saving more attractive than borrowing and spending. During a recession, the central bank will lower interest rates in order to make saving unattractive (at the expense of immediate consumption) and borrowing inexpensive.

The central bank base rate is the rate at which banks lend to each other using deposits held with the central bank. It is typically the lowest rate throughout the entire financial system. Moreover, it is typically utilized in exchange rate models because it is the easiest to compare across different countries and over time. (See Figure 5-2.)

Figure 5-2. Central bank base interest rates for selected economies, change over time

As one moves down the pyramid of size and liquidity, from large bank to small business to consumer, interest rates can be expected to rise incrementally in order to compensate for the perception of greater credit risk.

You can also utilize London Interbank Offer Rates (LIBOR) rates, which are used for interbank loans and are determined by market forces. Comparing sovereign bond yields —like the US 10-year Treasury Bond Rate versus the UK 10-year Guilt Rate—is yet another option, though these rates reflect differences in government creditworthiness as much as differences in price inflation and economic growth and are hence less applicable.

Except in rare circumstances (such as during crises), interest rate adjustments are carried out by central banks only at regularly scheduled meetings. At the conclusion of these meetings, all changes in monetary policy (including rate changes) are announced to the public through written press releases and/or via live press conferences. Fundamental analysts pay especially close attention to these meetings, which are the focus of tremendous short-term speculation in the credit and forex markets. (Technical analysts are also keenly aware of the meetings’ significance and may avoid all trading during the volatile periods immediately before and after the announcement.) Most central banks will also release the minutes from their meetings, detailing what took place, how board members (also known as governors) voted on proposed changes in monetary policy, and so forth.

Central banks usually telegraph their intentions in advance to avoid shocking the markets. Press releases may thus contain insight into the near-future direction of monetary policy and are the subject of intense analytical scrutiny. In fact, every investment bank employs a research team whose sole responsibility is to develop interest rate forecasts, which are then channeled into bets in the credit markets. As a result, interest rate futures prices can be used as a basis for assessing the “probability” of interest rate hikes and are an important tool for fundamental analysts. (In fact, research has shown that futures markets slightly underestimate changes in the federal funds rate, but they are nonetheless the best insights into where investors believe rates are headed.)

Per Figure 5-3, the Fed is not expected to raise the federal funds rate from the current level of 0.0%-0.25% at its upcoming December meeting. The markets wavered slightly from this assumption in July, but have since settled on a 0.0% probability.

Figure 5-3. Implied probability of federal funds rate change at December 2011 meeting (Source: The Cleveland Fed)

As for how central bank interest rate adjustments impact the forex markets in real-time, that depends on investors’ expectations and specific market conditions. If the actual change is consistent with analysts’ forecasts, relevant exchange rates probably won’t jump by much. If the rate change fails to accord with expectations or comes as a complete surprise, you would expect instant 50–100 PIP moves across the board.

Furthermore, in an atmosphere that is considered hospitable to the carry trade, a rate hike will make the corresponding currency more attractive to speculators and should cause immediate or near-term appreciation. The opposite should be true for an interest rate cut. When risk appetite is weak, rate changes will be ignored by markets or result in inverse changes to the respective currency in line with purchasing power parity. Of course, there are exceptions to this rule. When the European Central Bank announced a surprise cut in its benchmark rate in November 2011, investors responded by selling the euro. That’s not because the euro suddenly became a more attractive funding currency for the carry trade, but because the cut triggered concerns that the Eurozone sovereign debt crisis had become more serious.

Figure 5-4. Spot market reaction to November 2011 surprise European Central Bank rate cut

Inflation Analysis

From the standpoint of fundamental analysis, the importance of inflation is twofold: it directly erodes the value of the currency and is one of the primary drivers of monetary policy.

Remember from Chapter 3 that purchasing power parity is one of the central tenets of exchange rate theory. And for good reason! Inflation makes currency less valuable in both absolute and relative terms. As a medium of exchange and store of value, a currency is only useful/valuable insofar as it can be used to purchase goods and services, both now and in the future. If prices are rising by 5% per year, then one unit of currency will necessarily be worth 5% less one year from now!

Given that currencies are valued in terms of one another, inflation rates are mainly applicable to the forex markets on a comparative basis. (For instance, consider the possibility that inflation rates were synchronized at 5% throughout the entire world. In that case, the relative value of their currencies would not change, even though domestic consumers would suffer a 5% decline in domestic purchasing power.) This is one of the main reasons for the steady appreciation of the Japanese yen against the US dollar over the last several decades, which has taken place despite a handful of contradicting factors. Likewise, several emerging market currencies have stagnated because of inflation, their strong economies notwithstanding. As I explained, that’s because inflation has the same effect as currency depreciation. If macroeconomic fundamentals justify a 10% appreciation in the Brazilian real, but the Brazilian rate of inflation exceeds 10%, then the real should remain roughly in place in order for economic equilibrium to be maintained.

While purchasing power parity is a reasonable guide for making multi-year exchange rate forecasts, its explanatory power is fairly limited over the short term, where the sway of inflation is mainly psychological. As long as the inflation rate remains at an acceptable level (which varies from 0%-10%, depending on the country and the strength of its economy), it tends to elicit little response from consumers and investors. That’s because moderate inflation has been shown to be crucial to proper economic function. If inflation were too low (or even negative), it would offset the balance between saving and investing, induce consumers to hoard cash, and interfere with the ability of central banks to conduct monetary policy, among other things. On the other hand, high inflation can quickly spiral into hyperinflation, causing economic disruption, loss of savings, and even social unrest. None of the major currencies has experienced hyperinflation in the modern era of forex. Similarly, more than two decades have passed since a bout of hyperinflation has plagued any of the top-tier emerging currencies. While some paranoid gold bugs would certainly disagree, hyperinflation is not a likely possibility in any of the currencies that are discussed in this book.

At the same time, inflation is problematic for investors because it eats into investment returns. When inflation ticks up without a corresponding change in interest rates, the real interest rate (also known as the inflation-adjusted interest rate) is said to decline.

Likewise, a 10% return on an equity investment is not so attractive if the rate of inflation is also hovering around 10%.

Emerging market investors are especially sensitive to sudden upticks in inflation. That’s because currency appreciation has historically accounted for more than half of the returns earned by investors in emerging markets.  When inflation ticks up rapidly, emerging market investors will respond by shifting money back into industrialized economies until the responsible central bank takes steps toward monetary and price stability. By way of example, consider the case of the Brazilian real, whose speedy recovery in the wake of the financial crisis slowed to a halt in 2010, due in part to fears of rising inflation. The Brazilian real resumed its ascent in 2010, when the Bank of Brazil finally raised its benchmark Selic rate. This appreciation took place in spite of capital controls that were imposed by the central bank to deter speculators. (Note Figure 5-5.)

Of course, the principal application of inflation to the currency markets involves its role as a guide for monetary policy decisions. Most central banks have an overarching mandate to control inflation. The Federal Reserve Bank has slightly more latitude as it is charged both with maximizing employment and maintaining price stability. When inflation rises, central banks respond by tightening monetary policy in the form of interest rate hikes and other adjustments. (At the very least, they will acknowledge inflation in their press releases and offer some indication as to whether it is viewed as a problem.) This should cause prices to stabilize and economic growth to cool. When inflation begins to fall, the central bank will respond by taking necessary action, like cutting rates. Indicators of inflation thus receive tremendous attention from the financial markets as they tend to presage changes in interest rates.

Figure 5-5. Impact of rising inflation and falling real interest rates on the Brazilian real

This relationship does break down from time to time. In the wake of the financial crisis, emerging market currencies had fallen to multi-year lows. Emerging market central banks were happy about this development because lower exchange rates made their exports relatively cheaper. The downside of this currency depreciation was import inflation. If the price of oil is $90 per barrel, for example, South Africa will pay 720 rand per barrel at an exchange rate of 8 USD/ZAR, but 810 if the Rand depreciates to 9 USD/ZAR. There will also be a trickle-down impact across the entire economy.

As inflation picked up, then, emerging market central banks pondered raising interest rates. They feared, however, that rate hikes would invite speculative capital inflows from risk-driven investors eager to shake off the pall of the credit crisis. The resulting currency appreciation would affect exports and endanger their fragile economic recoveries. Sure enough, falling real interest rates caused emerging market currencies to stagnate in early 2010. Inflation rose further as emerging market central banks played monetary chicken with one another, opting to raise reserve requirement ratios rather than adjust interest rates. The Bank of Brazil finally broke down and hiked its benchmark Selic rate in late 2010, and other central banks followed suit in 2011. Their currencies resumed their appreciation shortly thereafter.

There are a handful of ways in which inflation is measured. Most governments have a branch that computes economic statistics. (In the United States, this task is delegated to the Departments of Labor and Commerce.) The Consumer Price Index (CPI) is perhaps the most comprehensive measure of inflation in an economy. Composed of a basket of tens of thousands of goods and services, it is designed to mimic the spending patterns of a broad spectrum of consumers. Of course, some items/sectors are weighted more heavily than others, such that a rise in the price of car tires will probably impact overall CPI less than a rise in home prices. CPI data is released once a month and is reported on both an overall basis and regional bases. It is often modified to exclude certain items, such as food and energy, which are considered too volatile. The end product is known as core inflation and represents one of the most important guides of monetary policy. (Conspiracy theorists will assert that this exclusion is intended to understate inflation, but to be fair, it also corrects for sudden declines in food and energy prices, as can be seen in Figure 5-6 below.)

There are a handful of secondary inflation indicators, such as the GDP deflator and the producer price index (PPI). The former is computed by the US Department of Commerce and is used as a basis for converting nominal GDP into real GDP. The latter measures inflation as experienced by manufacturers. As is evident from Figure 5-6, producer price indexes are closely connected with exchange rate fluctuations, since most manufactured goods are assembled with overseas components. Secondary inflation indexes include the Commodity Research Board (CRB) Futures Index, which consists of prices for 21 commodities, as well as the Employment Cost Index and Import Price Index (IPI). (In fact, the Federal Reserve Bank’s statistical database contains more than 1,000 different measurements of inflation, segmented by economic sector, geographic region, end user, and so on.) Most indexes are seasonally adjusted, annualized, and converted into percentage form for ease of comparison.

Figure 5-6. Various indicators of US inflation from 2001 to the present

Some analysts pay close attention to the Housing Price Index (HPI) under the belief that home prices play a critical role in guiding monetary policy. While the Fed certainly pays lip service to asset prices (including housing prices), however, it has insisted that these are outside of its mandate. In the past, the Fed has only been influenced by asset bubbles insofar as they threaten to affect the economy as a whole and price levels, broadly.

Component indicators are monitored because they inform predictions for future inflation. As this book goes to press, the federal funds rate stands at 0%, and history suggests that the Fed won’t hike rates until core inflation rises. In this case, rising inflation will probably be preceded by an increase in producer prices and/or a recovery in housing prices.

Some economists—Milton Friedman, notably—have argued that price inflation is a function of growth in the money supply. The theory goes that, if new money enters circulation, the value of existing currency declines. When the Fed increased the money supply in 2009 as part of its quantitative easing program, for example, critics argued that it would trigger hyperinflation and lead to a crash in the US dollar. Chairman of the Federal Reserve Bank Ben Bernanke steadfastly responded that if and when inflation creeps upward, the Fed would simply withdraw the newly printed money from circulation. (Thus far, Bernanke’s position has been upheld.)2 In fact, it has always been the Fed’s policy to ignore money supply. In 2006, it caused quite a stir when the Fed ceased collecting data on M3 (M2 plus large and long-term deposits) which is perhaps the broadest measure of US money supply. Fundamental analysts that disagree with the Fed’s interpretation can still access Ml (physical money such as coins and currency plus demand deposits) and M2 (M1 plus time-related deposits and savings deposits). Other central banks publish comparable data. Given the link between a continuously growing money supply and a declining US dollar (Figure 5-7), these data series might be worth paying attention to!

Figure 5-7. Correlation between rising M2 and declining (trade-weighted) US dollar

For guidance on where the markets think US inflation is headed, analysts should look at US Treasury Inflation Protected Securities (TIPS). TIPS are similar to US Treasury bonds, except that principal and interest payments are tied to the CPI. By calculating the breakeven point between TIPS and normal Treasury securities, it’s possible to determine inflation expectations for the next 5, 10, 20, and 30 years. For example, if the current 10-year US Treasury yield is 4.5%, and the yield on an equivalent TIPS bond is 7.5%, then the “breakeven” inflation rate is 3% per year. (This calculation ignores the liquidity/uncertainty premium built into TIPS, which is generally insubstantial.) If inflation expectations rise, this premium will also rise, even controlling for changing perceptions of US creditworthiness. Ignoring the 2008 volatility—which was an anomaly caused by the credit crisis—the expected inflation rate for the next 5 years has hovered around 2.5%-3%. (See Figure 5-8.) If you perform this calculation on the equivalent Japanese securities, in contrast, you will see that expectations there are for negative price inflation (also known as deflation).

Figure 5-8. Market expectations for 5-Year CPI inflation based on “breakeven” rates (Source: Bloomberg L.P.)

Economic Indicators

After inflation, gross domestic product (GDP) is the most important economic indicator, at least as far as the forex markets are concerned. The GDP growth rate—or rather, the real GDP growth rate, which controls for inflation—is a comprehensive barometer of the health of an economy. If the number is positive, it means that economic output is expanding, while a negative number implies a contraction. Real GDP is especially useful for comparative purposes. In a nutshell, the currencies of high-growth emerging economies should outperform major currencies, whose economies tend to exhibit slower growth.

Unfortunately, that’s probably the most profound generality that can be made. For example, there is only a slight connection between real GDP growth differentials and long-term exchange rate movements between Canada and the United States, as seen in Figure 5-9. Generally speaking, the US dollar has risen against the Loonie when the US/Canada differential was positive, and fared less well when the differential turned negative. At the same time, the Loonie has appreciated by more than 40% since 2002, even though the economies of the US and Canada have grown at roughly the same rate (the real GDP growth differential has hovered around 0) for the same period. In short, it might be difficult to establish an actionable trading strategy based on GDP alone.

Figure 5-9. USD / CAD exchange rate and real GDP growth differential

That’s not to say that the currency markets don’t take GDP seriously. On the contrary, GDP figures are probably secondary only to inflation indicators in their ability to create a stir and drive instantaneous reactions. This can be seen especially in the frantic trading that takes place in the minutes leading up to and immediately following their official release.

The same can be said about most of the various other economic indicators, which are absorbed into the currency markets either right away, not at all, or indirectly through other indicators. As for which indicators are important (those that have the power to move the market), that depends on the market narrative at any given time. In the wake of the 2008 housing market collapse, for example, housing indicators suddenly acquired tremendous influence as the financial markets looked to the housing sector to lead the economic recovery. There are indicators that measure supply, by way of housing starts and construction permits and inventory, as well as those that measure demand, by way of mortgage applications, residential sales, and vacancy rates. And of course, there are dozens of indexes that measure nothing but price, segmented by type of dwelling, price- range, region, and so forth. The most famous index is probably the Case-Shiller Home Price Index, though it is not necessarily the most comprehensive.

There are some commentators who would insist that there are certain indicators that are always important, but my experience suggests that this is not actually the case. That’s probably due to the fact that there are thousands of indicators covering every facet of every economy. To try to monitor more than a handful with any level of dedication would be futile at best and counterproductive at worst. That’s not just because most indicators are irrelevant, but also because many are contradictory. For trading purposes, it’s best to stick to a few of the most prominent leading indicators. These indicators precede changes in the economy and must be distinguished from lagging indicators, which follow changes in the economy.

Most forex news websites (and most financial news websites, for that matter) compile a calendar of all economic indicators, along with a description of each, scheduled release/date time, previous value, and consensus forecast (like the one in Figure 5-10). Some editors will go one step further and attempt to gauge the relative importance of each indicator. From monitoring these lists, forex forums, and media coverage, it’s usually fairly easy to determine which indicators are worth paying attention to at any given time.

Figure 5-10. Sample Economic Calendar (Source: ForexPros.com)

A good rule of thumb is that if CNBC and Bloomberg News are not featuring live coverage of the indicator’s release, it probably won’t sway the markets much. As with inflation, interest rates, and GDP figures, the number that is reported is not significant in and of itself, but only relative to market expectations. It’s not uncommon for a speculative buildup in advance of the release to drive a 50 PIP move in one direction, only to reverse completely when the indicator fails to conform to expectations. It should also be noted that all initial data releases are preliminary and are always accompanied by modified final numbers for the previous period.

As for why indicators’ relative significance varies over time, the answer is that the markets are capricious and that significance is self-fulfilling. Sometimes the rationale is indirect. Employment indicators, for example, would seem to have very little direct bearing on currencies. Because they can influence monetary policy (such as when a high unemployment rate prevented the Fed from hiking interest rates despite the onset of economic recovery in 2010) one must still pay attention to them.

Practitioners of technical analysis should also be aware of economic indicators’ scheduled release times. The spikes in volatility that they tend to produce can confound technical strategies and trigger massive losses among those caught unaware.