The foreign exchange (forex) market has grown to be the most liquid financial market in the world. In its tri-annual survey last year, the Bank for International Settlements found the forex market is now trading more than $4 trillion in daily turnover, more than any other financial market.
While that size ensures plenty of liquidity, it also is an indication that there are many experienced professional forex traders who know what to look for (see "John Taylor: Definitely smart money").
While some trade forex based purely on technical analysis, Scott Boyd, currency analyst at Oanda, says that would be a mistake. "You always read about technical analysis vs. fundamental analysis. I don’t know why there’s this idea that you can only be one or the other. You have to be both and [the Middle East] turmoil illustrates that," he says. "There was no way of seeing that happening from a technical standpoint. You can’t ignore fundamentals; you have to pay attention to both."
Technical analysis can help with many trades, but there is a reason markets move when reports are released. So, to help any investor learning the ropes, we have compiled our list of the top five fundamental factors in the forex market.
1. Interest rates: Forex markets are complex and while there are many fundamental factors that affect their value, ultimately, interest rates and expectations of their direction are key. "I look at [interest rates] as the price of a commodity. Investors are going to try and access securities with the best return, weighing the risk implications as well," Boyd says.
Interest rates are directly controlled by a country’s (or region’s) central bank. Changes to a country’s key rate (the rate banks charge each other) are a central bank’s most powerful tool and have a significant effect on the currency.
Richard Regan, senior trader at TradeMaven, says even rumors of changes to an interest rate can produce dramatic moves in the forex market. "You’ll see a lot of activity when there are expectations for interest rates to change. When you look at countries that are talking about raising interest rates, everybody watches that very closely because any indication that their central bank is even considering a change can cause a drastic move in the currency."
Interest rate changes have taken on new meaning in the current economic environment and rate changes have been magnified in the forex market.
While interest rates are a general fundamental factor for currencies, they also provide the impetus for the carry trade where traders buy the currency from a country with a higher interest rate against the currency of a country with lower interest rates, earning the differential. The trade generally works, but can become oversubscribed, leading to massive reversals. Understanding the dynamics of the carry trade is a growing fundamental factor that is important to understand.
2. Employment: While the Federal Reserve in the United States has a dual mandate to stabilize prices and to promote full employment, that is not necessarily the case for other central banks. "Interest rates are directly controlled by central banks, but employment and economic growth aren’t necessarily under their control," Boyd says.
Employment numbers are a factor for two reasons. First, employment directly affects consumer spending. Second, that consumer spending affects inflation, which plays into central bank decisions on interest rates.
"As employment increases, you can expect consumer spending in the country to increase a bit. That’s going to increase your domestic demand and help with employment [further]. If it gets to the point where inflation is a concern, that’s when you’ll see central banks stepping in and raising interest rates to ease spending," Boyd says.
Consequently, employment can have an immediate effect on currencies while potentially providing a forecast of what a central bank may do.
3. Economic growth and trade: A lot of reports and outlooks factor into a country’s expectations for economic growth. While interest rates and employment numbers can point to those expectations, other reports also provide insight into where a country’s economy is headed.
"You can look at GDP, consumer price index, anything that shows inflation or growth. All those things add to the story," Boyd says. "If manufacturers are increasing their inventory, you can take that as a sign that they expect business to pick up in the [near future]."
According to Regan, earnings are an early indicator for an economy. "As soon as you start to see earnings improve, you know the economy likely is soon to follow," he says.
There are a number of reports that show these growth expectations, but some carry more weight than others. Boyd says the housing sector is one of the most important for determining future direction because the lag time is so great. "As houses come into play now, they’re not actually hitting the market for six months to a year. It definitely gives you some insight into where that sector thinks things are going," he says.
Trade is a key factor for many countries’ economies and although there are benefits to having a strong currency, a rising currency means that the cost of that country’s goods are rising against its competitors.
Central banks often will manage/manipulate their currency by selling it after it rises to an unacceptable level. China has longed pegged its yuan — much to the consternation of the last few U.S. administrations — to the value of the U.S. dollar, ensuring the cost of their goods do not rise relative to the dollar. And while the Japanese yen floats, the Japanese central bank periodically in the past has sold the yen when it became too strong relative to other currencies.
4. Geopolitical events/Acts of God: Forex markets are open 24 hours a day, five days a week. Consequently, they move fast when any news hits. "Exchange rates react much more quickly to geopolitical events than other forms of investing. Currencies are more volatile. It’s a 24-hour market that reacts very quickly to news and events," Boyd says.
These events include pretty much anything that couldn’t have been predicted such as war, civil unrest, weather situations or anything that causes uncertainty in an economy. "These are pretty broad-based [events]," Regan says. "Anything that is bad enough news on a geopolitical basis is going to have an impact on currencies."
Events in themselves do not move currencies; rather it is the underlying factors at play. The Libyan civil unrest is a good example of this. While the events are stark enough, the real fear in the market revolves around Libya’s oil production and, more importantly, regional oil production if it leads to contagion in the region, particularly to Saudi Arabia. If oil production is threatened, then oil prices must rise, which push gasoline prices. Consumers then must spend more on gas, leaving them less to spend elsewhere, which can lead to stagnation in the economy.
5. Commodity prices: Commodity prices affect currencies differently depending on the use of those commodities in each country. A lot of that depends on whether a country is an importer or exporter of a particular commodity (see "Follow the yellow brick road," below).
Crude oil prices typically are a good example of this. Canada is generally thought of as the currency to benefit most from rising oil prices because it exports so much oil. Alternatively, the United States often is hindered from rising oil prices because studies have shown that as gas prices rise, consumers cut spending on other discretionary items to make up the difference.
"[The Aussie and Canadian dollars] react most quickly to commodity changes. The impact that commodity prices have on other currencies is probably more from a demand side," Boyd says. "If demand is up, the Aussie and Canadian get that boost right away, but then it’s a matter of where that demand is coming from."
Currencies move for numerous reasons, ranging from central bank actions to weather disasters. It is important to remember, though, that exchange rates are always expressed in pairs, so you are always measuring pros and cons of two currencies.
One more thing to consider is that while currencies are measured by their relative strength vs. other currencies, they also are measured by their stability. The U.S. dollar has long been the reserve currency of the world. For all its flaws, even today, it is seen as perhaps the most stable currency; so when the global credit crisis hit the dollar rallied sharply. The dollar rallied on bad news because it was viewed as a safe haven.