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Fundamental Analysis

What is fundamental analysis?

Fundamental analysis in FOREX is a type of market analysis which involves studying of the economic and political situation of countries to trade currencies more effectively. It gives information on how the big political and national economy-related events influence currency market. Figures provided by national statistical agencies and statements given in speeches by important politicians and central bankers are known among the traders as economic announcements that have great impact on currency market moves. In particular, announcements related to United States economy and politics are the primary to keep an eye on. Fundamental analysis is the most essential way retail traders can increase their odds for profit in the most of the time randomly moving FOREX market.


What moves the price of a currency?

The price of a floating exchange rate currency is commensurate with the ratio of demand and supply. The higher the demand (market participants are willing to buy more of the currency), the higher the price and vice versa. Changes in supply have exactly opposite effect so higher supply (more of it is beeing offerred in the market) brings about a decrease in the currency price and lower supply will increase the price. These basic economic rules are essential for understanding the complexity and stochasticity of the FOREX market. As the US dollar is the world's most dominant reserve currency, all other assets in global markets are priced in USD. In consequence, every change in the price of any asset (commodity, equity, derivative, etc.) indirectly affects the value of USD and hence of all currency pairs containing USD. There are so many different markets, assets, participants, and events affecting exchange rates of currencies that the changes observed as a currency price action display random or stochastic character (discussed in more detail in previous chapter). There are only a few kinds of event and large market participant's action that can cause a major move in a currency price. Among the events, only economic announcements and some planned political events are known to happen in advance and are listed by many web sites as the Economic Calendar.


Economic Calendar

Economic calendar is created by economists where they predict different economics figures and values according to previous months. It contains next data:
Date — Time — Currency — Data Released — Actual — Forecast — Previous
For example: If the forecast is better than the previous figure, then US dollar usually is going to strengthen against other currencies. But when news are due, traders have to check the actual data. If to look at oil prices, a rising price will result in weakening of currencies for countries which depend on huge oil import, e.g. America, Japan.

How to read FOREX Economic Calendar

It is important to know the time of High impact data release if you trade affected currency pair. During actual news release market becomes volatile. The strength of the volatility depends on the "factor of surprise" brought in the news. "Factor of surprise" can be defined as a level of unexpectedness, where traders compare Forecast data to Actually released data.
Medium impact economic data should also be kept in mind in case the factor of surprise turns to be high. Low impact data most of the time do not shift FOREX market significantly.
Column Previous in FOREX Calendar — provides data from last release. Column Forecast indicates numbers that economists are predicting and expecting for the upcoming release today. Column Actual is updated only after the data is out. At the very second when data becomes available it is instantly compared against Forecast values, and depending on overall positiveness or negativeness of the news for the currency plus taking into consideration the factor of surprise, price dips or rises in a matter of seconds.
Economic News impact — increased market volatility — usually lasts for 1-3 minutes (highest volatility); next 5-10 minutes market experiences corrective/adaptive volatility, where price settles in summarizing new market shift.


What are the most powerful figures that move FOREX market?

Interest rate
Traditionally, if a country's central bank raises its interest rates, its currency will strengthen because investors will shift their assets to that country to gain higher returns.


Trade balance, budget and treasury budget
A country that has a significant Trade Balance deficit will generally have a weak currency as there will be continuous commercial sellings of its currency.


Gross Domestic Product (GDP)
GDP is reported quarterly and is followed very closely as it is a primary indicator of the strength of economic activity. A high GDP figure is usually followed by expectations of higher interest rates, which is mostly positive for the currency.


Consumer Price Index (CPI)
A consumer price index (CPI) measures changes in the price level of market basket of consumer goods and services purchased by households. The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. Sub-indices and sub-sub-indices are computed for different categories and sub-categories of goods and services, being combined to produce the overall index with weights reflecting their shares in the total of the consumer expenditures covered by the index. It is one of several price indices calculated by most national statistical agencies. The annual percentage change in a CPI is used as a measure of inflation. A CPI can be used to index (i.e., adjust for the effect of inflation) the real value of wages, salaries, pensions, for regulating prices and for deflating monetary magnitudes to show changes in real values. In most countries, the CPI is, along with the population census one of the most closely watched national economic statistics.


Non-farm Payrolls (NFP)
Nonfarm payroll is a monthly report generated and reported by the United States Department of Labor intended to represent the total number of paid US workers of any business. Despite the name nonfarm payroll, the report excludes workers from general government jobs, private household jobs, employees of nonprofit organizations and farm employees. It is an influential statistic and economic indicator. The financial assets most affected by the NFP data include the US dollar, equities and gold. The markets react very quickly and most of the time in a very volatile fashion around the time the NFP data is released. Decreases in the payroll employment are considered as signs of a weak economic activity that could eventually lead to lower interest rates, which has negative impact on the currency.


Cross-Asset (Cross-Market) Correlations

A cross-asset correlation is a relationship between two instruments belonging in different asset classes. After the global financial crisis of 2008, there is a significant increase of cross-asset correlations between equities, FOREX currencies, commodities, credit, and interest rate products.

US Equities

There is a particularly strong correlation between FOREX currencies and US equities. This correlation is enhanced by carry trading, trading on margin, and cross-asset arbitrage. The strongest FOREX-equity correlation exists between USDJPY and the US equity markets. When the risk appetite for buying stocks increases then investors usually borrow money in Japanese yen in order to buy these stocks. That is happening as the Japanese Yen offers traditionally very low borrowing rates. The result is that when equities go up the USDJPY pair goes up too. This reflects also in equity indices, so US equity indices are directly correlated to USDJPY.

Commodities

The implementation of portfolio diversification techniques during the past 20 years concluded in a major investment appetite for commodities. Commodities are highly correlated to both currencies and equities. The currency rate of major commodity exporters is highly influenced by fluctuations in the commodity markets. For example, the Australian Dollar is highly correlated to gold as Australia is the world's largest gold exporter - AUDUSD has had 80% historical correlation to the gold price. In addition, several currencies are correlated to Crude Oil, for example, the Canadian Dollar, the Norwegian Krone, and the Russian Ruble. The commodity prices, in general, are negatively correlated to the US Dollar. The reason is that commodities are priced in US Dollars.

Interest Rates and Government Bonds

The level of interest rates is the core of any investment decision regarding currencies, equities, bonds, etc. Any modification in the level of interest rates can change dramatically the risk/return combinations of all financial instruments. During periods of financial turmoils, investors become risk-averse and thus they tend to sell equities in order to buy government bonds. There is a strong correlation between USDCHF and the yield of US bonds. Note that the yield and the price of a government bond are negatively correlated, and therefore USDCHF is directly correlated to US bond yields and inversely correlated to US Bond Prices.




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