Fundamental Analysis
Your work as a trader will be done prior to the trade being executed. Traders spend huge amounts of their time in research and studying data they have produced from their technical analysis indicators or economic data that is coming over their news screens. Fundamental analysis is all about interpreting economic indicators, social factors, and government policies, and all three can have a significant influence on the price of a country’s domestic currency.
The factors that a trader analyzes for fundamental analysis are interest rates, growth rates, inflation rates, and unemployment levels. These issues all impact on the supply and demand of a currency with interest rates and the overall strength of an economy (gross domestic product, GDP) being the two key factors influencing a currency. News stories can also affect the price of a currency which is why traders have news feeds from such agencies as Reuters, CNN, and Bloomberg, live on their screens. News events can have a dramatic short-term effect on a currency causing extreme volatility, particularly speeches by influential people such as governors of central banks, or economic ministers. This is why for a novice trader “trading the news” is not recommended because it could be such a disaster that the trader never recovers.
Economic Calendar
To help position themselves in the face of forthcoming news and economic events, traders keep an eye on the economic calendar which is published daily. Economic and political news can change the direction of a currency pair in seconds, and fundamentals that are true at an instance of time can be rendered absolutely meaningless by fresh fundamentals a few seconds later. The economic calendar enables traders to keep track of economic indicators and political events that impact currency movements.
The economic news for traders in the financial markets is programmed months in advance. Traders will know in advance when a meeting of the European Central Bank to discuss policy on interest levels will take place on a particular date in the future. This gives traders time to do some research and analysis and position themselves accordingly. All brokers publish a live economic calendar which updates almost immediately the economic data are released.
Take a look at the Economic Calendar for the September 1, 2017 (Figure 4.1).
Figure 4.1 Economic calendar
As you can see, the calendar has seven columns.
Column 1—Time that the data are going to be released
Column 2—The currency affected by the news
Column 3—The event that will occur
Column 4—The volatility impact on the currency/market (the published economic calendar is shaded red for high volatility, orange for mild volatility and yellow for no volatility)
Column 5—The actual published data
Column 6—A consensus of the data
Column 7—Previously published numbers
On this calendar, there are several events that will have a big impact on the currency markets, all have been coded red. These are the U.S. unemployment figures, average hourly earnings, U.S. nonfarm payroll numbers, the ISM (Institute for Supply Management) prices paid, and the ISM manufacturing purchasing managers’ index (PMI). The unemployment rate missed its target and was slightly higher than the forecast and last month’s numbers. The average hourly earnings were down on both the forecast and last month’s numbers. The nonfarm payrolls increased by 156,000, but this was a lot worse than the forecast and the previous month’s number had been revised down also. These statistics all had a dramatic effect on the dollar, and as we can see from Figure 4.2 there were wild fluctuations in the markets in the span of half an hour.
Figure 4.2 EUR/USD 1-hour chart
The dollar initially lost 60 pips in a few minutes as the worse than forecast news was digested even though worse than expected. Then, as the overall trend for the United States was of a strengthening economy, the dollar recovered quite dramatically and gained 80 pips in a few short minutes. Imagine if you had bought dollars just before the figures were released and seeing the dollar weakening you closed out your losing position and traded again, this time selling dollars. You would then be staring at your screen in horror as the dollar dramatically strengthened and you had another losing trade on your hands. The lesson here is to never trade economic news either just before the news breaks or just after its broken. Always wait for the market to settle back down again.
Later in this chapter, there are explanations of the key economic data that cause short-term extreme volatility in the market. If you understand what the data are and why it affect the markets, you should then be able to position yourself on the right side of the market once the immediate impact has settled down. Remember that short-term volatility does not mean a reversal in the trend.
Traders are constantly analyzing future economic events to try and understand before the announcement what the news might be. The consensus column on the economic calendar indicates the average estimate of all the analysis. Once this has been done, traders then place trades according to where they think the currencies will be when the announcement is released. By the time the announcement is made, traders have probably priced in the value of the currency pair. That is why when the released figure is the same as the consensus number, the market does not respond.
Trading the News
Economic news is one of the biggest drivers of short-term currency movements in the forex markets or in any other financial market for that matter. The currency markets respond very easily to economic news, especially the news coming out of the United States, as 80 percent of foreign exchange trading involves the dollar. But also, economic news coming from other major economies can dramatically affect their domestic currency.
Trading the news has become an accepted strategy in the forex markets in recent times. It is almost a regular occurrence to see currency pairs shift from 50 to 100 pips or more within a few seconds of a major economic news release. You are now probably thinking “that’s got to be easy money,” maybe it is or maybe it all depends on your preparation in anticipating the news release.
Trading on the release of economic news releases can be a major tool in your trading armory as long as you perform due diligence on the data and its potential impact on the markets. Economic news releases regularly stimulate strong short-term currency movements, which could offer big trading prospects for you, especially as the forex markets are open 24 hours a day over several time zones, so there are plenty of chances on nearly every trading day to grab a lot of pips driven by a news release.
Obviously, you can cherry-pick the currencies and news releases of the major economies which you want to concentrate on, however, because the dollar is the most traded currency, economic news coming out of the United States tends to bring about a marked reaction in the market.
Trading news is not as easy as it perhaps sounds. Both the consensus number and the revisions that come after publication are important. Also, some news is more significant than others; its importance depends on the economic size of the country where the data are being released and the significance of the news in relation to the other data being released on the same day.
The economic data that have a tendency to seriously affect price action in a currency are
• Interest rate decisions
• Retail sales
• Industrial production
• Inflation as indicated by consumer prices or producer prices
• Trade balance
• Unemployment
• GDP
In addition, surveys related to business, manufacturing, and consumer confidence are also significant. The comparative importance of the economic data may also change, as certain data may be more important this month than other data. Therefore, you should keep abreast of what is important to the market now.
As fundamental analysis, unlike technical analysis, is more of a long-term trading strategy, so when trading the news, your strategy should reflect that. Which is why I said earlier that you should not trade immediately prior or post a news release. Look at the long-term impact on the domestic currency of the economic data being published in the context of the significance of the news being better, worse, or what the market expects. This thought process will enable you to decide on the most profitable entry or exit strategy.
Initial Jobless Claims
The Initial Jobless Claims released weekly by the US Department of Labour is a measure of the number of people filing first-time claims for state unemployment insurance. These statistics provide a measure of strength in the labor market. A larger than expected number indicates weakness in this market which influences the strength and direction of the U.S. economy. Largely speaking, a decreasing number should be taken as positive or bullish for the dollar, and conversely, higher claims indicate that the economy is weakening. The financial markets closely follow this number as it gives early warning on the direction of the economy (Figure 4.3).
Figure 4.3 Initial jobless claims
When the unemployed in the United States have been out of work for more than 26 weeks, they move onto extended federal benefits and do not make weekly claims, so a reduction in claims might not accurately reflect the actual number of unemployed but show a better picture than exists in reality.
As jobless claims essentially ignore half of the unemployed, the financial markets look at two sets of data: the jobless claims and the extended claims. In reality, the extended claims are 1 week behind the jobless claims (continuing claims) so it is never 100 percent accurate, however it does give a more realistic picture.
Unemployment Rates
The unemployment rate released by the US Department of Labour is a percentage that is derived from dividing the number of unemployed workers by the total civilian labor force. It represents the percentage of people actively seeking employment and willing to work (Figure 4.4).
Figure 4.4 Unemployment rate
In general, a higher rate is seen as a weakening/recessionary economy, while on the contrary, a growing economy sees its unemployment rate decreasing. Therefore, a decrease of the figure is seen as bullish for the USD, while an increase is seen as negative (or bearish), although by itself the number cannot determinate the markets move, as it depends on the headline numbers of the nonfarm payroll.
Nonfarm Payroll
The nonfarm payrolls released by the US Department of Labour shows the number of new jobs created during the previous month, in all non-agricultural business. The monthly changes in payrolls can be extremely volatile, due to its close relationship with economic policy decisions made by the Central Bank.
The number is also subject to strong revisions (a circle indicates a revised number) in future months which also tends to trigger volatility in the forex market. Generally speaking, a high reading is seen as positive (or bullish) for the USD, while a low reading is seen as negative (or bearish), although previous month’s revisions and the unemployment rate are as relevant as the headline figure, and therefore market’s reaction depends on how the market assesses them all.
Consumer Price Index
The Consumer Price Index (CPI) Ex-Food and Energy is released by the US Department of Labour Statistics and is a measure of price movements through the comparison between the retail prices of a representative shopping basket of goods and services. Volatile products such as food and energy are excluded in order to capture a more accurate and smoother calculation. Generally speaking, a high reading is seen as positive (or bullish) for the USD, while a low reading is seen as negative (or Bearish) (see Figures 4.5 and 4.6).
Figure 4.5 Nonfarm payroll
Figure 4.6 Consumer price index
The CPI is an important economic indicator (reported monthly 2 weeks after the reporting month), because it measures adjustments up or down in the selling prices consumers pay for goods and services. As such, it is a valuable early indicator of inflation. Inflation is a sign that the purchasing power of a country’s currency is in decline and each unit of local currency buys fewer goods and services. A rise in inflation has a very negative effect on a currency. The producer price index (PPI) which feeds into the CPI controls inflationary trends and prevents the local currency from depreciating too much. If a local currency becomes less valued because of inflationary pressure, the demand for that currency decreases. This is especially evident if the country in question imports a high amount of goods and commodities that are considered valuable and needful from a country that has low production costs. These goods become more expensive as the local currency declines against the exporter’s currency and the inflation rate rises in tandem as prices increase.
Markit Manufacturing PMI
The Manufacturing PMI released by Markit Economics captures business conditions in the manufacturing sector. As the manufacturing sector dominates a large part of total GDP, the manufacturing PMI is an important indicator of business conditions and the overall economic condition in the United States.
Points above 50 imply the economy is expanding and investors see this as bullish for the USD, whereas a result below 50 points indicates an economic contraction, and weighs negatively on the currency and is seen as bearish for the USD (Figure 4.7).
Figure 4.7 Markit manufacturing PMI
The Institute for Supply Management (ISM) Manufacturing Index shows business conditions in the U.S. manufacturing sector. It is a significant indicator of the overall economic condition in the United States. A result above 50 is seen as positive (or bullish) for the USD, whereas a result below 50 is seen as negative (or bearish).
Retail Sales Ex Autos
The Retail Sales ex Autos released by the US Census Bureau is data published monthly that show all goods sold by retailers based on a sampling of retail stores of different types and sizes except for the automobile sector. The retail sales index is often taken as an indicator of consumer confidence. This report is the “advance” report, which can be revised fairly significantly after the final numbers are calculated. Positive economic growth anticipates bullish movements for the USD, whereas negative economic growth is inclined toward a bearish reaction for the USD.
Retail Sales
The Retail Sales released by the US Census Bureau measures the total receipts of retail stores. Monthly percent changes reflect the rate of changes of such sales. Changes in Retail Sales are widely followed as an indicator of consumer spending. Generally speaking, a high reading is seen as positive (or bullish) for the USD, while a low reading is seen as negative (or bearish).
It is revised quite considerably after the final figures are calculated. Traders and analysts prefer to look at the retail sales figure “ex auto” which means that the numbers exclude car sales because they are expensive items and distort the final figure. The number without the car sales is considered a better measure of retail sales trends (Figure 4.8).
Figure 4.8 Retail sales
The report manages to capture the retail sales on a broad front and includes in-store sales as well as mail order sales and other out-of-store sales such as the Internet. It is broken down into several categories such as food, beverages, and clothing.
In addition, the retail sales are also a large constituent of total GDP and any long-term reduction in retail sales could signal a pending recession with a reduction in VAT receipts and company head counts. The retail sales figure is also fairly current as they can be collected quickly and provide data that are only a couple of weeks old.
The forex market finds the retail sales figure a difficult animal to analyze. Europeans and Asians like to see Americans in a buying mood because that can strengthen interest rates which are good for the dollar (bullish). However, too strong retail sales could be detrimental to the dollar because many goods are imported and that means there is demand for nondollar currencies to pay for the foreign goods. Weak retail sales could spell a recession and that too is not good for the dollar.
FOMC Minutes
FOMC stands for the Federal Open Market Committee that organizes eight meetings in a year which review economic and financial conditions in the United States. It also determines the appropriate stance of monetary policy and assesses the risks to its long-run goals of price stability and sustainable economic growth. FOMC Minutes are released by the Board of Governors of the Federal Reserve and are a clear guide to the future U.S. interest rate policy (Figure 4.9).
Figure 4.9 FOMC minutes
When it comes to the markets, the impact of interest rates and the effects are far broader than just the level of a mortgage rate. The interest rates that investors are particularly interested in are the interest rates which are set by the central banks of countries, particularly the interest rate set in the United States by the Federal Reserve. Central banks tend to use interest rates to stop an economic scenario where there is too much money chasing after too little produce and this leads to inflation in prices. By reducing or increasing the amount of money available for purchasing produce/goods a central bank can control inflation.
By increasing the interest rates, a central bank attempts to reduce the supply of money by making it more expensive to obtain. An interest rate increase does not have an immediate effect on the markets. What happens immediately however is that it suddenly becomes more expensive for banks to borrow money from the central banks. Banks in their turn increase the interest rates that they charge for lending money to their customers. Credit card and mortgage interest is increased particularly if they are not a fixed rate but have a variable rate. As people start to feel the effect of less money being around, they have less disposable income and are only able to spend money on bills which themselves have become more expensive. This in turn affects businesses ability to earn revenues and increased profits.
Gross Domestic Product
The GDP Annualized released by the US Bureau of Economic Analysis displays the monetary value of all the goods, services, and structures produced within a country in a given period of time. GDP Annualized is a gross measure of market activity because it indicates the pace at which a country’s economy is growing or decreasing (Figure 4.10).
Figure 4.10 GDP
Generally speaking, a high reading or a better than expected number is seen as positive (bullish) for the USD, while a low reading is negative (bearish).
Consumer Sentiment Reports
The Index of Consumer Sentiment (ICS) is an economic survey which is published monthly by the University of Michigan. It is designed to measure the consumer’s confidence in the U.S. economy.
Two-thirds of expenditures and production in the economy of the United States is dedicated to private consumption and consumer spending. This includes such things as retail sales, utilities, medical health care, and rent. This is a very big sector of the economy and the accuracy of the numbers have an effect on some other key numbers which economists focus on, such as interest rates, employment, and inflation. The ability of a consumer to spend is indicated through the income, interest rates, and wealth, therefore comparing all these variables with the ICS can indicate what level of expenditure the consumer is likely to spend in the future. Any dramatic swing of confidence could cause a short-term spike in the markets.
Crude Oil Prices
Countries such as the United States, the Euro-zone countries, Japan, and India are extremely dependent on the crude oil price. If crude oil prices increase, these countries will see an increase in their imports, which in turn, as oil is priced in dollars, leads to an increase in the sales of their respective currencies, and a decrease in its value.
A Country’s Political Condition
A country that has a stable government indicates to investors that the policies both economic and social are consistent and directed toward a growing GDP. This type of environment also leads to a stable currency. However, if a country has an unstable government and a series of general elections, this indicates uncertainty for the government’s economic policies and often has a negative impact on the value of the country’s domestic currency.
Price of Gold
The fluctuations in the price of gold can have a sudden impact on the domestic currencies of the countries which are the main producers as well as exporters of gold. The two major exporters of gold in the world are Canada and Australia, so if the price of gold rises, their currencies will tend to appreciate as gold buyers purchase their currencies to pay for the gold. In contrast, the countries who are net importers of gold will find their domestic currencies declining in value as the price of gold goes up.
Quantitative Easing
You only have to open a financial newspaper today to see the words “quantitative easing” and turn on a financial news channel to hear someone welcoming it or saying that it would not work. What is quantitative easing and why is it so dramatic? Actually, it is dramatic because in a nutshell it means creating gigantic amounts of money from nothing in the hope that the economy gets back on track. Many economists think that when you want to pick up the economy you must get more money into circulation. Unfortunately, there are very few ways in which this can be done.
One way is for the government to spend money by recompensing people to build things such as roads or factories or stadiums. That would certainly get more money into people’s pockets. However, this is not a politically popular idea. It can be done once but not repeated.
Another way is for the Federal Reserve to reduce interest rates, which then makes it cheaper to borrow money. The theory being that people borrow more, and therefore purchase more, and build more original things. That has already happened when the Federal Reserve pulled interest rates all the way down to zero. You cannot go any lower than that.
These two tools have been used throughout economic history as we know it, either government spending or cutting interest rates. However, if these methods do not work, then the last resort is quantitative easing.
So how does quantitative easing work? Essentially, the Federal Reserve says that it is willing to buy up government securities held by banks for a little more than anyone else is willing to pay. The banks obviously like that and sell the bonds they are holding to the Federal Reserve. Now the banks have a cash pile of billions of dollars. But where did that money come from? That is the magic that the Federal Reserve or any other central bank can do. The money comes out of a hat. In other words, they invent it electronically.
So now the banks have billions of dollars. The Federal Reserve is hoping that the banks will decide to lend the money to companies and people to invest or buy things. This in turn stimulates the economy. This sounds like a win situation for everyone, however there are many economists who believe that quantitative easing does not work and it is too early to say if it is working this time. In the meantime, the United Kingdom and Europe are following the same strategy to stimulate their economies. At this point in time it seems to be working and the American economy is showing strong growth. Despite some economists having reservations, many other economists say that it is better than doing nothing and far better than austerity.
All the data and statistics that I have mentioned so far in this chapter can have a significant effect on the price action of the U.S. dollar. However, these same statistics and data also have a similar effect their particular countries domestic currency volatility. Take a look at an extract of the economic calendar for the September 8, 2017 (Figure 4.11).
Figure 4.11 Economic calendar
At 8:30 a.m. the Consumers Inflation Expectations report was released in the United Kingdom. This is a report issued by the Bank of England which shows the percentage that consumers expect the cost of goods and services to change over the next 12 months. It can cause quite volatile price action for the GBP as the dark bar indicates (Figure 4.12).
Figure 4.12 GBP/USD 30M chart
However, the actual number as compared with last month’s figure was the same, and the market’s reaction was very subdued for half an hour although later in the morning the GBP did strengthen by 80 or so pips.
Also on the same day at 12:30 p.m., the Net Change in Employment and the Unemployment Rate were released in Canada. Both numbers could have a major impact on price action and the bars are coded dark accordingly. The Net Change in Employment actually was a little better than expected and the Unemployment Rate was slightly down on the forecast. Both results were considered positive for the Canadian dollar, and you might have expected the Canadian dollar to appreciate. If you had traded supporting your sentiment, you would have made a bad trade because as you can see from Figure 4.13, the Canadian dollar spiked in favor of the U.S. dollar on the release of the figures. It then came back to the price it was at immediately before the news was released.
Figure 4.13 USD/CAD 5M chart
In fact, the Canadian dollar had been doing well in long term since the interest rate hike in June, up to the release of the statistics, which indicates that the news was already priced into the rate. The dollar bulls took control after that and the Canadian dollar started a weak trend as rumors that the Bank of Canada does not foresee another rate hike anytime soon.
Notice that there were other economic data affecting the EUR and GBP that day, which did not have any significant effect on those currencies and were not expected to, as the volatility bars were shaded much lighter (no volatility) than dark and lighter than dark (mild volatility).
The Canadian dollar spike on the release of the employment numbers is a good example of the dangers of trading the news just before or just after the release of data. You cannot preempt the market unless you are very lucky, so do not take the risk. Position yourself prior to the news event making sure you have the appropriate stop losses in place in case of a spike against you. Or, wait until the market has settled back down before you trade. Fundamental analysis is important to understand in conjunction with technical analysis, however fundamental analysis sometimes has dramatic short-term effects on price action which can wipe out all your hard-earned profits.