Fundamental Analysis

Fundamental analysis is a way of looking at the forex market by analyzing economic, social, and political forces that may affect the supply and demand of an asset.
If you think about it, this makes a whole lot of sense! Just like in your Economics 101 class, it is supply and demand that determines price, or in our case, the currency exchange rate.

Using supply and demand as an indicator of where price could be headed is easy. The hard part is analyzing all of the factors that affect supply and demand.

In other words, you have to look at different factors to determine whose economy is rockin’ like a Taylor Swift song, and whose economy sucks.
You have to understand the reasons of why and how certain events like an increase in the unemployment rate affects a country’s economy and monetary policy which ultimately, affects the level of demand for its currency.
The idea behind this type of analysis is that if a country’s current or future economic outlook is good, their currency should strengthen.
The better shape a country’s economy is, the more foreign businesses and investors will invest in that country. This results in the need to purchase that country’s currency to obtain those assets.
In a nutshell, this is what fundamental analysis is:

For example, let’s say that the U.S. dollar has been gaining strength because the U.S. economy is improving.

As the economy gets better, raising interest rates may be needed to control growth and inflation.

Higher bank profit rates make dollar-denominated financial assets more attractive.
In order to get their hands on these lovely assets, traders and investors have to buy some greenbacks first. As a result, the value of the dollar will likely increase.
Later on in the course, you will learn which economic data points tends to drive currency prices, and why they do so.

You will know who the Fed Chairman is and how retail sales data reflects the economy. You’ll be spitting out global interest rates like baseball statistics.

But for now, just know that fundamental analysis is a way of analyzing the potential moves of a currency through the strength or weakness of that country’s economic outlook. It’s going to be awesome, we promise!

Unemployment Rate

Categories Economic Indicators

Definition

The unemployment rate is basically the percentage of the people in the work force without jobs but is able and willing to work. It is measured by getting the ratio of unemployed people who are willing and able to work versus the total number of people in the work force.
It is important to discern between people who are unemployed and those who are simply not working. Some people may be studying, working from home, handicapped or retired. These people are not part of the work force and are not included in the unemployment rate.
Importance:
The unemployment rate is considered as a lagging indicator. This means that it only changes after the underlying economic conditions of a nation have already changed. The unemployment rate could cause moderate market volatility because it provides traders clues about future interest rates and monetary policies.
Market Impact:
Lower than expected unemployment rates tend to appreciate currencies because traders believe that it could lead to higher interest rates. Alternatively, greater than expected unemployment rates could weaken currencies as it is expected to lead to lower interest rates.

Central Bank Intervention

Categories Other

Definition

Currency intervention occurs when one central bank or more buys (or sells) a currency in the foreign exchange market in order to raise (or lower) its value against another currency.
Why Intervene?

Intervention usually happens when a nation’s currency is undergoing excessive downward or upward pressure from market players – usually speculators.
A significant decline in the value of a currency has the following drawbacks:
# Raises the price of imported goods and services and triggers inflation. This will push the central bank to raise interest rates, which will likely hurt asset markets and economic growth. This could also lead to additional losses in the currency.

# A nation with a large current account deficit (buys more goods and services than it sells from abroad) that is dependent upon foreign inflows of capital may undergo a dangerous slowdown in the financing of its deficit, which will require rising interest rates to maintain the value of the currency and, could risk serious repercussions on growth.

# Pushes up the exchange rate of the nation’s trading partners and drive up the price of their exports in the global market place. This will also trigger serious economic slowdown, especially for export-dependent countries.
Looking at the other side of the coin, central banks also intervene to stem excessive appreciation of their currency, which makes exports less attractive and weighs on the balance of payments.
Means and Forms of Intervention:
Foreign exchange intervention takes several shapes and forms. Here are the most common:
# Intervention. Also known as “jawboning”. This occurs when officials from the Ministry of Finance (Treasury), central bank or other politicians “talk up” (or talk down) a currency. This is either done by threatening to commit real intervention (actual buying/selling of currency), or simply by indicating that the currency is undervalued or overvalued. This is the cheapest and simplest form of intervention because it does not involve the use of foreign currency reserves. Nonetheless, its simplicity doesn’t always imply effectiveness. A nation whose central bank is known to intervene more frequently and effectively than other nations is usually more effective in verbal intervention.

# Operational Intervention. This is the actual buying or selling of a currency by a nation’s central bank, usually on behalf of the Finance Ministry or Treasury.

# Concerted Intervention. This happens when several nations co-ordinate in driving up or down a certain currency using their own foreign currency reserves. Its success is dependent upon its breadth (number of countries involved) and depth (total amount of the intervention). Concerted intervention could also be verbal when officials from several nations unite in expressing their concern over a continuously falling/rising currency.

# Sterilized Intervention. When a central bank sterilizes its interventions, it offsets these actions through its monetary policy practices (open market operations or interest rate targets adjustments). Selling a currency can be sterilized when the central bank sells money market instruments (short term securities) to drain back the excess funds in circulation as a result of the intervention.
FX interventions only go unsterilized (or partially sterilized) when action in the currency market is in line with monetary and foreign exchange policies, i.e. when the case for intervention is urgent. This occurred in the concerted interventions of the “Plaza Accord” in September 1985 when G7 collaborated to stem the excessive rise of the dollar by buying their currencies and selling the greenback. The action eventually proved to be successful because it was accompanied by supporting monetary policies. Japan raised its short-term interest rates by 200 bps after that weekend, and the 3-month euroyen rate soared to 8.25%, making Japanese deposits more attractive than their US counterpart.
Another example of unsterilized intervention was in February 1987 at the “Louvre Accord” when the G7 joined forces to stop the plunge of the dollar. On that occasion, the Federal Reserve engaged in a series of monetary tightening, pushing up rates by 300 bps to as high as 9.25% in September.
Impact on Currency Markets:

Before listing the determinants of a successful FX intervention, it is important to define “success”. Thus, a central bank that spends about $5 billion (medium-size) on intervention and manages to raise/lift the value of its currency by about 2% against the major currencies over the next 30 minutes is said to be successful. Even if the currency ends up losing its gains over the next two trading sessions, the proven ability of that central bank to move the market in the first place gives it some kind of respect for the next time it “threatens” to step in.
# Size Matters. The magnitude of the intervention is usually proportional to the resulting move of the currency. Central banks equipped with substantial foreign currency reserves (usually denominated in dollars outside the US), are those that command the most respect in FX interventions. As of Q3 2003, the three central banks with the highest amount of FX reserves were: the Bank of Japan ($550 billion); the Bank of China ($346 billion) and European Central Bank ($330 billion).

# Timing. Successful FX interventions depend on timing. The more surprising the intervention, the more likely it is that market players are caught off-guard by a large inflow of orders. In contrast, when intervention is largely anticipated, the shock is better absorbed and the impact is less.

# Momentum. In order for the “timing” element to work best, intervention is more ideally implemented when the currency is already moving in the intended direction of the intervention. The large volume of the FX market ($1.2 trillion per day) dwarfs any intervention order of $3-5 billion. So central banks usually try to avoid intervening against the market trend, preferring to wait for more favorable currents. This may be done through verbal posturing (jawboning), which sets the general tone for a more fruitful action when the actual intervention begins.

# Sterilization. Central banks engaging in monetary policy measures in line with their FX actions (unsterilized intervention) are more likely to trigger a more favorable and lasting change in the currency.
Implications for Traders:
# During central bank interventions, currency traders are advised to take extra care when submitting orders and selecting stop losses.

# It is not advisable to trade against the currents of intervention. A single sell order by a central bank for instance, could trigger a series of stop loss orders by players that will exacerbate the selling and create gapping in the market. If you insist on trading against the market, then your stop loss orders must be somewhat closer to your positions than at normal market conditions.

# Be aware of levels of support. It is near these points (usually below them) at which central banks step in to lift currencies.

Employment Report

Categories Other

Definition

The Employment Situation Report is released on a monthly basis. It includes a basket of employment reports such as the Unemployment rate, Average Hourly Earnings, and the Non Farm Payrolls report. The Non Farm Payrolls report is arguably one of biggest market movers in the Forex. If you are looking for a report that creates a lot of volatility then this is the one for you!
What exactly is the Non Farm Payrolls report? What does it measure?
Formal answer: The Non Farm Payrolls report, or NFP for short, is actually part of the Employment Situation report which also includes the Unemployment Rate, Average Hourly Earnings, and Average Workweek Hours. The NFP seems to get the most attention because it measures the actual number of paid employees (full and part time) in the business and government establishments.
BabyPips answer: The NFP basically tells us whether the labor market is shrinking or expanding. In other words, it will let me know how good my chances are of getting hired as a male model for SuperHot Modeling Agency, Inc. If the NFP has been growing then it means the labor market is hot, and my chances of getting hired are good. However, if the NFP has been declining then my chances of being a male model are ”not” good and my dreams of walking down that runway would probably be shattered. Of course it could also be my ugly exterior thats holding me back….NAH!
So why does this report tend to move the market so much?
”Formal answer:” The NFP along with the other reports included in the Employment Situation give traders a way to gauge the future direction of the economy.
”BabyPips answer:”Everyone” watches this report closely. Because everyone watches it closely, it moves violently no matter what the report actually says. However, since the Employment Situation covers everything from the number of workers to how much they’re making, it makes this report a powerful tool for "guessing" where the economy is headed. For example:
If the labor market is growing, that means more people are making money. The more people that make money, the more spending there will be. More spending results in a higher GDP, and GDP my friend, is the broadest measure of the economy.
Ok so how does the Employment Situation report affect the Dollar?
Basically if the Employment Situation is positive (growing NFP, lower unemployment rate) then it’s also positive for the Dollar. On the other hand if the Employment Situation is negative (decreasing NFP, higher unemployment rate) then it’s also negative for the Dollar.
This report sounds like a lot of fun to watch. When does it come out?
The Employment Situation report comes out on the first Friday of every month.
Additional Resources for the NFP:
http://www.bls.gov/ces – Employment Situation Historical Data

Employment Cost Index

Categories Economic Indicators

Definition

The Employement Cost Index (ECI) is generally considered to be one of the most comprehensive measurement of labor costs and their growth rate and as such, it is said to signal changes in wage inflation.
Importance:

The impacts of the data can herald changes in interest rates, as shown by larger than expected increases on the prior results, which may cause interest rates to rise. Large growth rates in the ECI also increase the likelihood for an increase in the Federal Funds Rate.
Background:

The Employment Cost Index is closely watched by many sectors, including the Federal Reserve and those involved in the currency markets as it accurately measures changes in labor costs for monetary based wages such as salaries, but also reflects changes in non monetary forms of wages such as common fringe benefits occurring in private industries. These factors are measured for both public sector workers as well as those employed in state and local governments jobs, and takes into account at all levels of responsibility.
While the overall influence on currency markets and foreign exchange rates may be considered at times uncertain, high wages inflation generally leads to higher overall inflation and eventually a loss of competitiveness. However, it can also lead to higher nominal level in interest rates which would tend in the end to strengthen the exchange rate.
Source:
U.S. Department of Labor, Bureau of Labor Statistics
Frequency:
Monthly
Availability:
Last week of the month following the prior quarter to which it refers.
Additions:
None.
Links:
http://www.bls.gov/news.release/eci.toc.htm Bureau of Labor Statistics Official Website – Employment Cost Index

Federal Reserve

Categories Central Banks

Definition

The Federal Reserve of the United States, commonly known as the Fed, is the organization responsible for monitoring and maintaining the United States currency supply. Established by Congress in 1913, the Fed is composed of a Washington D.C.-based Board of Governors, twelve large regional banks, and a number of smaller affiliated institutions.
The Federal Reserve of the United States has a number of methods for influencing the American money supply. Chief among these is the power of the Fed to increase or decrease the amount of currency in circulation. The Fed can purchase or sell government securities to its primary traders, which brings additional Federal Reserve Notes into circulation or removes excess paper money from the supply. The Fed also works with the U.S. Mint to print additional paper money, or to destroy unneeded currency.
Another of the Fed’s financial powers is its ability to influence the short-term interest rate. The Fed does this by changing the default rate at which it loans money to fellow banks. Since the Fed’s default rate is one of the major factors in determining the nationwide prime interest rate, the Fed’s actions can indirectly increase or decrease the yield from interest-accruing assets. This in turn plays a role in determining investor behavior, and the trends of the market as a whole.
In more detail, the rate that the Fed lends money to depository institutions is called the Discount Rate. That is set above the ”nominal rate” which is the rate that the depository institutions lend money to each other to meet reserve requirements at the Fed. The nominal rate is what is commonly known as the Federal Funds Rate. It is set by open market operations.
Since the money supply is a factor in determining the overall trade balance between currency markets, foreign exchange traders who work with US currency tend to keep a close eye on the actions of the Federal Reserve.
Janet Yellen is the current Chairman of the Federal Reserve System.
Links:
The Federal Reserve Official Website