The Basics of Fundamental Analysis

In this section we will examine the various economic indicators released by the governments, central banks and statistical agencies of nations. We’re not going into which indicator is what (although we will do that later), but our goal is to show you the interactions between the various data, and how the fundamental factors influence economic events and trends in currency trading.

Nonetheless, the information provided here would prove to be extremely useful to all kinds of traders, regardless of the market they are most active in, because in the globalized and highly integrated financial markets of today, it’s impossible to think of one market segment being isolated from others. This is an excellent article for beginners seeking to understand how money supply, interest rates, industrial production, unemployment statistics, balance of payment and more fundamental factors affect currency valuation.

Before beginning, let us note that the most important driver of a currency’s value is the main rate set by the central bank controlling the supply of the currency. Central banks are the only source of coins and banknotes, they also decide on the price the cheapest loans that nations can make. In a healthy, growing economic environment, higher interest rates will lead to currency appreciation, while lower rates will cause depreciation.

Fundamental analysis in forex aims to measure supply and demand for a particular currency. Supply and demand of course depend on a large number of factors, but at the most basic level, they are related to the amount of money that is out there. Thus, we need to first characterize the concept of money supply, and by understanding it and examining how it’s influenced by fundamental changes in a nation’s economy, we can understand how and why a currency appreciates. We can then turn our knowledge into profit.

Money supply

Money supply is a measure of the amount of money circulating in a given nation’s currency. It’s not only paper money or coins, but also bank deposits, repossessions, money market fund accounts and other forms of financial activity. The basic principles behind its calculation are very simple, and the data is provided by government sources on a regular basis. We won’t go into the details of how and why money supply is important in the calculations of central banks here, but we can safely say that regardless of the school, the character and history of the institution in question, money supply always plays an important role in determining interest rate policies and consequently, currency prices.

The coins and bank notes part of money supply

In modern economies, money has different forms, but in fact, it can be characterized as any sort of legal medium for borrowing and lending. We’re most used to regarding money supply (and therefore the supply of a currency in the global markets) as being largely represented by coins and banknotes (known as M1 in technical parlance), but in fact, the total amount of money that can be used to expand borrowing greatly exceeds the supply of coins and banknotes, because the modern banking system allows financial institutions to lend values that are multiples of the actual cash they hold in reserve. So the reader must keep in mind that the following discussions are mostly about M1, the coins and banknotes part of money supply. Otherwise, we’d have to incorporate interest rates to our discussion, which would complicate the subject unnecessarily.

The calculation of money supply varies among central banks, and the importance attached to this particular indicator also differs. The trader need not know the intricacies of all the calculations, but perhaps understanding the basic principle is necessary. If you can do basic arithmetic, such as division, multiplication and addition and subtraction, this will be child’s play for you:

M*V = P*Q or M*V=GDP

The simple equations above state that the total quantity of money (M) multiplied by the speed of circulation of money (“How many times does money change hands?” = V) is equal to nominal GDP, that is, the average price of all goods and services in an economy (P) multiplied by their quantity (Q).

First, notice how important this equation is. In essence, it allows us to relate the quantity of money to the GDP of a nation (which is easily measured), and as the quantity of money is of utmost importance to us forex traders (because it directly influences supply and demand), it’s clear that we must understand this concept well.

The concept of money supply – an example

So let’s illustrate the concept of money supply with a very basic example.

Suppose that John bakes a loaf of bread, and that Jane, John’s customer, has 10 dollars issued by the central bank of Sampleland. Jane pays 10 dollars for John’s bread. Then, John exchanges the 10 dollars which he received from Jane with Rich, who has written and owns one paperback book, also priced at 10 dollars. In short, Jane pays John, who pays Rich.

P (average price of the goods) is 10 + 10/2 = 10 (it’s easy, because both the bread and the book are 10 dollars.)

M (total amount of money in circulation) = 10 (we only have a ten dollar bill in circulation in our example)

Q (quantity of goods) = 2 (one loaf of bread, and one book)

V (the speed or velocity of the circulation of money) = 2 (because our ten dollar bill changed hands twice, once from Jane to John, and then from John to Rich)

M*V=GDP then, the GDP of Sampleland is 20 dollars.

To understand the significance of money supply (denoted by M), let’s see what happens if the central bank of Sampleland were to decide to issue 20 dollar bills, instead of the 10 dollars in our example. What would happen? Supposing that the denizens of our imaginary nation have no savings and don’t save, all the new money would replace the 10 USD bills, and the GDP of the nation would be:

20*2 = 40.

But hold on there! How can the GDP of Sampleland increase when the amount produced is still constant? Remember that we still have only one loaf of bread, and only one paperback book changing hands. So we can’t help but conclude that Sampleland is suffering from inflation, with prices going up, while productivity remains the same.

Increasing money supply increases inflation

As we see in the example above, money supply has a direct bearing on inflation. If the speed of money circulation remains the same, and the productivity of a nation’s economy is stable (that is, the number and quality of the products are unchanging), we find that the new money issued by central banks to temporarily boost economic activity would inevitably create inflation. Thus, central banks always keep money supply statistics in mind when making interest rate decisions. Nonetheless, money supply is only a single one of the determinants that cause prices to rise or fall, and factors such as overall economic health, employment, status of the banking system and many others play a very important role in determining price trends.

What is the significance of money supply for a forex trader?

First, all things being equal the currency of a nation with a faster money supply growth will tend to depreciate against that of a nation with slower growth. This is the simple result of supply and demand: The more of a currency in the supply, the less value it will have. Nonetheless, the market is very reluctant to punish a currency on increasing money supply, if, as we’ll soon examine, the productivity and economic production of a nation are healthy and expanding.

Second, contraction in money supply can often be a sign of major problems in a nation’s economy. Such contractions usually lead to interest rate reductions, and in a healthy global economy, cause the currency to depreciate. Conversely, broad money supply growth (termed M2) in the high single digits in developed economies, and in the double digits in emerging markets, is a sign that the economy is booming, and interest rates may need to be increased as a result. In a healthy, growing global economic environment, this would lead the currency to appreciate.

Industrial production and capacity utilization data are regularly released by the Federal Reserve in the United States, the Eurostat for the Euro area, and for Japan by the Ministry of Economy, Trade and Industry. These statistics measure the amount of production by a nation’s factories. For instance, in the US, the Fed’s methodology measures the production, capacity, and capacity utilization of US miners, manufacturers and utilities.

The industrial production and capacity utilization trend is important

The data is released monthly and revised frequently, so the trader should always keep in mind that the picture painted by the latest releases may be quite different from the underlying trend that will emerge after the eventual revisions. In other words, buying or selling anything in response to the minute changes in the value of this indicator can hardly be considered trading on the basis of fundamental analysis. But the trader’s analysis will benefit greatly from identifying the trend of the data, comparing and confirming it with data obtained from other sources, and eventually evaluating the health of the manufacturing sector and the economy in general.

Let us remember that all activity in an economy is dependent on credit. Thus, industrial activity is often anticipated by developments in the financial markets. If banks are apprehensive that their credit losses will rise as a result of contraction in economic activity or their own faulty practices, they may refuse to provide the financing that manufacturers need for expanding or just staying in business.

The opposite may also be true: If the industrial sector, for whatever reason, is in danger of going through a major wave of bankruptcies, even a financial sector that is fundamentally healthy may be imperiled by the losses generated. It’s always important to recall that economic events occur as a result of constant interaction between the various actors, and a one-sided analysis is prone to be erroneous.

Now let’s go back to our example of Sampleland, and see what happens when industrial production contracts or rises, and how the value of this indicator impacts inflation, and consequently, interest rates and monetary policy which are of utmost importance to us as currency traders.

We had said that the central bank of Sampleland had decided to expand money supply by 100% by circulating 20 dollar bills, or adding another 10 dollars to the 10 already existing. In our equation, the result was

M*V = 20 *2 = GDP

In other words, we had a doubling of nominal GDP, without doubling our production capacity or our actual production, and ended up with 100% inflation.

Now let’s say that John the baker, and Rich the publisher, both increase their industrial capacity and production by producing two of the items that they were producing in our previous example. What will happen to the prices, and inflation?

M (total amount of money in circulation) = 20 (we now have twenty dollars in total in circulation)

Q (quantity of goods) = 4 (two loaves of bread, and two books)

V (the speed or velocity of the circulation of money) = 2 (because our dollar bills still changes hands twice: once from Jane to John, and then from John to Rich)

P*Q = M*V, that is P = MV/Q, and so, P = 20*2/4 = 10

What do we find here? The prices are back to where they should have been, and our inflationary problem has evaporated altogether. By matching money supply growth with actual growth in production, we were able to avoid inflation, which means that the currency of Sampleland will not have to depreciate against those of other nations.

We will return back to this subject later, as we examine central banks and interest rate decisions.

Unemployment statistics

Apart from the methodological differences in the measurements of different institutions, unemployment statistics measure what they are named after: Whether the economy is gaining jobs or losing them; how long the unemployed must search before finding a job; the demographic aspect of unemployment trends, and a number of other issues which are useful to policy makers, but not as much to traders.

In the US the unemployment data are updated weekly and monthly through the publication of non-farm payrolls and weekly jobless claims. Non-farm payrolls measure the payroll changes of non-farming related firms, including both the government and private sector, while weekly jobless claims report on the applications for unemployment benefits. It’s important to note that the BLS in the US tends to underestimate job losses during the beginning of a recession, and job gains during the beginning of a period of boom.

Read more on how the non-farm payrolls data influences the forex market.

Why are unemployment numbers so important for both policy makers and market participants? Because, as creators of economic activity, consumers — be they scientists or construction workers — have a very important role in determining the velocity component of the money supply equation we discussed before. The fewer actors there are in an economy, the slower the velocity of money will be. And, all else being constant, slower velocity will lead to slower GDP growth, and even stagnation.

In a consumer-oriented economy, such as the US economy of past decades, the detrimental impact of high unemployment is even greater. Since such an economy depends on consumption to a much greater extent than an economy dependent on trade, government spending or tourism, higher unemployment is sure to create longer-lasting and deeper problems.

In our example above where we discussed the role of money supply and its relationship to GDP, we can discuss the impact of unemployment by increasing the number of actors. Some of the additional characters we could add would be able to produce additional products, and their employees would later start their own businesses, all adding up to the GDP of Sampleland. Conversely, when firms lay off workers, some of the demand created by circulation of money would disappear, causing some of the producer firms to become bankrupt, eventually contracting the GDP.

In a positive employment environment, John and Rich’s firms would each have to enlist additional workers, the Central Bank would have to issue additional dollar bills to make sure they’re all paid (increasing the money supply) and John and Rich would have to create more products so that their new employees would be able to satisfy their cravings for food and education. All that would naturally lead to an increase in GDP, and would eventually lead to even greater prosperity, as some of the more innovative workers would start their own firms, and create even more products for consumption.

The significance of high unemployment for forex traders lies in its relationship to the interest rate policies of banks and economic decisions of politicians. In general, high unemployment is a very good leading indicator for the depreciation of a currency, because central banks respond to the development by lowering interest rates, and governments respond by borrowing more, which all lead to greater supply of the underlying currency, versus others.

Central Bank Interest Rates

This is perhaps the most important data released by news agencies, and it’s loudly trumpeted all over the world on TV screens, radios, and the Internet. The interest rates that central banks set define the cost of the cheapest money available in an economy. Since the central bank is the major source of all currency and related credit in a system, the rates that they set basically decide the availability of credit to all kinds of end-users: consumers, firms or banks. Interest rates are perhaps the single most important indicator that influence currency trends, because:

1. Interest rates directly influence money supply and velocity of money by increasing or reducing the quantity and cost of borrowing in a financial system. Thus, even if there’s no major economic change taking place, the central bank can control the value of its currency simply by modifying its supply (the money supply). A good example of this kind of direct and intentional tempering with a national currency is seen in the actions of the Central Banks of major exporter nations in Asia, such as Japan, Singapore or China.
2. Interest rates define the competitiveness of a currency in attracting excess cash that cannot be channeled to business or investment, but must somehow be utilized to create returns. For example, the enormous amounts of forex reserves accumulated by exporter nations such as China or by commodity producers such as Saudi Arabia or Russia, all have to be channeled somewhere else, because the depth and complexity of the domestic economies of these nations does not allow them to create good returns. By offering a high interest rate on dormant money, so to speak, the central bank creates an attraction center for the excess cash floating around, which creates money inflows to its currency, which causes the currency to appreciate.
3. Domestically, as we already hinted, interest rates determine the dynamism of a nation’s economy. Currency traders of all sizes, including giant banks, can position themselves to participate and profit from a nation’s economical upswing by purchasing that nation’s assets, creating demand for the nation’s currency and causing it to appreciate. The anticipation of such an upswing or downswing, is often dependent on central bank interest rates.

We studied all the different data such as money supply, industrial production and unemployment statistics, which brings us to the subject of interest rates. One of the most successful methods for profiting in forex is using interest rate expectations to anticipate a trend, and then acting on it. All the precautions and notes in the previous part are of course valid, and the trader should be wary of bubbles and market delusions.

How can a simple trader suceed?

Now, of course, at this point the reader will ask: How can it be possible that I, a humble trader with limited resources, be able to anticipate what a learned, well-educated central banker will do, who has access to data of far better quality and quantity than I do?

It may seem counter-intuitive, but in fact it’s quite possible to do that, and the frequency of success is far greater than the “humble trader” would expect. How so? Because central bankers and politicians are in fact very far from being the impassionate, realistic, careful actors that good traders are.

Mr. Bernanke’s testimony hinting that the recent crisis is contained; his insistence in the summer of 2008 that inflation is a danger; the suggestions of the German Economics Minister in the autumn of 2008, that Germany is in no danger of going into a recession; the bubbles of Mr. Greenspan; Mr. Putin starting a war heading into a major global economic crisis; the Turkish prime minister’s suggestions that the Lira would eventually stabilize, are just drops in the ocean of all the blunders of policy makers throughout history.

Since all these people are emotional, biased and base their expectations and predictions on their wishes and dreams, the impartial trader is perfectly capable of beating them at their own game, identifying their lies (or lack of judgement), and capitalizing on his own predictions. The key here, of course, is humility: the trader should be ready to change course once facts contradict him, unlike the politician or the theorist who will instead attempt to rationalize his failures by ever more complex explanations.

What kind of factors lead central banks to change their rates?

Modern central banks are increasingly moving towards inflation targeting as the main guidance of their interest rate decisions. The ECB, Bank of Canada, Reserve Bank of Australia, and central banks of South Africa, South Korea and Turkey among others, use inflation targeting as their policy compass in setting rates. Since in this model a single indicator carries overwhelming importance, the central bank has less leeway in deviating from its legally stated goals without losing credibility, and its actions are in general more predictable.

In inflation targeting, the central bank simply attempts to steer the inflation rate to a legally mandated target percentage rate set out by the lawgiver.

Some other central banks, mostly located in Asia and in the Middle East, use a fixed exchange rate, or a floating or fixed currency band as their main gauge in setting policy rates. Examples of this are Singapore, Saudi Arabia, China and Taiwan. Almost all of these nations are exporters, and they aim to keep their products competitive by controlling the value of their currency against the currencies of their major trade partners. In other cases, political considerations can play a major role, and most Gulf States in the Middle East are examples.

In the US, the Federal Reserve is thought to attach great importance to inflation statistics in determing policy, but it’s constrained by its “dual mandate” of contributing to price stability and low unemployment. In practice, the Fed is heavily tilted toward maintaining unemployment low, and it’s actions are slightly less predictable as a result.

Regardless of the principles of the central bank in question, inflation always plays a crucial role in determining the direction of central bank policies. But regardless of the rhetoric employed by central bank officials while communicating their goals, they can never be completely insensitive to the expectations and demands of politicians, business leaders and the consumers in general.

Thus, as we examine the historical record of central banks in setting interest rates, we find that they attach much greater value to healthy GDP growth and economical buoyancy, and are therefore slower to react to booms and busts. In examining interest rate trends, the trader should keep inflation in focus during times of healthy economic growth, but in times of economic slag, he should more or less disregard it in favor of unemployment statistics and money supply growth values. Central banks would not be willing to suffer high unemployment or anemic money supply growth for long periods of time, and under such circumstances rates are highly likely to come down; even more so if the political leadership of a nation lacks vision and discipline.

How can the trader use interest rate changes and trends to make long term investments in a currency?

The key to making successful investments in the forex market lies in the ability to isolate “noise” from data relevant to our analysis. The trader should regard the patchy economic data coming from a country as being parts of a whole, and he should only make decisions once he’s able to construct the whole from the incoming pieces of information.

We have already stated that central banks are the main setters of borrowing costs, and as a modern economy functions on credit, interest rates are by far the most important drivers of forex trends. But we are not speaking of periods of weeks after rate changes are announced, nor are we speaking of months.

The time period during which the effects of interest rate changes are felt ends only at the time when central banks reverse the policies in action. In other words, economic activity buoyed or contracted by central bank policies tends to compound its own effect in time: The effect of a change in policy will last as long as the financial intermediation system comprised of banks, money market funds, hedge funds and others is functioning. The rate change is not a one-off event, but it’s effective throughout the time period during which the central bank maintains it.

Now, once we understand that the supply of a currency is determined by interest rates, and that interest rate changes have effects that are continuous over the period of time determined by central bank policies, we are ready to construct a currency strategy. We have not yet discussed the role of current account and balance of payments on currency trends, but even without them, we can build a preliminary strategy that’s likely to work well for us in a globalized, free international economic environment: The trader simply sells a currency of which the central bank interest rates are low and stable, or going lower still, and buy another where the rates are high and stable, or going higher.

This is termed the carry trade, but in fact pure carry traders are but a fraction of those who employ this method on a grand scale. Instead, while the retail trader will buy the high yielding currency and be content with the interest income over a period of time, the larger, more important and sophisticated actors like commercial firms, hedge funds or banks will use the currency they buy to fund investments in the economy that they are entering.

They will open factories, buy stocks, buy out local firms and engage in a great deal of activity with the aim of participating in the nation’s boom. This kind of circulation can eventually create a self-sustaining feedback loop of continuous profit for those who are participating in it, but is also greatly prone to creating bubbles. Nonetheless, the carry trade is an excellent way to exploit interest rate trends for profit in the currency market as long as the trader is aware of the perils of this strategy and remains alert on the health of the economy of which he’s holding the currency.

Read more on carry trading.

Balance of Payments

Simply put, the balance of payments is the balance sheet of a nation. Current account, capital account, and the trade balance are all parts of it. What use are they for the forex trader? It’s just as important as a company balance sheet is (or should be) to the stock trader: They are the most comprehensive measure of a nation’s economic health. Let’s examine the components of this important item:

The trade balance is the most basic component, and it’s simply the difference between the goods and services imports and exports of a nation. A positive value signifies a surplus, while a negative value means that the nation is importing more than it can sell. The trade balance is a part of the current account.

Current account is the sum of the trade balance with two items added, called net factor income, and current transfers. Net factor income is simply the cash return from a nation’s firms’ subsidiaries, worker remittances, income on royalties or licenses, rent on foreign property owned, and so on. Net transfers constitutes in- or outflows that are unilateral, such as aid. A positive current account suggest that the nation is on net generating more forex inflows than outflows, and is associated with central bank reserve accumulation. Negative current account suggests that the nation is in need of additional foreign currency to be supplied by the other part of the balance of payments, the capital account.

Capital account is a general term for the change in ownership of a nation’s assets, such as real estate, factories, stock and bond ownership, bank accounts and loans, and so forth.

Let us first define this in a dialogue. B is a beginner, and ST is a successful trader.

B: What happens if a nation’s goods exports such as computers, cars, clothing are less than its imports?

ST: The gap should be closed by services exports, such as tourism.

B: And what if tourism revenues are not enough to close the gap?

ST: It will register a trade deficit, which means that the nation is unable to pay for its imports with revenue from exports only. It will finance the gap with other items of the current account

B: Such as?

ST: The net-factor income. If the nation’s imports are more than its exports (it buys more than it sells), the deficit maybe closed by items such as worker remittances, income on royalties or licenses, rent on foreign property owned, and the like. Net-factor income includes all other sources of cash flow except trade. The poorest nations, with negligible net-factor income, depend on international transfers (such as aid) to finance their trade deficits.

B: And if net-factor income is also insufficient to meet the trade deficit?

ST: Then the nation has a current account deficit, which is the unpleasant situation where cash flow of a nation’s operations (very much like a corporation) is unable to meet its expenses. This situation will, under normal circumstances, cause currency depreciation.

B: Is there a way to finance the current account deficit?

ST: Yes there is. As we just mentioned, if the nation cannot meet its expenses through, trade, aid or external transfers (such as the royalties or worker remittances that were discussed), it can choose to sell its assets, such as real estate, government bonds or bank accounts. Remember, with a current account deficit, the nation is unable to pay for what it’s buying through various channels. This gap is closed by the nation, in essence, selling itself, its skyscrapers, bonds, stocks and any other asset that constitutes capital. Of course, the nation can simply borrow to sustain the deficit, and the borrowed funds arrive in the shape of international loans or foreigners depositing funds in the nation’s banks for interest income.

B: So the capital account is useful for current account deficits. I’d like to ask though, is it possible that the capital account not only meet, but exceed the current account deficit? What happens when there’s such a surplus?

ST: It’s possible. In that case, the cash in excess of the current account deficit will go to central bank reserves. It means that the nation is selling its assets faster than the deficit it is accumulating through the current account side of the balance of payments.

B: Is there any disadvantage or pitfall associated with capital account financing the current account?

ST: Yes, because it’s probably not a good idea to sell your income-generating assets. More importantly, when a nation sells assets to finance its day-to-day operations, it’s financing temporary expenditure with long-term assets. In other words, it’s like mortgaging or selling the house and living on rent, in order to buy a washing machine or refrigerator. Does it sound smart?

B: No.

ST: Current account deficits can create currency shocks, because as soon as the foreign buyers’ appetite worsens, the nation can only depend on its currency reserves. If they’re not sizable, a currency crisis will follow.

B: And now, please tell me, how do the current account, trade balance or balance of payments lead a currency to depreciate or appreciate?

ST: Sure. In a nutshell, just like any individual or corporation, a nation has to balance its balance sheet. Its expenditures and liabilities most cover each other. If at any level of the external balance (be it a current account or trade balance), the deficits cannot be financed by inflows from another source, the nation will either have to print money as Zimbabwe does (at the time this article was written), or offer higher relative interest rates to attract foreign currency deposits, which it can use to cover its expenditures.

B: And how does this lead to currency depreciation?

ST: This depends on the global economic environment. In an environment of risk tolerance where global economy is growing, unemployment is low or falling, and there’s a lot of dormant money (accumulated through trade surpluses or speculation), the higher interest rates that a cash-squeezed central bank pays can cause the underlying currency to appreciate, which is nonsensical, but as long as profits are made, there’s no problem. Remember, anything that pays a high interest rate is risky, and risky assets are in general priced lower. So the currency of a high-interest rate nation appreciating is always temporary.

If, on the other hand, risk tolerance is low, global economy is slowing, and there’s a lot of uncertainty about the future, with dormant money going to reserve currencies or other hard assets such as gold, the high interest rates will be useless, and the currency will depreciate.

B: Can you explain directly why the currency depreciates?

ST: In the worst-case scenario, the central bank will have to increase the money supply by printing cash, but usually through manipulation of the lending channels (causing more money to change hands). And of course, as money supply grows with no growth in productivity, depreciation and/or inflation will follow. Since we are discussing forex and the deficit is external, the result will be depreciation, as discussed in the previous chapter on money supply.

B: So you say, in short, that we should always keep in mind the general global economic environment before deciding on how dangerous a current account deficit is.

ST: Yes.

Further reading:

See all our articles on fundamental analysis.

Read more about fundamental forex factors.

How to use fundamental analysis to profit in forex.