Forex traders rely on fundamental and technical analysis the same way futures and equity traders do. The use of technical analysis in forex is much the same: price is assumed to reflect the fundamentals. But unlike companies, countries can print money.
Since fundamental analysis is about looking at the intrinsic value of an investment, its application in forex entails looking at the economic conditions that affect the valuation of a nation’s currency. Here we look at some of the major fundamental factors that play a role in a currency’s movement.
“Currencies move for numerous reasons, ranging from central bank actions to weather disasters,” says Nadia Simmons, forex and oil trading strategist at SunshineProfits.com. “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.”
Traders are typically attracted to the foreign exchange (forex) market by the relatively high leverage and 24-hour trading.
“Of course, high leverage is a double-edged sword: it can help boost traders’ potential profits, but also amplify losses,” says Matt Weller, senior technical analyst at Forex.com.
As long as traders limit their use of leverage, the currency market is particularly well-suited to newer traders, according to Weller. With forex, like futures, it is just as easy to sell as to buy.
The forex market also is much more liquid than any other market in the world, with more than $5 trillion in daily notional volume, meaning that it is often quicker, easier and cheaper to get into and out of trades than in other markets (see “A bigger playground,” right).
While that size ensures plenty of liquidity, it also is an indication that there are many experienced professional traders who know what to look for.
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. 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. “Without a doubt, central bank interest rates are the most important fundamental driver of the forex market,” Weller says. “All other fundamental data can be interpreted through the lens of central bank monetary policy.”
Weller adds that the next most important fundamental factors are inflation and employment because those are the two variables that central bankers focus on when setting monetary policy.
Higher-than-expected inflation readings are typically a positive factor for a developed market currency because rising prices make the central bank more likely to raise interest rates. On the other side of the coin, a weak employment report usually hurts the currency in question because it means the relevant central bank may be forced to cut rates.
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,” Simmons says. “When you look at countries that are talking about raising interest rates, everybody watches very closely.”
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 United States—to the value of the U.S. dollar, ensuring the cost of their goods do not rise relative to the dollar, though it has loosened the peg somewhat in recent years. And while the Japanese yen floats, the Japanese central bank periodically has sold the yen when it became too strong relative to other currencies.
Interest rate changes have taken on new meaning in the current economic environment. With much of the West stuck in a zero interest rate environment, forex volatility has dropped dramatically (see “What happened to forex volatility?,” below).
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. The trade generally works, but can become oversubscribed, leading to massive reversals. Understanding the dynamics of the carry trade is an important fundamental to understand.