Fundamental analysis

What is fundamental analysis? 

This is a quite tricky type of analysis, which in addition to charts, you will need to employ news websites and financial calendars. The guiding principle of fundamental analysis is that any big news, political speeches, meetings of central bankers or various trade unions like the G-8, as well as published data on economic development and even, for example, an earthquake. All these events can affect what happens in your Terminal with various currency pairs. And they affect every other trading instrument. If you learn to identify these patterns you can likely predict the behavior of the national currencies of the countries where such events took place.

Where can I find information on economic events?

First of all, as we mentioned earlier, information on upcoming important economic events, published data on key indicators, as well as their descriptions and any market predictions made by financial analytics can be found on our calendar of financial events located on our website. Also note the calendar of holidays on the world's stock exchanges. During these holidays trading on that currency will be particularly active and occur in much smaller volumes.

What are the tools of fundamental analysis?

You really can’t get by without some tools to help you out – you can’t follow every piece of news and analyze every single world event. There are some good FOREX news services out there, like the like Dow Jones Tape, which displays a continuous stream of news reports and information direct from the various exchanges. This one-line stream of non-stop information tells you what people are saying in the market, what the major indicators are predicting, and what new data has been published (in real time). Also during speeches by political or economic leaders, you will see excerpts from them and each of these messages can have a strong impact on the currency. In General, this tape is very useful, and at times almost irreplaceable. This is an especially invaluable tool if you are thinking seriously about basing your trading on fundamental analysis. This service can be purchased on the official Dow Jones website. In addition to that, you can find daily analytics based on the principles of fundamental analysis on our website.

How do you trade on rumors, expectations and forecasts?

News can either be expected, i.e., those things we expect to hear about in the near future (summits, published data, financial reports, election results, etc) or unexpected (floods, acts of terrorism, interventions, political instability, etc). So, when certain news or events are expected, rumors and predictions will begin to surface. These may be in the form of analysts' forecasts, commentary from famous traders, large brokerages, insider information directly from the exchange or even messages that begin with words like “the rumor on the market is..." These rumors can be influential enough to cause the price on a certain instrument to go up or down.

For example, let’s say traders are waiting for news on whether the GDP of United States has gone up or down. Analysts are officially forecasting that this new economic data should be quite optimistic. Keeping it in mind traders start opening orders to buy dollars, so when the news breaks and the true movement of the GDP is known they can make money on the jump in prices. After all, the better the data which reflects the current financial situation in the country the more confident the currency becomes and the faster it grows in value.

Now let's take a look at three different scenarios. First - based upon rumors and expectations, dollar prices climb upwards, but when the actual GDP numbers are released, it’s still lower than the previous one. Expectations were not fulfilled and the dollar starts to fall sharply. If traders have time to close their orders to buy and open a selling order, that’s great, but everything happens so fast that many of them start to lose money.

Another scenario: the real value of GDP coincides with the forecasts, i.e., traders correctly predicted the direction of movement and the dollar’s price continues to slowly rise.

And the last scenario of events is most pleasant for traders that open a buy transaction based on rumors: the value of GDP turns out even better than expected and the price of the dollar increases rapidly. Traders refer to this as a “rally.”

Anyway, if the news runs against the current market trend, its effect on the behavior of the instrument’s price won’t last long. For example, if the price of dollar has been steadily growing all the week, the same negative GDP figures will only bring the price down for no more than a couple of hours, then, most likely, it will recover and continue to rise. But if the expected news not only supports the current trend, but exceeds all expectations, movement will continue in the same direction, only much faster. But, when the dust settles, a roll-back in the opposite direction is quite possible as many traders close their buy transactions, losing confidence in the further growth of the prices (they are too high). Usually, during a roll-back (also called a correction), the price falls about one-third of the distance from the start of the trend. Keep in mind that if the trend is strong and the price starts going up again, then this is called a "pivot point" and now might be a good time to open a transaction to buy (the same is true in the opposite direction – you would want to sell).

Here is an example of such a correction: look at the EURUSD pair in the H1 time-frame. At 01.02.2013, 18:00, a downward trend began that ends on 05.02.2013 at 18:00 by rolling back in the opposite direction about of third of the length of the trend, just like we explained previously.

In this case, the pivot point at which the roll-back began is 1.34651 (near the black candlestick with white) and the pivot point that marks the continuation of downward movement is at 1.35959 (near the white candlestick with black).

How does the market respond to the publication of indicators?

Look in the calendar of economic events. There you will see a large number of indicators, although working with them can be quite difficult at first. Therefore, it’s best to abide by two rules. The first is to trade with the trend, and the second is to open transactions when important new data is published. However, it is still important to understand all this in order to be successful at trading, so let's start with the basics. Once you understand the fundamental ways that currency prices react to changes in certain indicators and the release of certain news you will be able to understand and all the rest.

Of particular importance are news items relating to changes in the Base interest rate, Trade balances, Payment balances (Current Account/Balance of Payments), Gross domestic product (GDP), Gross national product (GNP), Retail sales data, Housing numbers (Housing Starts), Industrial production indices, Job creation outside of the agricultural sector (Non-farm Payrolls), Stock indices (DJI, DAX, FTSE, NIKKEY, etc), as well as the prices of government bonds (T-bills & T-bonds). If the new values of these indicators are better than in the previous period, i.e., their value grows, then the national currency of the country for which they are published will also go up.

At the same time, if the values of the following parameters from the list go up, then the price of the national currency will go down: PPI (Producer Price Index), Inflation indices like the consumer price index and the wholesale price index, Unemployment rates, Money supply data (M4, M3, M2, M1, M0 money supply), The retail price index, and Jobless claims amongst others.

But, be careful. In different economic environments with different combinations of indicators and currency news, the price may respond to these indicators in different ways. Be sure to keep this in mind - this is the complexity of fundamental analysis – you have to take everything into account.

How do you trade on the news?

Actually, it is quite difficult, because, as we have repeatedly stated, you have to take everything into account. Let's take a look at some examples that will help you understand the principles of trading using fundamental analysis.

To start, open the AUDNZD (Australian dollar to New Zealand dollar) currency pair in your Terminal. How will news affect this pair? If there are positive developments in Australia or negative ones in New Zealand, then the price for this pair goes up (AUD is strengthened), and conversely, if something negative happens in Australia and all is well and fine in New Zealand, the rate will fall (AUD is weakened and NZD gains momentum). Now that we understand that principle, let’s choose the M1 time frame and take a look at crosshair 06.02.2013, 23:45 (snapshot). Here you will see an interesting candlestick: the market falls sharply at first and then shoots upwards just as dramatically - and all occurs within one minute.

Why did this happen?

The answer can be found in the economic calendar: on February 6th at 23:45 several pieces of data regarding New Zealand were published. The first was the unemployment rate for the 4th quarter of last year. It was not as high as analysts had anticipated: they thought that would be 7.1% and, in fact it was only 6.9%. This is an important indicator: when unemployment declines it means the economy is beginning to improve. So, of one-minute period the AUDNZD currency pair went down in price as the New Zealand dollar began to strengthen. But then, after a couple of seconds, data is published on the number of jobs created per year and per quarter (Employment Change), which is also an important indicator, as well as the overall proportion of workers to the total population (Participation Rate). These new pieces of data are not only worse than previous values, but also worse than the forecasts analysts were making. That’s why, in the same minute that the price for the AUDNZD currency pair began falling, it made a dramatic reversal and shot upwards due to the fact that the New Zealand dollar started to lose its appeal. By the way, you will notice the exact same movement in the GBPNZD currency pair at the same point in time (snapshot).

By the way, if you look at another pair - the NZDUSD for February, you will see an absolutely identical candlestick, but in the opposite direction, i.e., black. This is reflection of how the NZD responded to the minute’s news and went down (snapshot). The same thing occurred with the NZDCHF and NZDCAD currency pairs (two snapshots).

Let's consider this point and the relationship between currency pairs: If a currency is in the first position, then when positive news comes out, the price for the pair will begin to grow. But for pairs where this currency appears second, the price will go down.

The situation that we described above can, in principle, be analyzed very quickly. The only tool you need for this is the economic events calendar. But if you look at the M30 time-frame for the EURUSD pair and go to February 7, 2013 at 14:30, you'll see seven candlesticks in a row at the bottom of the chart.

There are several reasons for this occurrence. First of all, at 14:45 GMT+2, it was announced that the Eurozone interest rate would remain unchanged, just as it did six months ago. Stability is not a bad thing. In fact, the base rate is one of the most important mechanisms with which economic conditions are governed. Commercial banks look to the Central Bank's target rate to set their interest rates on loans and deposits.

But because the interest rate remained unchanged, it was not the cause of this scenario. The cause actually lies in a speech made by Mario Draghi, the head of the Eurozone Central Bank, and the response to the speech from members present at that EU Summit. Draghi said that the euro’s growth wasn’t too bad and that it's a sign of returning confidence in the currency. But at the same time, some European politicians, led by the President of France, Francois Hollande, demanded the central bank's intervention to decrease the value of the national currency, because a "strong euro reduces the competitiveness of European products on the world market.” It was these words that provoked a flurry of orders to sell EURUSD. Then, a little later, at 15:30, positive data came out regarding the United States, which only added fuel to the fire and strengthened the confidence of traders that the black candlesticks would continue.

What aspects of economic policies affect the Forex?

The key issues of any economic policy can be described as inflation, unemployment, the base interest rate, the exchange rate, as well as the deficit or surplus in the state budget. In order to better understand the processes that take place in the market, it might be helpful to understand what happens to the economy of a given country when you change each of these aspects.

The interest rate and the inflation rate. The interest rate is undoubtedly a very important indicator of the state of an economy. When the central bank adjusts its size by increasing or decreasing the rate it stimulates private banks seeking to borrow, or vice versa, it can also limit their opportunities to borrow.

When the interest rate goes down money becomes more available, or cheaper, and currency’s value goes down. Now you can borrow from the government at that reduced percentage, which is what commercial banks and other businesses do. The result is increased business activity. However, if the interest rate is reduced, the total money supply starts to grow, and with it growing inflation and inflation indicators (different price indices). Because there is more money in circulation, demand starts to outpace supply and that is not correct. There must be balance. Consequently, to bring everything back to normal, you have to raise the prices of goods and services. And the rate at which prices grow is called the inflation rate.

At times when traders expect inflation figures to go pretty high, they start to sell the currency as soon as possible, so as to not get caught when the price begins to drop sharply. To prevent strong acceleration in inflation and balance the country's economy, the central bank will again raise the base rate, causing the value of the currency to start going up and as the currency rate goes up, inflation will begin to slow. Of course, the higher the interest rate, the less beneficial it is to the population as a whole. Higher interest rates cause credit to become more expensive, increase demand for goods, and decrease the amount of money in the hands of the people. Obviously, this is not the most desirable situation.

At the same time, an unchanged interest rate indicates a stable situation in the country, not good or bad, just stable. This means that the central bank does not currently consider it necessary to regulate economic processes globally. Every time the base rate remains unchanged, it’s important to pay attention to what is said during the meeting of the central bank. What arguments are put forward for keeping the rate unchanged and what are their plans for the future. It is statements like these that usually have a strong impact on the behavior of the national currency’s price. There is a direct correlation: optimistic forecasts and confirmations increase the rate and negative discussions are capable of greatly reducing the price.

Unemployment. This is perhaps the most burning question. Each of us, in one way or another, does not want to be left without work and without means of subsistence. At the governmental level, if the unemployment rate is soaring, then that means there are a lot more people that want to work than there are jobs. When people are out of work (usually it is a question of layoffs) they generally apply for government aid. Consequently, they do not bring any benefit to the state, produce nothing, do not provide any services and do not pay taxes. Social tensions begin to rise as people who have no income cannot fully consume the goods and services provided by other workers, because they don't have enough money for that. Hence the conclusion that the country’s economy is unstable and businesses, unable to pay their workers, reduced their staffing, start "tightening their belts.” This state of affairs certainly weakens the position of the national currency and it loses ground in relation to the other pairs. The main task of the central bank under these conditions is to prevent higher inflation, rising prices and interest rates. This is to ensure that the situation for companies improves and stabilizes so they can once again create jobs. Thus, there is a direct link: while unemployment is rising the Central Bank will not raise interest rates.

At the same time, the complete absence of unemployment is also a violation of the balance and leads to failure by employees to adequately perform their duties. They realize that nobody is trying to take their job and if they get fired they quickly find another one. Therefore an unemployment rate of 4-5% is optimum for developed countries.

Budget deficits. Here too we find an ambiguous situation. In fact, the short-term effect of the size of the deficit or surplus in the state budget for the national currency is minimal, but in the long term, the impact of this aspect can become rather noticeable. If you look at currency pairs where the dollar is in the first position (USDCHF, USDJPY, USDCAD) you will see in the monthly time-frame that the American currency has been essentially losing value since about 2001 and the main reason for this is the large budget deficit that is keeps on growing with every passing day.

A deficit basically means that state expenditures exceed its income, which increases the national debt, lowers the value of the national currency and causes inflation to rise. However, the government may choose not to raise interest rates, even in this situation. When a country has a high level of debt and a weakened financial sector, low rates can help prevent a chain reaction of bankruptcies. In order to keep these numbers in check, the United States Federal Reserve bank has held interest rates at close to zero levels since 2008, and sometimes even at zero, like in November of 2011. Thanks to these low levels, corporations and banks are able to service their debts, gradually returning the entire system back to normal. If rates do rise, then money will become more expensive and it will immediately increase pressure in the market, business and real estate sectors. Growing unemployment and an increasing number of defaults on loans, in the end, will lead to a general banking crisis.

This begs the question, how do you solve this problem at the state level?

The answer is that you solve it by reducing domestic spending (healthcare, education, government aid) – basically by reducing the amount of services that the government provides free of charge. Of course, the middle class can afford paid education or medical care, but the poor really suffer in these situations. Another solution is a tax increase, i.e., deduct money from the salaries of workers who are already suffering. If you implement both of these together, you will manage to offend the vast majority of the population.

Budget surplus. At the same time, a budget surplus is not always a good thing, because it often speaks to high taxes or small expenditures on the health, education and defense of the country. So again, there should be a balance in everything and even a budget deficit (not huge, but moderate – one that uplifts the country) is perfectly normal.

The exchange rate. With regard to the exchange rate, the cause lies in one of two things: either the national currency is too cheap or too expensive. If the exchange rate is extremely high (i.e., the currency is worth too much), it becomes unattractive for exporters from other countries that have trade and industrial relations with the given country to trade at such high rates. After all, the higher the rate, the more expensive the goods of that country. Of course, when this happens, other countries stop buying your country’s goods since it is no longer profitable and the government loses a substantial part of it’s income. If the currency is too cheap and the market share is not very high, then isn’t profitable for importers to bring goods into the country and sell them here for a small price.

That’s why the exchange rate is one of the key indicators that the central bank is required to monitor. Incidentally, the central bank can intervene in the Forex market. That is, it can make a major purchase or a sale of its national currency and thereby stabilize the situation.

How does a currency intervention work?

The amount of the transactions is usually in the millions or even billions of dollars. Sometimes interventions are called "infusions" of money into the market or in the opposite case - "withdrawals." These transactions are always unexpected and on the chart they look like sudden, huge vertical spikes going either up or down.

It all depends on intent of the central bank – whether it wants to raise the country's exchange rate or lower it. If there is currently too much currency on the market, it will be too cheap and the central bank will buy up the surplus. In this scenario, you’ll see the rate suddenly jump upwards.

The reverse situation occurs often enough as well. This is where the central bank sells currency to reduce its rates. In this situation traders will see a sharp vertical line going down. Typically, this is done in order to create more attractive conditions for export activities. In addition, these same actions are taken by banks in other countries. They often buy large amounts of euros and dollars in exchange for their currency to keep up their country's gold and currency reserves. One example of a currency intervention by the Bank of Japan can be seen on the daily chart for CHFJPY. On 15.09.2010 you can see a long white candlestick between 83.239 and 85.494.

How do you distinguish fake intervention from real ones? You must understand that interventions can be both real and fictitious. The difference between them is that in real interventions, the bank does actually enter the market and conduct, say, the purchase of currency and then publishes a report of its actions. A fake intervention is just a rumor that the bank may conduct a similar intervention. All the traders then jump into the market quickly open orders to buy, for example, to make dramatic profits from the jump in prices. However, the bank doesn’t actually do anything in these situations. The resulting price movement occurs due to the fact that a huge number of traders placed orders in one direction.

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