FOREX ANALYSIS
Is the study of determining whether to buy, sell, or wait on trading a currency pair.
TYPES OF FOREX ANALYSIS
- Fundamental analysis
- Technical analysis
- Sentiment analysis
What is Fundamental Analysis?
Is the analysis that focus on looking at the forex market by analyzing economic, social, disasters and political factors that may affect currency prices. Fundamental analysis essentially informs traders and investors why the market advances and declines, and provides a trade decision: to buy, sell or trade flat.
Fundamental analysis is composed of three core elements:
- Central bank policies
- Economic indicators
- Geopolitical events
These three components working in harmony should translate to clearer market trends and present potential trading opportunities. If one of these areas is in disorder, interpreting a fundamental picture becomes difficult.
CENTRAL BANK
A country’s central bank is charged with the duty of regulating banking institutions and implementing monetary policies.
Everything begins with the central bank and they’re assessment of economic indicators. Traders and investors attempt to anticipate a central bank’s actions by evaluating economic indicators and reacting to the outcomes from the forecast.
The market projects a forecast for an economic indicator and subsequently responds to the actual figure released
There are eight major central banks today:
- US Federal Reserve Bank (FED)
- European Central Bank (ECB)
- Bank of England (BOE)
- Bank of Japan (BOJ)
- Swiss National Bank (SNB)
- Bank of Canada (BOC)
- Reserve Bank of Australia (RBA)
- Reserve Bank of New Zealand (RBNZ)
ECONOMIC INDICATORS
Economic indicators, as their name implies, are statistics often on a macroeconomic scale designed to measure economic activity. Traders and investors use these indicators to analyses the well-being of a country’s economy. Government organizations and private groups release several economic reports on a weekly, monthly and quarterly basis, each measuring activity in a particular segment of the economy.
Economic indicator data are released on economic calendar that trader and investor use to analyses the market. Example of economic indicators affecting forex market are
Gross Domestic Product (GDP): A measure of a country's economic output. Changes in GDP can indicate the strength or weakness of an economy.
Consumer Price Index (CPI): Measures inflation by tracking changes in the prices of a basket of consumer goods and services.
Unemployment Rate: Indicates the percentage of the workforce that is unemployed. Low unemployment rates are generally positive for a currency.
GEOPOLITICAL EVENTS
Geopolitical tensions can complicate technical analysis and fundamental analysis, distorting the general flow of key fundamental drivers in the market. However, absent of disruptive geopolitical events, trending markets become visible.
Geopolitics events are divided into wars and conflicts, terrorist attacks, floods, upcoming election, pandemic, political unrest and protest as well as international tensions. US-China trade is a good example and the ‘Brexit’ situation (United Kingdom exit from the European Union).
The announcements surrounding geopolitical issues are usually not scheduled, unlike the central bank announcements and economic data. As you can imagine, this may cause confusion in currency markets and make them difficult to trade.
Major Fundamentals that Play a Big Role in Forex Market
- Interest rate decisions by central banks
- Employment and Unemployment data
- Retail Sales
- Economic Growth (GDP)
- Inflation Report (CPI)
- Producer Price Index(PPI)
- Initial Jobless Claim
- Bank Holiday
- Non-Farm Payroll (NFP)
- Industrial Production Index
- Presidential Speech or Meeting
Interest rate decision
Interest rates play a significant role in influencing the forex market. Central banks, which control monetary policy, use interest rates as a tool to achieve economic objectives. Higher interest rates in a country can attract foreign capital seeking better returns, leading to an increase in demand for that currency. As a result, the currency tends to appreciate.
How interest rate affects the currency price?
Interest rate differentials between two countries influence exchange rates. Currencies with higher interest rates tend to appreciate against currencies with lower interest rates. Traders and investors seek to profit from interest rate differentials by borrowing in a currency with low-interest rates and investing in a currency with high-interest rates, a strategy known as the Carry Trade.
For example, if the interest rate in Country X is 6% and the interest rate in Country R is 3%, investors may borrow in Country R's currency at 3% and invest in Country X's currency, earning the 3% interest rate differential.
Note; Carry trade strategy comes with its own set of risks. In particular, if the value of the borrowed currency, known as the funding currency, strengthens against the currency being invested in, the carry trade can become unprofitable.
How do interest rate affects inflation?
Changes in interest rates affect inflationary pressures in an economy. Higher interest rates can help control inflation by reducing consumer spending and borrowing, thereby maintaining the currency's purchasing power.
By rising interest rate people start to save more, which will push down demand for goods and services and lead to lower prices. As demand for goods and services fall, this should have a knock-on effect on prices. Shops might even reduce the cost of goods to try to encourage people to buy them.
Lower interest rates may stimulate economic activity but can also lead to inflationary pressures if demand outpaces supply, potentially eroding the currency's value.
In theory, inflation and interest rates have an “inverse” relationship:
- When interest rates are low, inflation tends to rise
- When interest rates are high, inflation tends to fall
Employment and Unemployment change
Changes in employment and unemployment levels can significantly impact the forex market as they are key indicators of a country's economic health. Employment data is closely monitored by traders, investors, and policymakers, and it can influence currency values.
Increasing employment levels are generally associated with economic growth and higher consumer spending. As more people are employed, there is a boost in disposable income and consumer confidence. Strong economic growth and increased consumer spending can attract foreign investment, positively impacting the currency and vice versa is true.
Retail Sales
Retail sales data is a key economic indicator that can have a significant impact on the foreign exchange (forex) market. Retail sales reflect the total sales of goods and services by retailers to end consumers, providing insights into consumer spending patterns.
Positive retail sales data often leads to increased confidence in the domestic currency. As the economy appears strong, investors may favor the currency, leading to appreciation. Conversely, weak retail sales can lead to concerns about economic growth, potentially resulting in a weaker currency.
What is Core Retail sale?
An economic indicator that tracks the month-to-month increase or decrease in consumer spending excludes sales of automobiles and parts, gasoline, and building materials. By focusing on core retail sales, analysts can better assess the underlying trends in consumer behavior and purchasing power.
Gross Domestic Product (GDP)
Gross Domestic Product (GDP) is a fundamental economic indicator that measures the total value of goods and services produced within a country's borders over a specific period. As one of the most critical indicators of a country's economic health, GDP has a profound impact on the foreign exchange (forex) market.
High GDP growth rates are generally associated with a strong and healthy economy. When a country's GDP is expanding, it often leads to increased employment, higher income levels, and overall economic prosperity. A strong and growing economy tends to attract foreign investment, which can result in increased demand for the country's currency and contribute to currency strength.
Inflation Report (CPI)
The Consumer Price Index (CPI) is a crucial economic indicator that measures the average change over time in the prices paid by urban consumers for a basket of goods and services including food and energy. CPI is widely used to assess inflation, and its impact on the foreign exchange (forex) market is significant.
Traders in the forex market closely monitor CPI releases and compare them with market expectations. If CPI data deviates significantly from expectations, it can lead to market volatility. Speculators may adjust their positions based on the inflation outlook, affecting currency values.
How the CPI affects currency price?
High CPI may inspire interest rate hikes by a central bank in an attempt to control the inflationary trend. When a country’s interest rates are higher, it is likely that its currency will strengthen as demand for it increases.
Conversely, lower inflation may lead to decreased interest rates and weaker demand for a country’s currency, prompting consumers to spend, putting more money into circulation, and generally stimulating a slower economy.
What is Core CPI?
Core CPI stands for Core Consumer Price Index. It is a measure of inflation that tracks the changes in the price of a basket of goods and services over time, excluding food and energy.
The rationale behind excluding food and energy prices is that they tend to be more volatile and can fluctuate significantly due to factors like weather, geopolitical events, or changes in oil prices. By excluding these components, core CPI aims to provide a more stable measure of underlying inflation trends, making it useful for policymakers and economists in assessing the overall health of an economy and formulating monetary policy.
If core CPI comes in higher than expected, it may lead investors to anticipate tighter monetary policy in the future, which can strengthen the currency. Conversely, lower-than-expected core CPI may lead to expectations of looser monetary policy and potentially weaken the currency.
Producer Price Index(PPI)
The Producer Price Index (PPI) is a key economic indicator that measures the average change in selling prices that producers receive for their goods and services. The PPI tracks price changes for a wide range of goods and services at various stages of production, including raw materials, intermediate goods, and finished goods. It covers industries such as manufacturing, mining, agriculture, and utilities.
If the PPI shows a significant increase in producer prices, it may lead to expectations of higher consumer prices in the future, as producers may pass on these higher costs to consumers. In response, investors and traders may adjust their inflation expectations, which can influence currency prices. Currencies of countries experiencing higher inflation expectations may depreciate relative to currencies of countries with lower inflation expectations.
What is Core PPI?
Core PPI" typically refers to a subset of the Producer Price Index (PPI) that excludes food and energy.
Core PPI data is important for economists, policymakers, and investors because it provides insights into the underlying inflationary pressures in the production process, which can eventually affect consumer prices.
Non-Farm Payroll (NFP)
"NFP" stands for Non-Farm Payrolls. It is a key economic indicator released by the United States Bureau of Labor Statistics (BLS) on a monthly basis. The Non-Farm Payrolls report provides information about the total number of paid workers in the U.S. economy, excluding farm workers, government employees, private household employees, and employees of non-profit organizations.
The Non-Farm Payrolls (NFP) report is a key economic indicator released first Friday of each monthly in the United States. The Non-Farm Payrolls report has a significant impact on financial markets, particularly on currency, bond, and equity markets.
A higher-than-expected increase in non-farm payrolls is generally considered positive for the economy and may strengthen the U.S. dollar. Conversely, a lower-than-expected increase or a decline in non-farm payrolls may be interpreted as a sign of economic weakness, potentially leading to a weaker U.S. dollar.
Initial Jobless Claim
Initial Jobless Claims is a key economic indicator in the United States that provides insights into the labor market's health. It measures the number of individuals who have filed for unemployment benefits for the first time during a given week.
A decreasing number of Initial Jobless Claims is generally interpreted as a positive sign for the labor market and the broader economy. It suggests that fewer individuals are losing their jobs, indicating economic health and stability. Conversely, an increase in jobless claims may signal economic challenges, potentially leading to negative sentiment in the forex market.
Fundamental analysis is often complemented by technical analysis, where traders analyze historical price charts and patterns. Successful forex traders typically use a combination of both approaches and stay informed about economic indicators and events that can impact currency markets. It's essential to note that the forex market is dynamic, and factors influencing currencies can change rapidly, requiring traders to stay vigilant and adapt their strategies accordingly.