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.