What is Fundamental Analysis in Forex trading? | Fundamental Analysis Complete Guide for Beginner’s
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Fundamental analysis involves the examination and studying of the relative economic, monetary, fiscal and political aspects of the countries whose currencies are being traded. Macroeconomic factors include GDP, inflation, interest rates, unemployment, trade balance and so on. Even though there are pure technical traders in the market, the best trading strategies are the ones which include both fundamental and technical analysis, because fundamentals are what primarily drive the Forex market.
Fundamental Analysis of the Forex Market
There are basically two ways of forecasting the movement of a currency: technical analysis and fundamental analysis. In the first part of this course, we have gone through some aspects of using technical analysis to try to predict the next move of a currency, and in this second part, we will focus on the fundamental approach.What is Fundamental Analysis?
Fundamental analysis involves the examination and studying of the relative economic, monetary, fiscal, and political aspects of the countries whose currencies are being traded. Macroeconomic factors include GDP, inflation, interest rates, unemployment, trade balance and so on. Even though there are pure technical traders in the market, the best trading strategies are the ones that include both fundamental and technical analysis, because fundamentals are what primarily drive the Forex market.It can be quite overwhelming initially for someone who has no background in economics to gain an interest in the correlation between fundamental factors and currency movements, but the trick is to focus on the countries of the currency pair/s that you are trading. For example, if you trade EUR/USD, you should have an idea of what are the various fundamental factors that can affect Europe and the US, and be aware of the day's or week's upcoming US and Eurozone-related economic releases.
Economic reports are not the only fundamental factors to watch. One should also take note of when key decision-makers are scheduled to speak, whether to the media, Senate or universities as they could be discussing the economy, interest rates, inflation, or other issues that affect currency valuations. Even changes in policy wording when addressing certain issues can cause market volatility, especially when commenting on interest rates.
In the next few lessons, you will learn about the key fundamentals that affect each major currency, and have an idea of what fundamental aspects to look out for when trading these currencies.
Key Fundamentals Impacting the US Dollar
Here I will give you a rundown of the most important factors affecting the US dollar when it comes to Forex trading.Federal Reserve Bank ("The Fed")
The Fed is the American central bank, which is responsible for setting and implementing the country's monetary policy. Its main policy signals are open market operations, the discount rate and the Fed Funds rate. Twice a year, the Fed Chairman, who currently is Ben Bernanke, reports to the US Congress on the commitee's economic views and projections, and these are major movers of the Forex market. It is the most important central bank in the world because its policy decisions will impact the world's largest economy, which will then have implications on the rest of the world.Federal Open Market Committee (FOMC)
The Fed sets and implements monetary policy through the FOMC. The FOMC consists of 12 voting members, including the seven governors of the Federal Reserve Board and five district Reserve Bank presidents. The Chairman of the Board of Governors serves as the permanent Chairman of the FOMC. While all 12 Reserve Bank presidents participate in every FOMC meeting, only those serving as FOMC members may vote. The committee makes interest rate announcements eight times a year.Fed Funds Rate
This is the undisputed most important, and thus the most widely watched interest rate in the world. It is the interest rate that depositary institutions charge one another for overnight loans.The Fed uses this rate to send clear monetary policy signals to the markets. During times of strong inflationary pressures, the Fed may announce raising the fed funds rate, and this course of monetary action is called tightening. However, when the Fed wishes to stimulate the growth of the US economy, it may decrease this rate in order to promote more growth and consumption. The currency market's discounting mechanism means that these possible rate adjustments are normally priced in prior to the actual announcement. What currency traders need to watch out for is the accompanying statement delivered by the Fed, which can give signals of future monetary policy actions. The interest rate decision is one of the most important factors driving the Forex market. A rising interest rate is seen as US dollar-positive, at least in the short term.US Treasury Bonds
The 30-year Treasury bond ("long bond") has long been considered a benchmark asset-class, and is a very important indicator of markets’ expectations on inflation. As in all bonds, the yield on the 30-year treasury is inversely related to the price. Generally, high interest rates make the US treasury bonds and treasury bills more attractive to foreign investors; they would try to buy these bonds, and this buying would drive the value of the US dollar up. The long bond is normally impacted by shifting capital flows triggered by global considerations such as financial or political turmoil in emerging markets. Such demand for US treasuries due to their safe nature could helping appreciate the dollar. However, its role as a benchmark has gradually given way to its 10-year counterpart.The Forex market usually refers to the 10-year bond when comparing its yield with other 10-year bonds overseas, such as the Euro (German 10-year bund), Japan (10-year JGB) and the UK (10-year gilt). The spread differential (difference in yields) between the yield on 10-year US Treasury bond and that of foreign bonds impacts the exchange rate. A higher US yield usually benefits the US dollar against foreign currencies, but since Forex traders trade not just based on bond yields, but on many other factors, the correlation is not perfect, especially in the shorter term.
Economic Indicators
Non-Farm Payrolls (NFP) - The most market-moving data in the Forex market. A monthly change reflects the number of net new jobs created or lost during the month. Large increases in payroll/employment are signs of a strong economy, and may influence the Fed's decision in raising interest rates. Extremely high price volatility expected.
Personal Consumption Expenditure (PCE) - PCE is the amount of money individuals spend on goods and services, and is the Fed's favourite indicator of inflation. The PCE deflator is a better indicator than the CPI because it better accounts for the fact that, as prices of goods and services change, people's spending habits change. Unlike the CPI, the PCE deflator tracks a variable basket of goods and services. An increase in PCE would indicate higher inflation pressures. This data is widely anticipated by the Forex market. High price volatility to be expected.
Consumer Price Index (CPI) - It is a measure of the average level of prices of a fixed basket of goods and services purchased by consumers. An increase in core-CPI (excludes the more volatile food and energy components) would indicate higher inflation pressures. This is widely watched by the Forex market. High volatility to be expected.
Producer Price Index (PPI) - It is a measure of the average level of prices of a fixed basket of goods received by domestic producers for their output. The monthly data serves as an indication of commodity inflation. An increase in PPI usually leads to higher consumer price inflation, which in turn could lead to higher interest rates, and therefore positive for the US dollar. Moderate to high price volatility expected.
Consumer Confidence - This is a monthly survey, prepared by the Conference Board, that measures the degree of optimism on the state of economy that consumers reflect through their saving and spending activities. It is seen as a lagging indicator that confirms that the state of the economy. An increase in spending today may reflect the results of an economy that has recovered a few months ago. Conversely, a decrease in spending today may confirm an ongoing recession. However, it may also impact future spending as people read about how consumers are more optimistic about the economy. The Forex market perceives higher consumer confidence to translate into higher consumer spending, which in turn could spark higher inflation. High price volatility to be expected.
Durable Goods - It is a measure of the volume of shipments of goods with a normal life span of at least three years that are placed with domestic manufacturers for immediate and future delivery. This monthly indicator provides a measure of production and employment in the durable goods sector. Rising orders are usually associated with stronger economic activity, which in turn could lead to higher interest rates, which make the US dollar more attractive to own. High price volatility to be expected.
ISM Manufacturing - This Purchasing Managers Index, published by the Institute for Supply Management, is based on surveys of 300 purchasing managers from 20 different industries regarding manufacturing activity. When the PMI is greater than 50, the economy is considered to be expanding. If PMI is less than 50, it represents a contracting economy. Moderate to high price volatility expected.
Treasury International Capital Flow (TICs) - This monthly survey collects data on the level of US holdings of foreign securities, and foreign holdings of US securities, excluding direct investment. This data is highly watched by Forex players as an indication of whether foreign appetite for US assets can continue to fund the widening US deficit. It also indicates demand for US government debt from foreign central banks, whether they are accumulating or dumping US assets. Moderate to high price volatility expected.
Gross Domestic Product (GDP) - It is a measure of the total production and consumption of goods and services in the US. An advance release is more widely watched by the Forex market than the final release unless there is a major revision done. The market usually associates a high GDP figure with expectations of higher interest rates. Little price volatility expected.
Trade Balance - This is a measure of the difference between exports and imports of goods and services. Forex traders tend to focus on seasonally adjusted trade figures over three-month periods. In general, a country with a huge trade balance deficit tends to have a weaker currency due to the continued commercial selling of the currency, but this capital outflow may be offset by financial investment flows into the country by foreign countries. Little to moderate price volatility expected.
Retail Sales - This monthly index measures the total goods sold by a sampling of retail stores. Retail sales (ex-autos) is widely followed as indicators of consumer confidence and consumer consumption. Moderate price volatility expected.
Industrial Production - This index tracks the physical output of US factories, mines and utilities on a monthly basis. An increase is generally positive for the US dollar. Little to moderate price volatility expected.
The Beige Book - The Beige Book is the commonly used term for the Fed report entitled: "Summary of Commentary on Current Economic Conditions by Federal Reserve District". It is published two Wednesdays before every FOMC meeting, 8 times per year, and is used as a gauge on the strength of the economy, and not a commentary on the views of Fed members. It usually does not move the Forex market much unless surprising findings give hints on the course of future monetary action.
You can find the release calendar of the Beige Book on the Fed website (http://www.federalreserve.gov/FOMC/BeigeBook/2006/).You can find the release calendar of the Beige Book on the Fed website (http://www.federalreserve.gov/FOMC/BeigeBook/2006/).
You can find the release calendar of the Beige Book on the Fed website (http://www.federalreserve.gov/FOMC/BeigeBook/2006/).
Existing Home Sales - A private report on sales of previously owned single-family homes. Provides clues about the state of the housing market in the US. Moderate price volatility expected.
University of Michigan Consumer Confidence - A monthly survey to evaluate consumers' perceptions of the overall business climate. There is a direct correlation between consumer sentiment and the growth of consumer spending. Consumer spending makes constitutes 2/3 of US GDP. Moderate price volatility expected.
Empire State Manufacturing - A monthly survey carried out on participants from a variety of industries within New York state on the evaluation of current and upcoming conditions. Moderate price volatility expected.
Philly Fed - A survey of manufacturing in the Philadelphia Reserve Bank district. Not a major market-mover.
Stock Markets
The correlation between the US dollar and the US stock markets can be positive or negative. Generally speaking, when the stock market, for example, the Dow, is performing well, foreign investment dollars are expected to flow in to seize the opportunity, hence making the US dollar stronger. This thus shows a positive correlation. But since the stock markets move not just based on corporate earnings and global considerations, but also on interest rate expectations, they can move in opposite directions to the US dollar. For example, if the markets are anticipating an increase in US interest rates, the US stock markets may plunge due to investors fearing that higher rates would eat into corporate profits, whereas the US dollar may shoot skyward with such an expectation, since investors want to rush in buying US dollars so that they can earn high interest rates on their dollars. This illustrates a negative correlation.Comments by Influential People
Watch out for comments made by government officials like the US Treasury Secretary or by Fed officials when they schedule speeches to the media or universities. Any talk about interest rates will certainly move the market in a big way.Commodity Prices
Gold - The US is the world's second largest producer of gold, after South Africa. A general rule of thumb is that gold normally does not move in line with the US dollar, that is, when gold rallies, the US dollar usually does not appreciate as well. This is because during periods of geopolitical instability, traders and investors prefer to place their investments in gold as a safe haven, turning away from the dollar. However, this general rule can be broken in the ever-changing Forex market. For a week in July 2006, we actually saw a strong rally in the US dollar when gold prices went up due to geopolitical tensions in the Middle East.Oil - An increasing oil price results in higher inflation, which negatively impacts the US economy. Higher oil prices are eventually passed down to transportation, heating and utility costs, and to almost every finished product, as well as food and commodities in general. The correlation between oil prices and the US dollar can be positive or negative. Generally, higher oil prices hurt the US economy, and so is bad for the dollar. But there are also times when higher oil prices result in an appreciation of the dollar, since oil, in majority, is priced in US dollars.
Changes in Currency Regimes
Talks of China's Yuan revaluation against the US dollar or reserve diversification among foreign central banks may hurt the US dollar because these central banks may feel less inclined to own US dollars and dollar-denominated assets.Geopolitical Tensions
Depending on the situation, sometimes the US dollar is a safe-haven currency instead of the Swiss Franc in times of international tension or war. Although the US dollar is a hard currency, meaning that investors have confidence in it, it has many unresolved problems such as the large fiscal and trade deficits in the US, and the pegging of many Asian currencies to the dollar, and therefore the US dollar does not appreciate as their trade surpluses with the US grow.Key Fundamentals Impacting the Euro
Here is a rundown of the most important factors affecting the Euro when it comes to Forex trading.The European Monetary Union (EMU)
The EMU currently consists of 12 countries that have adopted the euro, and they are listed in order of GDP: Germany, France, Italy, Spain, Netherlands, Belgium, Austria, Finland, Portugal, Ireland, Luxembourg and Greece. The European Union's growing role in international trade has important implications for the role of the euro as a reserve currency.European Central Bank (ECB)
The ECB is responsible for setting the monetary policy of all the countries that adopted the euro. The Governing Council is the decision-making body, and consists of the Executive Board and the governors of the national central banks. The Executive Board consists of the ECB President, Vice-President, and four other members. Currently, the ECB President is Jean Claude Trichet. The ECB's main objectives are to maintain price stability and to promote non-inflationary growth within the Eurozone. The ECB aims to maintain annual increase in Harmonized Index of Consumer Prices (HICP) below 2%.The ECB holds a Council meeting every other Thursday to discuss monetary policy, and the monetary policy is expected to be changed if it schedules a press conference afterwards, in which it gives its outlook on monetary policy and the economy as a whole.
Refinancing Rate
The ECB’s refinancing rate is the Bank’s key short-term interest rate used for managing liquidity. The difference between the refinancing rate and the US Fed Funds rate is a good indicator for the EUR/USD.10-year Government Bonds
The German 10-year Bund is normally used as the European benchmark. The difference in interest rates between the Eurozone and the US is an important indicator of future euro exchange rates against the US dollar. It helps to track the spread between the 10-year US treasury bond and the 10-year German bund. If the bund yields are higher than the treasury yields, and the differential widens, it implies euro bullishness. This interest rate differential is usually related to the economic outlook of the US and the Eurozone, which is another fundamental driver of the exchange rate.Economic Indicators
Since Germany is the largest economy in the Eurozone, responsible for over 30% of the total GDP, its economic data are the most widely followed in the Forex market. Euro-wide statistics, although still in their infancy, are also widely followed by market players.German IFO Survey - A widely watched indicator of business confidence. This survey samples over 7000 German companies, and mainly measures the average of current business conditions and their future expectations. The results consist of the business climate headline figure plus current business conditions and business expectations. It is positive for the euro if the numbers are higher than that of the previous month. High price volatility expected.
German ZEW Survey - This is a monthly survey among 350 financial analysts and institutional investors in Germany, and measures their six-months expectations concerning the economy, inflation rates, interest rates, stock markets, exchange rates and oil prices. The ZEW Indicator of Economic Sentiment is a leading indicator for the German economy, similar to the IFO Survey. This is a major market-moving data for EUR/USD. High price volatility expected.
Harmonized Index of Consumer Prices (HICP) - This is an inflation indicator closely monitored by the ECB, which aims to contain the Eurozone inflation below 2%. It is a weighted average of price indices of member states in order to show the consumer price index for all of Eurozone. Moderate to high price volatility expected.
Eurozone Gross Domestic Product (GDP) - The market will focus on the quarter-on-quarter figure. A positive figure indicates expansion of the Eurozone economy, whereas a negative figure indicates contraction. Little to moderate price volatility expected.
German Industrial Production - This data reflects the industrial output of Europe's largest economy, and is an important leading indicator of Europe's economic well-being. The market tends to focus on the annual rate change and the seasonally adjusted month-on-month figure. Little price volatility expected.
Budget Deficits of Individual Member Countries - According to the Stability and Growth Pact, deficits of member states must be kept below 3% of GDP. The market keeps an eye on any overshoot targets. Little price volatility expected.
EUR/USD and USD/CHF
A strong negative correlation exists between EUR/USD and USD/CHF. If USD/CHF declines, you are very likely to see EUR/USD rally. One reason for this close correlation is because the Swiss economy is largely dependent upon the Eurozone economies.Political Factors
The euro is very susceptible to political instability, particularly in the Eurozone.Key Fundamentals Impacting the Swiss Franc
Here I will give you a rundown of the most important factors affecting the Swiss Franc when it comes to Forex trading.Swiss National Bank (SNB)
The Swiss National Bank consists of a three-person committee which oversees and reviews the country's monetary policy at least once every quarter, but decisions on monetary changes can be announced at any time. Unlike other central banks, the SNB uses a target range in the 3-month London Interbank Offer Rate (LIBOR) to adjust monetary policy in order to achieve its inflation target at the midpoint of this corridor. This Swiss LIBOR rate is the most important money market rate for Swiss Franc investments. SNB officials can affect the Swiss Franc by occasionally making remarks regarding liquidity, money supply or the currency itself. The current Chairman of the SNB is Jean-Pierre Roth.3-month Euro Swiss Futures
The interest rate differentials between the 3-month Euro-swiss futures and the 3-month Euro-dollar futures act as an important indicator of potential capital flows as they indicate the amount of yield offered by US fixed income assets over Swiss fixed income assets or vice versa. If the Euro-swiss yield is higher than that of the Euro-dollar, and is increasing, then investors are more inclined to move their money into buying the Swiss fixed income assets, and so this supports the Swiss franc. The opposite is true.Economic Indicators
Despite the fact that the Swiss franc is mainly driven by external events rather domestic economic conditions, it is still important to keep track of the following Swiss economic indicators.KOF Leading Indicators - A composite of business surveys from various sectors of the economy (industry, retail and wholesale) that is combined to form a leading indicator that aims to project GDP growth approximately 8 months into the future.
Consumer Price Index (CPI) - A measure of inflation in Switzerland; a significant change may have implications for interest rate policy in Switzerland.
Gross Domestic Product (GDP) - This is a measure of the total production and consumption of goods and services in Switzerland. The GDP price deflator is used to convert output measured at current prices into constant-dollar GDP. Rising growth indicates expansion of the economy, and decreasing or negative growth indicates contraction.
USD/CHF and EUR/USD
These two currency pairs have an inverse relationship, meaning that when EUR/USD goes up, USD/CHF goes down in general, and vice versa. The highly negative correlation between these two pairs is one the strongest in the Forex market, and this is due to the proximity of the Swiss economy to the Eurozone. 60% of Swiss exports are destined for the EU, while 80% of imports come from the EU. The two economies are very closely linked, especially since exports account for over 40% of Swiss GDP. Either currency pair can take the lead or push the other along. Look for clues in any significant price levels in both pairs and the upcoming news releases.Cross Rate Effect
USD/CHF is generally a synthetic currency derived from EUR/USD and EUR/CHF. Traders who want to bypass the more illiquid USD/CHF will trade EUR/CHF, and sometimes, traders use EUR/CHF as a leading indicator for USD/CHF.Traditional Safe-Haven Status
Due to the highly secretive nature of the Switzerland's banking system and its political neutrality, the Swiss franc has traditionally enjoyed an advantageous role as a “flight to safety” currency. In 2003, the US war in Iraq contributed to its strength. 40% of its currency used to be backed by gold, which had largely contributed to the franc’s solidity, but in 2005, the Swiss government sold the country's inventory of gold, and returned the money to the country's cantons. Even as the Swiss franc's popularity as a safe-haven currency has waned in preference to the US dollar recently, it remains a valuable alternative in the Forex markets.Key Fundamentals Impacting the Japanese Yen
The following is a guide to the most important factors affecting the yen when it comes to Forex trading.
Ministry of Finance (MOF)
The MOF is the key political and monetary institution in Japan. Even though the Japanese government granted the Bank of Japan (BOJ) operational independence from the MOF with a series of laws in 1998, the latter still has a very strong influence on the BOJ, and the Japanese currency. The MOF is well-known for its verbal foreign exchange interventions. As an export-driven economy, a weaker yen will help in making its exports more attractive to other countries, hence, it is no secret that the government likes to keep its currency suppressed. Watch out for comments from MOF officials regarding their concerns about any undesirable appreciation or depreciation of the yen. Their comments tend to move the USD/JPY and yen crosses a lot.Bank of Japan (BOJ)
The Bank of Japan is the Japanese central bank. It is the key monetary policy-making body in Japan, and is mainly responsible for maintaining the stability of the Japanese financial system among other things. The BOJ executes all official Japanese forex transactions based on instructions from the MOF. Meetings on monetary policy are held twice a month with immediate press releases. Currently, the governor of the BOJ is Toshihiko Fukui, who assumed the post in March 2003. The BOJ only recently asserted its independence by raising interest rates despite calls from government ministers, especially Finance minister Koji Omi, to leave the zero interest rates on hold.Interest Rates
The overnight call rate is the key short-term interbank rate, and is used by the BOJ to signal monetary policy. The zero interest rate policy (ZIRP) was introduced in March 2001 in an attempt to revive the economy, which had been in long-term recession since the early 1990s, and was only recently abandoned in July 2006 when the BOJ raised the key interest rate to 0.25%.Japanese Government Bonds (JGBs)
JGBs are issued by the MOF for financing purposes. The yield differential between the 10-year JGB and the US 10-year treasury bonds is a key indicator of long-term interest rate spread. For example, rising JGB yields will tend to support the yen and put downside pressure on the US dollar. Another thing to note is that Japan's sovereign bonds normally move in the opposite direction to the Nikkei.Economic Indicators
Consumer Price Index (CPI) - It is a measure of the average level of prices of a fixed basket of goods and services purchased by consumers. An increase in core-CPI (excludes the more volatile food and energy components) would indicate higher inflation pressures. This is widely watched by the Forex market. Moderate to high price volatility to be expected.
Tankan Survey - The Tankan is an economic survey of Japanese businesses issued by the Bank of Japan, which it then uses to formulate monetary policy. The report gives an overview of the business climate in Japan, and is released four times a year- in April, July, October and December. It is widely anticipated by the Forex market players. Moderate to high price volatility to be expected.
Gross Domestic Product (GDP) - The Forex market is most concerned with preliminary GDP year-on-year and quarter-on-quarter figures, which is a broad measure of the total production and consumption of goods and services in Japan. Little to moderate price volatility to be expected.
Trade data - Import and export figures measure the value of goods shipped into and out of Japan. The Forex market is generally more concerned with exports figures, followed by import figures. Japan's main export partners are the US and China. Since Japan is heavily dependent on international trade, it also imports a wide variety of goods from China and the US. Keep an eye on the current account data which is released monthly. Little to moderate price volatility to be expected.
Employment - The employment release is a measure of the number of jobs created and the unemployment rate. It serves as a leading economic indicator, and is widely watched by the Forex market. Little to moderate price volatility to be expected.
Japan's Stock Market
A rise in yen will usually result in a decline of the Nikkei, which is Japan's leading stock index, and the reverse is also true. A stronger yen could affect the profitability of major export companies as exports become more expensive, whereas a weaker yen would allow the country's big exporters to compete more effectively.Chinese Yuan Revaluation
In July 2005, China adjusted the yuan by 2.1% against the dollar, and allowed it to float within tight bands. Within two days, USD/JPY dropped 300 pips with the yen reacting positively to the news. Appreciation of yuan against the dollar is very beneficial to the yen in two ways: Firstly, as the largest exporter to China, Japan will gain to benefit when Chinese companies spend more on goods from Japan due to the strong yuan. Secondly, Japanese goods will become more competitive against their Chinese counterparts in the global markets as both Japan and China are trading competitors. Expect more yuan speculation and further Chinese revaluation announcements as China is continually pressured by world leaders to float its currency more freely.Effects of Carry Trades
Japan offers one of the lowest interest rates in the world, and its currency offers a good interest rate differential with other currencies that have high interest rates like the US dollar, British Pound and New Zealand dollar. Carry traders make the interest differential by shorting the Japanese yen against the higher-yielding currencies, thus depressing yen. However, rapidly rising price levels have pressured the BOJ into raising rates in July 2006, and possibly a few more times this or next year. If Japan's interest rates go up further while the other central banks do not raise rates, carry trade of USD/JPY and other cross yen pairs may not seem as attractive as before if the spread narrows. In that case, we may be seeing the end of easy carry trades.Geopolitical Tensions
Tensions with North Korea pose a great risk to Japan as it has the strongest ties to North Korea out of the G-7 nations. Threatening words or actions from North Korea will most likely cause the yen to fall.Oil Prices
Japan is one of the world's largest net oil importers and is most vulnerable to rising crude oil prices. It imports 99% its oil and also imports vast amounts of natural gas and other energy resources, and thus is extremely sensitive to rising energy costs. When oil prices skyrocket, the Japanese economy suffers. In fact, the value of the yen has taken a toll with the continual increase in oil prices in recent years. Hence, rising oil prices in general will cause the yen to decline in value.Key Fundamentals Impacting the British Pound
The following is a guide to the most important factors affecting the British Pound when it comes to Forex trading.Bank of England (BOE)
The Bank of England is the central bank of the United Kingdom, and is responsible for setting monetary policy in order to maintain price stability. Interest rates are determined by the Bank’s Monetary Policy Committee (MPC). The MPC sets an interest rate to achieve an inflation target determined by the Treasury Chancellor. The Bank's Monetary Policy Committee (MPC) is made up of nine members – the Governor, the two Deputy Governors, the Bank's Chief Economist, the Executive Director for Markets and four external experts. Presently, the retail price index (RPIX) inflation of 2.5% acts as the inflation target.Interest Rates
The bank repo rate is the key rate used in monetary policy to meet the Treasury's inflation target. This is the main interest rate that the Forex market watches. Adjustments to this rate will affect the rates given by commercial banks to savers and borrowers. A higher interest rate may be set to control inflation, and a lower rate may be set to stimulate economic growth and expansion. The MPC meets every month to set the interest rate. Each member of the MPC has a vote to set interest rates at the level they believe is consistent with achieving the inflation target. The MPC's decision is not based on a consensus of opinion; it reflects the votes of each individual member.UK Gilts
The interest rate differential between the yield on the 10-year UK gilts and the yield on the 10-year US treasury bonds is widely watched by the Forex markets as that can affect GBP/USD flows as investors continually seek higher-yielding assets. The interest rate differential between the 10-year UK gilts and the 10-year German bunds also can affect EUR/GBP flows for the same reason that investors are drawn to higher fixed-income yields.Economic Indicators
Retail Price Index - This index measures inflation in the United Kingdom. It is a measure of the change in prices of a basket of goods and services, which the typical household might buy. RPI-X, which excludes mortgage interest costs, is the one favoured by the Treasury as its inflation target is 2.5% annual rise in RPI-X. The Bank of England however prefers another version of the underlying rate known as the core inflation rate, which excludes not only mortgage costs, but also taxation, and this is known as RPI-Y. Widely watched by Forex players. Moderate to high price volatility expected.
Purchasing Managers Index (PMI) - This is a monthly survey conducted by the Chartered Institute of Purchasing and Supply (CIPS), It is a composite indicator of sector conditions in which an index above 50 means growth, and below 50 means contraction. Moderate price volatility expected.
Gross Domestic Product (GDP) - The Bureau of Statistics conducts a quarterly report of the GDP, which measures the total production and consumption of goods and services in the UK. Positive and increasing growth is perceived as a sign of an expanding economy and inflation, while slow or negative growth as a sign of a contracting economy. Little to moderate price volatility expected.
Industrial Production - This index measures the volume of production of the manufacturing, mining and quarrying, and energy supply industries. The Government and the Bank of England, among others, monitor this as an important indicator of industrial activity. This is the earliest official indicator on the performance of the UK industry. Moderate price volatility expected.
RICS House Balance - An index of house price inflation. Moderate price volatility expected.
Nationwide House Prices - An index of house prices. Moderate price volatility expected.
BRC Shop Price Index - An indicator of price changes in retail outlets, providing a picture of the inflation faced by consumers on the most commonly purchased items. Little price volatility expected.
Euro sterling Futures (Short Sterling)
The three-month contract reflects the market's expectations on eurosterling interest rates three months into the future. These contracts are useful in forecasting UK interest rate adjustments, which will eventually affect the price movements of GBP/USD.Pound Crosses
The EUR/GBP cross pair is the key rate to watch for the UK situation vs the euro situation since Europe is UK's main trade and investment partner. Movements of EUR/GBP may spillover to affect GBP/USD, and vice versa. Also, the sterling is popular as a safe haven when investors have doubts about the euro. If there are talks surrounding the possibility of British membership into the euro, euro may rise against the pound .Comments by UK Officials
Comments or speeches made by key decision-makers like the Treasury Chancellor regarding inflation, interest rates, strength of the British Pound, economic growth and the adoption of euro will affect the Forex market.Oil Prices
The UK is generally a net oil exporter, and its energy productions contribute about 10% to the UK's GDP. British Petroleum (BP), one of the world's largest energy company, is from the UK.If oil prices go up, the British pound tends to benefit and go up as well. Higher oil prices will benefit the country's oil exporters, and that is good for the UK economy.UK's Stock Market
FTSE-100 is the UK's leading stock index. It has relatively less influence on the currency, unlike in the US or Japan. FTSE-100 is positively correlated to the Dow Jones Industrial Index.Key fundamentals impacting the CAD, AUD, NZD
The Australian dollar, New Zealand dollar and Canadian dollar are commodity currencies; they represent countries that are major commodity producers. In this lesson, I will introduce you to these countries and their currencies.
The Australian Dollar
The Australian dollar has been a free-floating currency since December 1983, and has usually acted as a proxy for gold due to the fact that Australia is the world's second largest producer of gold, after South Africa, hence any movements in gold prices will effect the Australian dollar. Historically, fluctuations in the price of gold have seen corresponding rise and falls in the Australian dollar. Rural and mineral exports make up over 60% of all manufacturing exports from Australia, therefore, the Australian dollar benefits when commodity prices increase, and declines when commodity prices decline.However, if commodity prices rise rapidly, Australian would face increased inflation, and the Reserve Bank of Australia (RBA) may be inclined to increase interest rates to fight inflation. This would make investors want to shift their money into Australia, and thus support the Australian dollar more. But since gold prices tend to increase during times of global uncertainty, the increased rates may not be too good for the Australian economy eventually. It should however be noted that there are other factors that could influence the price movements of the Australian dollar movements.
Since Australia has one of the highest interest rates among the industrialized countries, and is currently the sixth most traded currency in the global currency market (behind the US dollar, the euro, the yen, the British pound and the Swiss franc), the Australian dollar is a popular currency to use for carry trades. A carry trade involves buying a currency with a h rate, and selling a currency with a relatively low interest rate. Between 2001 and 2005, carry trades have contributed to the 57% appreciation of the Australian dollar against the US dollar.
Being a commodity producer, Australia is very susceptible to adverse weather conditions since agricultural-related activities are highly dependent on the weather. Drought conditions have caused a decrease of the country's GDP over many periods in history. For example, the drought from 1991 to 1995 shaved 0.5-0.7 percentage points from the GDP in 1991-1992 and 1994-1995.
The New Zealand Dollar
New Zealand's main trading partners are, in order of export volume, Australia, the US and Japan. Its highly efficient agricultural industry constitute the bulk of New Zealand's exports. New Zealand's heavy dependence on trade leaves its growth prospects vulnerable to economic performance in Australia especially. Since Australia is New Zealand's largest trading partner, its economy has been helped by strong economic relations with Australia. When the Australian economy is expanding and companies increase their imports from New Zealand, the New Zealand dollar will be one of the first to benefit. Both the New Zealand dollar and the Australia dollar are very positively correlated to each other; if AUD goes up, NZD follows suit, and the reverse is true too.The New Zealand dollar is more positively correlated to the Australian dollar than to commodity prices directly. Increased commodity prices benefit the Australian economy, which in turn translates to increased trade activities with New Zealand, and this is what makes the NZD a commodity-linked currency.
Like the Australia dollar, the New Zealand dollar is a popular choice for carry trades due to its high interest rates among the industrialized countries. Investors looking for higher yields buy the New Zealand dollar against a currency with a low yield. This impacts the demand for NZD, and may contribute to appreciation of the NZD. However, if interest rate differentials narrow when New Zealand does not increase rates against a currency of a country that continues to raise rates, that may cause investors to unwind their carry trade positions and pull down the NZD.
As a major commodity exporter, New Zealand's GDP is very sensitive to severe weather conditions which may adversely affect the country's agricultural activities. Its economic growth slowed in 1997 and 1998 due to the negative effects of the Asian financial crisis and two successive years of drought, but later rebounded in 1999.
Note that a weaker New Zealand dollar will make its exports more competitively priced, and stimulate more economic growth. At the time of writing (August 2006), New Zealand has a large current account deficit, and it has been a constant source of concern for New Zealand policymakers. As of July 2006, its current account deficit expanded to 9.3% of GDP. The economy needs an inflow of foreign funds to fund the current account deficit as domestic savings are not sufficient to fund it.
The Reserve Bank of New Zealand (RBNZ) remains very concerned about the country's inflation. Its target inflation is a CPI (Consumer Price Index) of 3%, and as of June 2006, its annual inflation is at 3.9%, which is at the top of the Reserve Bank’s target range. The CPI data is an important indicator to watch for Forex players.
The Canadian Dollar
Canada has considerable natural resources, and is one of the world’s largest producers of energy. According to the Energy Information Administration (EIA), Canada has the world's second largest oil reserves, just behind Saudi Arabia. Besides oil, Canada also exports huge amounts of nickel, copper, aluminum and zinc. With commodities accounting for 35% of Canada's exports, and these commodities are at or near record highs, the Canadian economy has experienced sustained economic growth..Almost all of Canada’s energy exports go to the US. Both Canada and the US have an interdependent energy relationship, trading oil, coal, natural gas and electricity. These two countries have the largest trading partnership in the world. With US importing 85% of Canada's exports, it is Canada's most important trading partner. Hence, the Canadian economy is closely linked to the economic health of the US. When the US economy expands, trade increases with Canadian companies, and so this will boost the overall Canadian economy. When the US economy slows down, US companies will import less from Canada, and so this will cause the Canadian economy to suffer.
A huge portion of the Canadian economy is linked to the price of oil, which causes the price of this commodity to be a major driver in the value of the Canadian dollar. Oil prices actually act as a leading indicator for the price action in the USD/CAD. Generally, there is a positive correlation between the Canadian dollar and oil prices. When oil prices go up, USD/CAD usually declines. When oil prices goes down, USD/CAD usually moves higher. The correlation is not straightforward of course, since we also have to take into consideration how badly the US economy will be affected by the rising oil prices, and how that may eventually reduce demand for Canadian goods.
When the Canadian dollar rises higher against the US dollar, Canadian exporters lose ground because their products will become more expensive for US buyers. Having a very strong currency is not too beneficial for countries that are net exporters, because importers have to pay more for the same products, and that will lose their competitive edge.
The Canadian dollar, like other commodity-based currencies, may slide if China adopts measures to slow its economy, since that could lead to less demand for commodities.One of the measures could include China ordering its banks to increase their reserves, which is the amount of money they have to keep on hand as cash or in other liquid investments. A bigger reserve requirement means less lending, and hence less economic growth.
The Bank of Canada (BOC) sets its price stability objective with a 2% inflation target, which is the mid point of the 1%-3% target range. The central bank favours the core consumer price index (excluding food and energy prices) as a guide for measuring the underlying inflation trend, and to better assess future changes in the total CPI figure. The 1-3% target range is renewed every 5 years, with the current period ending in 2006.
The Most Important Fundamental Factor - Inflation
In order to succeed as a winner in Forex trading, it is paramount to have an aerial knowledge of how inflation can affect financial markets around the world, including the currency markets.What is Inflation?
Inflation is the general upward movement of prices of most goods and services, and its effect is disadvantageous to every one, whether you trade or not. Inflation means that the value of money melts slowly with the passage of time. $10 buys less today than it could buy last year, and $10 last year could buy less than it could the year before. Not all price changes are "bad" per se if they are accompanied by improvements in the quality of goods, but these do not count as inflation.What Causes Inflation?
There are two main theories that explain the cause of inflation: demand-pull and cost-push.1) Demand-pull inflation usually results from an expanding economy. When a country's economy expands, its revenue grows faster than its ability to produce new goods and services. As a result of more income, people are more inclined to spend and demand products, and if the demand exceeds supply, shortages may occur, and prices will rise so as to feed the consumers' demand. Inflation can also result from a rapid growth in the supply of money and credit in the economy, which provides consumers with higher purchasing power. Central banks may not raise interest rates or may cut interest rates so as to stimulate more spending in the economy, and the resulting increased consumer spending may eventually increase demand for goods and services, which would give rise to shortages that push the prices upward.
2) Cost-push inflation occurs when there are spot shortages of raw materials or essential services that are needed to make things that people need. Such spot shortages increase the cost of wages and raw materials. The world is currently (2006) experiencing rising energy costs such as oil prices, which cause goods and services to cost more because oil is used as a raw material in so many goods in the economy, ranging from ........... Oil prices are reaching new highs as expanding economies such as China and India demand for more oil to fuel commercial and consumer demand. This increasing demand puts a lot of pressure on oil countries to pump more oil, and hence puts upward pressure on the price level. Sharp increase in crude oil prices produces an exogenous inflationary shock, especially for countries that are net importers of oil, and have many industries that use oil as an essential input in the manufacturing process. Because of higher costs of production, businesses pass these higher costs down to consumers, which then experience price increases in goods and services.
Note that although inflation often accompanies economic growth, there will be times when prices go up, but the economy worsens instead. This is called stagflation. Stagflation is usually triggered by high oil prices which hurt the economy.Central Banks and Interest Rates
When a country experiences inflationary pressures, its central bank is more inclined to adopt a monetary tightening policy, and it does this by deciding on the interest rates. In the US, interest rates are decided by the Federal Reserve, and the Fed monitors the inflation picture very closely based on inflation indicators such as the Consumer Price Index (CPI), Personal Consumption Expenditure (PCE) and Producer Price Index (PPI). Central banks actively try to maintain a specific rate of inflation, which is usually between 2% and 3%.The Fed does not publicly set a target for the inflation rate. Instead, they announce goals for the Fed Funds Rate, which is the interest rate at which banks lend their excess reserves to one another. When the Fed wants to curb inflation, it will announce a higher target for the Fed Funds Rate, and/or sell Treasuries to shrink the money supply (take them out of circulation), and raise rates. One of their top concerns is to maintain price stability in the economy. On the other hand, when the Fed wants to stimulate economic growth, it will cut the Fed Funds Rate, and/or buy Treasuries on the open market in order to increase money supply, so that private banks will then have more cash on hand to lend to consumers and businesses. Lower interest rates mean that people are more enticed into borrowing money from banks to finance big-ticket items like cars and houses, and businesses will borrow more to invest in expansion.
Inflation and the US Dollar
Whenever the Fed makes an announcement about raising interest rates in order to control inflation, the US dollar becomes the beneficiary. This is because if the USD has a higher interest rate than another currency which has a low interest rate, the pair will have a positive interest rate differential. This spread differential means that if you buy USD and sell the other currency with the lower interest rate at the same time, you stand to gain interest fees when you leave your positions overnight. A widening spread differential exists when one country continues to raise rates while the other country is not doing so, and that widening differential is good news for investors and traders who are seeking to put their money into higher-yielding assets. Rising inflation and hence rising interest rates in the US will help support the US dollar. This also applies to any other currency of the country that wants to raise interest rates in order to combat inflation.Any words uttered by any of the Fed officials, in particular the Fed Chairman, with regards to inflation or interest rates, will stir up sharp price movements in the currency markets, especially currency pairs with a US dollar component. Watch out as well when key officials from other countries' central banks make any verbal remarks about their country's inflation and/or interest rates.
Trading Tips
When inflation is rising in the US, it is good news for the US dollar. The opposite is true too, that when inflation is abating in the US, it is bad news for the US dollar.Many times, big currency moves are triggered by the release of inflation data such as CPI or PCE in the US.
Bond yields (especially 10-year bonds) are a very good indication of the market's perception of inflation expectations. If people expect higher inflation in the future, they do not want to invest in fixed income assets because the coupon rate will be eroded by inflationary effects. Hence, bond prices will go down, making the yield higher.
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