For a currency trader, fundamental analysis focuses on key underlying economic and political factors to determine the direction of a currency's value. There are a number of fundamental indicators traders may follow that reflect how an economy is changing and gleam insight into Forex market prices to come.
Why Is It Helpful?
In the long run, fundamentals drive price action by answering key questions regarding current events. Some common questions for the forex market are:
• Is the economy expanding rapidly or contracting?
• What parts of the economy are booming or about to bust?
• Are new jobs being created?
• What parts of the economy are central bankers most concerned with?
You can use the answers to these questions to determine if a currency will be strong or weak in the future.
Most investors look at three key variables: monetary indicators, economic indicators, and sentiment. Let's take a look into these variables by evaluating the US economy. Here is a brief explanation and example of each.
View Monetary Policy Reports
The following image shows the 30-Day Fed Fund Futures contract expiring Jan. 2007. This futures contract was taken 3 months before January 2007, when it was trading at 94.75. If you subtract the current price from 100 it tells you what the futures market expects the interest rate outlook to be. Since 100-94.75= 5.25%. The interest rate attached to the US Dollar at that time was approximately 5.25%, thus this suggests that futures market did not see an interest rate change in sight for the next few months. Translating this into a fundamental outlook, markets have priced in the likelihood that the US economy is slowing down or experiencing moderate growth - and that the central bank will not inclined to change rates in the next three months.
• Leading Indicators
• The Corporate Sector
• Manufacturing
• Unemployment
• Inflation
The reason you should care about economic indicators is because they drive the interest rate outlook. Remember, a growing economy can offer a higher yield. Let's see how they can be applied to develop a solid fundamental perspective on the US economy.
While there are many leading indicators, the US housing market is an excellent example. Building and buying a new home usually suggest extensive outlays (homes need to be constructed, financed and furnished), thus developments in the housing market usually precede developments in linked industries. Also the act of building and purchasing a home usually takes some time to complete, thus indicators like New Building Permits, Housing Starts and New Home Sales will usually precede the economic impact of what those reports measure. And since roughly 2/3rds of Americans own homes, the housing market has an inevitable impact on the economy.
The image below shows that the number of new homes being sold has declined since peaking in the summer of 2005. You can assume that this housing glut should eventually create a "trickle-down" effect & slow down consumers through lower consumer confidence and spending. As such, if the housing market is declining, its trend tends to be negative for an economy and currency, while a booming housing market tends to be beneficial.
View Leading Indicators Reports
US Corporate Profits
What to Watch for Manufacturing Most of the US economy revolves around the service sector (where less than a quarter of the US GDP relates to manufacturing), but because the manufacturing industry fluctuates far more than services, the majority of developments in GDP come from the manufacturing sector. Thus in forecasting the manufacturing industry fundamental analysts may better forecast the overall economy.
Trends in America's manufacturers are closely watched through a report called the ISM Manufacturing Survey. The survey evaluates several components of manufacturing in the US. But you do not need to look at the figures to get a bias from the reports. An ISM Report concluded, "It's apparent that manufacturing is losing momentum and feeling the effects of higher interest rates and a weaker housing market." You can easily interpret such an outlook into your fundamental analysis.
View GDP, Manufacturing and Production Reports
Changes in The Monthly US Employment Report are more closely scrutinized than any economic figure. Financial Markets tend to focus on the number of new jobs created, referred to as Non-Farm Payrolls (NFP's), revisions for the previous NFP and the unemployment rate.
The image below shows a 3-month average of new jobs (NFP's) created. After declining from the first half of 2006, the 3-month average looks to be steady between 120-150K new jobs. In the FX Market if new jobs surprise to the upside with the actual figure higher than expected, the market quickly shifts in favor of that currency. Since faster growth means higher yields, higher NFP figures fare well for a currency.
The fundamental analyst combines the payroll gains with the unemployment rate to get a good assessment of the tightness of the labor market. A low unemployment rate combined with steady job growth can push wages and interest rates higher. You can see in the image below that the unemployment rate looks to be at a low and decreasing, which should be good for the US Dollar if it remains there. If the unemployment rate were to climb higher, it would be bad for the dollar.
View Employment Reports
Where Does Inflation Stand? Inflation is the result of a growing economy since businesses will increase their prices when consumers buy more. Central bankers weigh both inflation and economic growth when setting short-term interest rates. If they think inflation is above their comfort level, they will raise interest rates and vice versa.
Inflation is affected by supply as well. This sort of price pressure is most commonly seen in the cost for food and energy, making the prices paid for these goods less controllable and volatile. As such, they pose a concern to economists but are often removed from key inflationary figures.
The image below shows the Core Consumer Price Index (CPI), a figure followed by fundamental analysts to determine inflationary pressure. The Core CPI figure shows the change in price for consumer goods and services excluding the volatile components like food and energy. By looking at this figure, inflation appears to be rising. The bias would be to raise interest rates. Due to this correlation, higher inflation tends to be positive for a currency if it results in a positive interest rate outlook.
View Price, Wage, Spending and Inflationary Reports
Michigan Consumer Sentiment Survey below gives a numerical value for consumer's current and future expectations. Since the figure appears to be increasing, traders can conclude that consumers have a positive outlook. At the time, this increase was largely attributed to the decrease in gas prices right after reaching summer highs.
Putting key fundamentals together will allow you to determine whether the economy is strong or weak. Together these fundamentals reflect the economic cycle as they show the way that growth changes as fundamental variables change. At the most basic level, these components show you whether a currency should be strong or weak. Now that you know the components, you can use them to decide where growth is according to the economic cycle below.
• Is the economy expanding rapidly or contracting?
• What parts of the economy are booming or about to bust?
• Are new jobs being created?
• What parts of the economy are central bankers most concerned with?
You can use the answers to these questions to determine if a currency will be strong or weak in the future.
What Fundamentals Are Worthwhile?
You should look at the most important fundamental variables and compare them to determine the true health of the economy. The most important variables will change year to year as international trade dynamics evolve and central bankers & investors redirect their fixations.Most investors look at three key variables: monetary indicators, economic indicators, and sentiment. Let's take a look into these variables by evaluating the US economy. Here is a brief explanation and example of each.
Currencies And Interest Rates
In basic terms, interest rates reflect how much you get paid for holding a currency, which is why rates drive the Forex Market. Interest rates are set by a combination of central banks decisions (which set short term rates) and the bond market developments (which determine longer term rates). If interest rates are going up it tends to suggest the economy is in a growth spurt. (Thus central bankers are inclined to ward off inflationary pressures with higher rates.) The currency tends to appreciate as a result. If interest rates are neutral or going down, it typically means growth is slowing (as bond markets bring long term rates down in the expectation that central bankers will offer more lax monetary policy), and the currency tends to depreciate as a result.View Monetary Policy Reports
The following image shows the 30-Day Fed Fund Futures contract expiring Jan. 2007. This futures contract was taken 3 months before January 2007, when it was trading at 94.75. If you subtract the current price from 100 it tells you what the futures market expects the interest rate outlook to be. Since 100-94.75= 5.25%. The interest rate attached to the US Dollar at that time was approximately 5.25%, thus this suggests that futures market did not see an interest rate change in sight for the next few months. Translating this into a fundamental outlook, markets have priced in the likelihood that the US economy is slowing down or experiencing moderate growth - and that the central bank will not inclined to change rates in the next three months.
Jan 2007 30-Day Fed Fund Futures Contract
Chart from Aug 2006 to Nov 2006
How can you use economic indicators?
Economic Indicators can be broken down as follows:• Leading Indicators
• The Corporate Sector
• Manufacturing
• Unemployment
• Inflation
The reason you should care about economic indicators is because they drive the interest rate outlook. Remember, a growing economy can offer a higher yield. Let's see how they can be applied to develop a solid fundamental perspective on the US economy.
Leading Indicators 101
Leading Indicators are those that tend to change before the wider economy changes. They should give your fundamental analysis a forward-looking bias since they are the best gauge for what is shaping the economy.While there are many leading indicators, the US housing market is an excellent example. Building and buying a new home usually suggest extensive outlays (homes need to be constructed, financed and furnished), thus developments in the housing market usually precede developments in linked industries. Also the act of building and purchasing a home usually takes some time to complete, thus indicators like New Building Permits, Housing Starts and New Home Sales will usually precede the economic impact of what those reports measure. And since roughly 2/3rds of Americans own homes, the housing market has an inevitable impact on the economy.
The image below shows that the number of new homes being sold has declined since peaking in the summer of 2005. You can assume that this housing glut should eventually create a "trickle-down" effect & slow down consumers through lower consumer confidence and spending. As such, if the housing market is declining, its trend tends to be negative for an economy and currency, while a booming housing market tends to be beneficial.
View Leading Indicators Reports
Corporate America
While the consumer is key to the economy, the corporate sector is also important. If companies are making money, they are more likely to invest, expand and employ. From the graph below, you can see that US corporate profits have been on the rise up to 2007 and should be a positive boost to the economy. If the Corporate world is improving the economy it will also benefit the US Dollar and vice versa.US Corporate Profits
What to Watch for Manufacturing Most of the US economy revolves around the service sector (where less than a quarter of the US GDP relates to manufacturing), but because the manufacturing industry fluctuates far more than services, the majority of developments in GDP come from the manufacturing sector. Thus in forecasting the manufacturing industry fundamental analysts may better forecast the overall economy.
Trends in America's manufacturers are closely watched through a report called the ISM Manufacturing Survey. The survey evaluates several components of manufacturing in the US. But you do not need to look at the figures to get a bias from the reports. An ISM Report concluded, "It's apparent that manufacturing is losing momentum and feeling the effects of higher interest rates and a weaker housing market." You can easily interpret such an outlook into your fundamental analysis.
View GDP, Manufacturing and Production Reports
The Job Outlook
Attracting the attention of politicians, central bankers, and investors, job creation acts as the backbone of a healthy economy. Assuring US consumers of a healthy job outlook loosens the wallets of a consumer-driven economy. By loosening their wallets, new jobs create difficulties for central bankers who look for signs of tightness in the labor market that create inflationary pressure.Changes in The Monthly US Employment Report are more closely scrutinized than any economic figure. Financial Markets tend to focus on the number of new jobs created, referred to as Non-Farm Payrolls (NFP's), revisions for the previous NFP and the unemployment rate.
The image below shows a 3-month average of new jobs (NFP's) created. After declining from the first half of 2006, the 3-month average looks to be steady between 120-150K new jobs. In the FX Market if new jobs surprise to the upside with the actual figure higher than expected, the market quickly shifts in favor of that currency. Since faster growth means higher yields, higher NFP figures fare well for a currency.
The fundamental analyst combines the payroll gains with the unemployment rate to get a good assessment of the tightness of the labor market. A low unemployment rate combined with steady job growth can push wages and interest rates higher. You can see in the image below that the unemployment rate looks to be at a low and decreasing, which should be good for the US Dollar if it remains there. If the unemployment rate were to climb higher, it would be bad for the dollar.
View Employment Reports
Where Does Inflation Stand? Inflation is the result of a growing economy since businesses will increase their prices when consumers buy more. Central bankers weigh both inflation and economic growth when setting short-term interest rates. If they think inflation is above their comfort level, they will raise interest rates and vice versa.
Inflation is affected by supply as well. This sort of price pressure is most commonly seen in the cost for food and energy, making the prices paid for these goods less controllable and volatile. As such, they pose a concern to economists but are often removed from key inflationary figures.
The image below shows the Core Consumer Price Index (CPI), a figure followed by fundamental analysts to determine inflationary pressure. The Core CPI figure shows the change in price for consumer goods and services excluding the volatile components like food and energy. By looking at this figure, inflation appears to be rising. The bias would be to raise interest rates. Due to this correlation, higher inflation tends to be positive for a currency if it results in a positive interest rate outlook.
View Price, Wage, Spending and Inflationary Reports
Sentiment and Confidence - Why Care About Feelings?
The currency market is a living, breathing market driven by the choices of individuals. Sentiment drives the market by setting the tone you can attribute to an economy. Since the consumer is the backbone of the economy, reports suggesting consumer confidence give clues to consumer spending habits.Michigan Consumer Sentiment Survey below gives a numerical value for consumer's current and future expectations. Since the figure appears to be increasing, traders can conclude that consumers have a positive outlook. At the time, this increase was largely attributed to the decrease in gas prices right after reaching summer highs.
Put it All Together
As a fundamental analyst, you can make better decisions regarding the direction of the economy by knowing the current events driving the FX market. If central bankers are focusing on the housing market being important to their interest rate decisions, then reading about the housing outlook will be the best fundamental analysis you can do.Putting key fundamentals together will allow you to determine whether the economy is strong or weak. Together these fundamentals reflect the economic cycle as they show the way that growth changes as fundamental variables change. At the most basic level, these components show you whether a currency should be strong or weak. Now that you know the components, you can use them to decide where growth is according to the economic cycle below.
No comments:
Post a Comment