Fundamental analysis is the analysis that examines economic, political and social indicators to predict the economic health of a nation through help of various news, information’s and tools like economic calendar which helps you stay updated on the happening of the global economies. Currencies can be viewed as the international representative of national economies; it follows, therefore, that economic health is an important component in currency valuation. The fundamental analyst constructs forecast models based on a myriad of different indicators to predict future currency movement.
This section outlines a number of theories and indicators—as well as political dimensions and monetary considerations—that are important in constructing Forex forecast models.
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Purchasing power parity
The absolute purchasing power parity (PPP) theory is based on the “law of one price”, which states that identical goods will have the same price in two countries when the exchange rate is at equilibrium. Price disparities between two identical commodities can be exploited by international arbitrageurs, who capitalize on the imbalance for profit, and in so doing push the market towards equilibrium. In practice, it is difficult to find two countries in which there are competitive markets for an identical product of identical quality, without the added cost of trade barriers, tariffs or transportation costs.
Relative PPP predicts national inflation rates to determine if particular currencies are over/undervalued. For instance, if the inflation rate is higher in the US vis-à-vis Switzerland, the market will adjust the currency values to reflect the reality. This is, again, an opportunity for traders who analyze inflationary indicators in search of profit potential.
The gross domestic product
The gross domestic product (GDP) is the total value of all the goods produced within national borders during a certain time period. The GDP determines the pace at which a national economy is growing or recessing. The equation to determine GDP is: consumption+investment+government spending+ (exports-imports). Consumption is by far the largest component, totaling approximately 2/3 of GDP. Quarterly GDP reports are broken into three announcements—advance, preliminary and final. After the final revision, GDP is not revised again until the July annual benchmark revisions. These revisions can be quite large, and affect the previous five years of data.
Personal income and personal consumption expenditures report
The personal consumption expenditures report (PCE) is the largest component of GDP. It indicates the change in the market value of all goods and services purchased by consumers.
Personal income is the total value of income received from all sources including workforce compensation, proprietors’ income, income from rents, dividends and interest and transfer payments (Social Security, unemployment and welfare). The difference between consumption and income is called the savings rate.
The personal income and consumption report, released at 8:30 EST on the first business day of the month, has become a significant economic indicator. While personal income and savings are not in and of themselves extremely important to financial markets, trends in personal income growth and the size of the savings rate can indicate future consumer spending patterns, which directly affect the GDP.
The balance of trade is the difference between national imports and exports over a certain timeframe. A quarterly trade report provides early clues into net export performance, which is indicative of strengthening competitive positioning, an indicator of coming economic growth. Import reports can help to measure domestic demand and consumer spending patterns, but the lag of this report relative to other consumption indicators renders it somewhat unimportant.
The leading indicators report is a compendium of previously announced economic indicators: new orders, job claims, money supply, average workweek, building permits and stock prices. Therefore, the report is extremely predictable and of little interest o the market.
The index of industrial production gauges the change in the nation’s industrial output and measures capacity utilization (an estimate of the percentage of factory capacity being used). The 85% capacity mark is perceived as a key barrier over which inflationary pressures are generated.
Durable goods orders
The durable goods order report measures new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods: products which last for an extended period of time (at least three years). Durable goods data offers insight into demand and business investment, and the durable goods orders report is considered a leading indicator of manufacturing activity, the largest component of industrial production.
Institute for supply management (ISM)
The ISM releases a monthly index of manufacturing conditions compiled from numerous industry reports and surveys. Financial markets are extremely sensitive to unexpected ISM changes, because the index is a good predictor of inflationary pressures; indeed, the Federal Reserve keeps a close watch on the index to help determine interest rate policy.
Housing starts measure the number of residential units for which construction has begun in the previous month. The housing sector is very interest rate sensitive, and a sudden jump in housing starts usually indicates that interest rates have reached a peak.
Single family home sales
The single family home sales report is a demand side indicator of housing sales. Sales are highly dependent on mortgage rates, and tend to react with a few months lag to rate changes. Sales will usually be highest after a recession, as pent up demand is released
Producer price index
The producer price index (PPI) measures price changes in the manufacturing sector. There are three broad subcategories within the PPI, which are generally used for economic analysis: crude intermediate and finished. The market tracks the finished goods index most closely, as it represents prices of goods ready for sale to the end user. The market places emphasis on the ‘core rate’ basket, excluding food and electricity, which are quite volatile and might obscure inflationary trends.
Consumer price index
The consumer price index (CPI) measures the average price paid by consumers for a specific basket of goods. The CPI is calculated by averaging the price changes of all the components of the basket in order to determine inflationary trends. It is the benchmark inflation index.
The employment report
The employment report is comprised of the household and establishment surveys. The surveys produce non-farm payrolls, average workweek, and average hourly figures. Together, these two surveys make up the employment report, the most timely and broadest indicator of economic activity released each month.
The household survey
is primarily used to indicate the unemployment rate. The rate is calculated by dividing the number of unemployed by the number of people in the workforce. The unemployment figure is quite volatile due, in part, to the small sample size of the survey—roughly 60,000 households. It is useful to crosscheck the household survey results with the labor and employment figures to determine whether changes are truly representative.
The establishment survey
measures productivity of the workforce. The most important component of the survey—and indeed, in the entire employment report—is non-farm payrolls. Non-farm payrolls measure the number of non-agricultural workers in the national workforce. The monthly changes in payrolls can be extremely volatile from one month to the next. However, aside from large swings and the possibility of rather substantial revisions to previous data, non-farm payrolls offers the most comprehensive and extensive snapshot of the economy.
There are two more important indicators in the employment report that bear mentioning: the average hourly earnings and average workweek figures. The average hourly earnings figure not only offers an indication of personal income growth, and consequently a possible indicator into future spending patterns, it also offers evidence of inflationary pressures. The number of hours worked by the non-agricultural workforce is an important determinant in both industrial production and personal income.
Unit labor cost
Non-farm productivity and costs measures worker productivity in relation to the cost of producing a unit of output. During times of inflationary concern, the unit labor cost index in this report can move the market. If productivity is falling, unit labor costs may be rising faster than hourly earnings, which could lead to unemployment.
Initial jobless claims
The Initial jobless claims report measures the number of filings for state jobless benefits. This report provides a timely, but often misleading, indicator of the direction of the economy. Due to the week-to-week volatility of jobless claims, many analysts track a four week average to get a better picture of the underlying trend. It typically takes a sustained move of at least 30,000 claims to signal a meaningful change in job growth.
The retail report extrapolates consumer spending patterns from total receipts from sample stores from different regions and product markets. Data is revised three months back, and changes can be quite substantial. Comprehensive benchmark revisions take place once every five years with the release of the Census of Retail Trade.
Employment Cost Index
The employment cost index (ECI) is a quarterly U.S. Department of Labor report measuring workforce compensation in more than 500 industries across the entire United States, in all states and major metropolitan areas. Like the average hourly earnings report, the ECI can indicate inflationary pressures, as increased production costs are eventually passed on to the consumer.
The consumer confidence index (CCI) measures the confidence consumers have in the economy, presently and in the future. There is a direct correlation between consumer confidence and spending—the future expectations portion of the index is generally viewed as a better indicator of future consumer spending patterns than the current conditions section.
The University of Michigan consumer sentiment index is almost identical to the CCI, but is twice monthly, in a preliminary and final reading.
The auto and truck sales report measures the monthly sales of all domestically produced vehicles. Big-ticket sales, such as motor vehicles, are interest rate sensitive, making the motor vehicle sector an important indicator of the state of the business cycle.
Chain store index
The U.S. Retail Chain Store Sales Index tracks spending at major chain stores that fit into the general merchandise, apparel and furniture category based on a representative sample of seven large retailers on a weekly basis. Though the report has little to say about broader consumption patterns, it possesses market importance as an early indicator of consumer spending, particularly during key sales seasons like December and August.
Governmental factors are vital to fundamental analysis. Changes in governmental monetary or fiscal policy—or political crises—will generate changes in the economy, which in turn affects the exchange rate. This is particularly evident in interest rate manipulation.
Interest rates An interest rate increase adjusts the interest differential in the favor of the representative currency provided that there is no parallel increase in the interest rate of the currency partner. For example, if there is an interest rate hike in the United States and no change in Japanese interest rates, the dollar will strengthen against the Yen. If in England, however, there is a similar interest rate movement, the USD/GBP currency pair will remain unchanged.
Political crises constitute the x factor in Forex trading. Unforeseen political turbulence or events can trigger sharp currency movements, leading to a sharp decrease in trade volume. The pip spread can, within seconds, widen by dozens of points. Unlike predictable political events, political crises strike quickly and traders must react quickly to avoid big losses.