Introduction
The term fundamental analysis is very widely used, but what does it actually mean? The definition of fundamental includes:
The foundation or base, forming an essential component of a system and something of great importance.
There are also musical, religious and scientific definitions of fundamental but its definition in relation to the FX market is quite specific – it is the study of the underlying factors that drive a currency’s price. In the FX market these underlying factors include the economy, central banks and politics.
We use fundamental analysis in the forex market to help us answer a few basic questions related to these factors, for example:
The forex trader making use of fundamental analysis takes the answers to these questions and applies them to the decisions they make when placing a trade in the forex market. To explain how this is done I will work through some real-life examples of how to trade using fundamental analysis later in the book.
Trading using economic data
The way to get the information needed for fundamental analysis is to look at the official economic data releases. For most of the world’s major economies, economic data is released regularly and it gives a glimpse of the overall economy and how fast it is growing. The key thing for me is that economic growth means future prosperity, which should then equate to a strengthening currency. Traders seek out growth because that is usually where the best opportunities lie to jump on an uptrend. Alternatively, economic data showing weakness in a country’s economy has the effect of weakening the currency.
The markets have a tendency to price in future growth and prosperity. The forex market, like the stock market, is thought to price in future growth expectations up to six months in advance. Hence markets don’t wait for the GDP release that comes out every three months before deciding on the direction of a currency; they react to the incremental flow of data from economic indicators throughout the month in anticipation of what that means for GDP and the overall health of the economy.
In addition to GDP the other indicators include inflation data, retail sales, industrial and manufacturing data, and data on consumer confidence. These are a timely update on the state of the economy and the occasions of their release can be major market-moving events.
In fact, there are thousands of economic indicators and it could make you dizzy if you tried to analyse them all and determine what they mean for growth. As an example of some of the kookier ways of measuring economic growth, some people may look at the hog market to try and detect Chinese consumption of pork and use that to deduce the strength of the Chinese economy. Others have been known to search out demand for a certain chemical found in paint and then try to apply that to demand for housing in the US.
Thankfully there are more accessible ways to understand what is going on from an economic perspective and for some people it is most effective to narrow the list down to a few key indicators. It is also possible to prioritise the indicators so that you can organise your analysis and know which to pay most attention to. I will now move on to introduce the economic indicators that I have found to be of most use in my own fundamental analysis. Before I do, a couple of words on finding economic data.
Use of an economic calendar
It is important to know when economic data is released and the easiest way to get this information is by using a calendar. You can get reliable up-to-date calendars on economic news websites like Bloomberg (www.bloomberg.com/markets/economic-calendar), some blogs have them – like Forex Factory (www.forexfactory.com), and the financial press often prints economic calendars at the start of each week. Also, ask your FX broker as they may provide you with a free calendar. Some even contain widgets that let you place orders or trade directly from the calendar.
Consensus
The key thing for traders to remember is that the actual data that comes out is only relevant based on whether it hits, misses or exceeds consensus. Consensus is an important word for the markets. Usually economic data calendars include the market’s expectation of the data release. The expected number is the mean of estimates from a number of economists who have been polled prior to the event and asked to give their views on what the number will be. Reuters and Bloomberg are some of the most popular data providers that measure the street’s expectations prior to major data releases.
As a general rule, a data miss (the figures released are worse than the forecasts) can be currency negative, a number around expectations usually has a negligible effect, and if the reading exceeds expectations this tends to be currency positive.
Economic indicators
In this section I introduce the four major fundamental indicators that I use to assess the forex market. These are:
For each I explain what the indicator is, when it is released, why it is significant and give examples of how it can be used.
1. Labour market surveys
What is it?
Without a shadow of a doubt the most important economic statistic for me is the US nonfarm payrolls (NFP) report. It is published by The Bureau of Labor Statistics and measures the number of jobs created in the nonfarm sector of the US economy each month.
When is NFP data released?
The first Friday of every month.
Why is NFP data significant?
American labour market statistics are important because they give an idea about the confidence of American businesses for the future. If a company believes growth will be strong for their product or service going forward they will hire more workers to meet the expected increase in demand. If they think demand is going to contract they will reduce their employee numbers.
Hiring by firms also has an impact on consumer confidence. If people have stable jobs then consumer confidence should be high and they will spend money, whereas if people are losing their jobs the first thing they usually do is cut their spending. Since consumption makes up 70% of the US economy (a level that is far from unique in the West) and jobs are a key component of whether or not consumers are spending, you can understand why the market is so obsessed by this indicator.
NFP data has an enormous impact on all financial markets. Currencies can move more than they customarily would on any normal day and it’s not unusual for the major dollar crosses to move a couple of hundred pips in either direction. Stock markets across the globe are also on high alert. Due to the huge amount of volatility that this data can generate, many traders in Asia and Australia stay awake or get up in the middle of the night to place a trade.
FX market example
Lots of people trade before, during and after nonfarm payrolls, and for some of the major FX brokers it can be their busiest day of the month. But I will let you in on my secret: I don’t trade the NFP release.
A colleague of mine used to sit patiently looking at his Bloomberg terminal on NFP Friday, as the payrolls report is called by the street, and when the number was released he looked at it, digested it and went about doing something else. He chose not to trade the actual figure itself.
This is an important lesson to all traders – economic data like the NFP can produce extremely volatile movement in the markets so some people prefer to wait for the dust to settle and trade when they have a better idea of what effect the NFP data has had. I follow this strategy (or non-strategy) over an NFP release.
Figure 1.1 shows you how volatile the immediate aftermath of an NFP release can be. I have chosen to show the impact the August 2012 data (released on 6 September) had on EURUSD, but it has a similar effect on USDJPY, AUDUSD, GBPUSD, etc. This was the EURUSD’s initial reaction to a disappointing payrolls number; the forecast was for a 130k gain in the number of jobs created, but the reality was that only 96k were created and this was considered a disappointment.
The data was released at 13.30 BST and the initial reaction was that the euro sold off sharply, dropping from 1.2650 to 1.2590 in a matter of seconds. It then meandered lower to 1.2570 before rebounding strongly to 1.2650 – back to where it started! – before the end of the London session. This shows you how erratic the market can be during this data release.
There are many reasons why the market can be so erratic on NFP Friday. Firstly, NFPs are one of the earliest releases each month and they are a bit like a new piece of the US economic jigsaw. Since the economy in the US is a complex beast, new information about its strength or weakness can cause shock waves in the financial markets, particularly the FX market. Secondly, hundreds of billions, if not trillions, are being traded during the release, which also causes excess volatility.
Figure 1.1: EURUSD on NFP Friday (6 September 2012)
In the above example it would have been so easy to get caught on the wrong side of that trade. NFP data can be particularly hard to predict so rather than take a bet on whether the number will beat or miss expectations, I wait it out.
Instead my trading strategy for NFPs is more long term. I do two things immediately after the NFP release:
On this occasion the data miss was extremely significant as it rounded off a week of bad economic data from the US. This data added to the body of evidence that the US economy was slowing down and would need some help from the US central bank to get going again (see the interest rate section for more).
Since central bank stimulus in the past has been dollar negative, I decided to put on a long EURUSD trade at 1.2650. Some may argue that I bought at the high of the day – how can that be a good trade!? – but in Figure 1.2 you will see that EURUSD rallied a staggering 400 points in the week after the NFP data was released. The circled area shows where I entered the trade, on 6 September 2012.
Figure 1.2: EURUSD (6 September to 21 September 2012)
2. Purchasing Managers Index (PMI) and Institute of Supply Management (ISM) surveys
What is it?
Purchasing Managers Index (PMI) surveys in Europe and China, and Institute of Supply Management (ISM) surveys in the US, are arguably the second most important pieces of economic data after NFPs.
They are useful for the currency trader for a couple of reasons. Firstly, they are used around the world and are not just US centric like payrolls, thus they can be a good gauge of global growth. Secondly, they are a snapshot of business sentiment in a wide variety of areas like exports, new orders and inventory levels. The results can be used to predict hiring patterns and also the strength of consumer demand.
PMI and ISM surveys originally focused on the manufacturing sector but as the manufacturing surveys evolved and grew in popularity they have expanded to the services and construction sectors. Each country’s PMI survey polls hundreds of domestic businesses on the level of new orders they have received, order backlogs, shipment orders, the prices they pay for materials, employment, new export orders and imports.
In the euro zone the fusion PMI Composite index is an important indicator of the overall performance of the currency bloc’s economy.
These surveys are conducted around the middle of the month before the data is released. The result is a diffusion index that measures expansion or contraction in service and manufacturing businesses. These indexes have values between 0 and 100, with 50 acting as the line between expansion and contraction. A strong release is above 50, a weak result is below 50.
When is the data released?
Usually the first week of every month (the exact day depends on each country). China and Europe do things differently and release first and second readings of their PMI surveys. The first reading is usually the third week of the survey month; the second reading usually takes place the first week of the next month. However, check your economic calendar as sometimes the timings can differ.
Why are they significant?
These surveys tend to have a close relationship with GDP data and are a timely signal of the growth (or lack of) in an economy. As I mentioned at the start of the chapter, the currency trader is always looking for where growth is strong and also where it is weak in order to find the best opportunities to go long or short a currency. ISM and PMI surveys provide this information.
FX market example
The actual PMI and ISM data releases can be good economic data to trade, in contrast to payrolls. For my part, I find it easier to read them. The index is either strong (above 50) or weak (below 50). Revisions are only relevant for the euro zone and China and they tend to be small, thus this is a well-respected and reliable gauge of economic strength or weakness.
When I trade the actual data release I tend to follow these steps:
A negative surprise in euro zone PMI data
Figure 1.3 shows EURUSD after the release of a weak preliminary reading of the September 2012 PMI data. The survey was below 50, which dashed hopes that the euro zone’s struggling economy was starting to recover. This weighed heavily on EURUSD. As you can see this cross fell from 1.3040 all the way to 1.2920 in the aftermath of the news.
Although the euro recovered some of the losses during the next day’s trading, this data is significant for the direction of the euro in the long term. The continued weakness in the euro zone economy could make some traders think twice before they put on a long euro trade in the coming weeks as the economic fundamentals look too weak to support the currency at a higher level.
Figure 1.3: EURUSD (20 September 2012)
GBP is also sensitive to PMI data releases. Let’s take a closer look at the UK’s October manufacturing PMI release on 1 November 2012. There are two ways to trade this piece of data:
Here is a trade set-up for trading the actual data release.
Figure 1.4: GBPUSD short-term chart
Remember that trading around the data release can be volatile and extra risky, so this is usually a short-term strategy. A longer-term trader may prefer to trade once they have digested the release. However, in this example that would have only been profitable for a couple of weeks. In mid-November market sentiment shifted as risky currencies like the pound started to rally and the trend changed (see Figure 1.5).
Figure 1.5: GBPUSD 1-month chart
3. Inflation data
What is inflation data?
Inflation is an important part of a country’s economic picture. Fundamental traders should always know what direction inflation data is moving and the pace of change for the economies of the currencies they are trading.
There are two types of inflation to look out for: CPI (consumer price index) data and also PPI (producer price index) data. The CPI data measures price changes paid by the consumer at the supermarket, shopping centre, etc. The PPI data measures the change in prices of items as they leave the factory gate.
There are also two components to the inflation picture to be aware of: headline and core prices. Headline inflation includes the price of food and energy, while core inflation strips food and energy prices out. Some central banks prefer to focus on the core measure as it is considered more stable. This is because energy and food prices can be extremely volatile – for example, the price of corn or vegetables can be impacted by a freak weather pattern that causes their price to soar one month over the next. This could cause a big spike in headline inflation, but it is likely to be a temporary phenomenon (hence the volatility).
Central banks don’t want to change the direction of monetary policy based on a single factor affecting the price of corn, or any lone item, so they look at the core inflation rate instead, which is considered to be a smoother measure of price changes and trends in the economy.
When is inflation data released?
Inflation data is usually released in the middle of each month, but it does depend on the country. The euro zone, UK, US and China tend to release inflation data monthly, while Australia and New Zealand release it quarterly.
Be sure to consult an economic data calendar so that you know the date and time of these releases.
Why is inflation data significant?
Changes in price data are an important way to determine the state of the economy. Usually falling prices mean that activity is slowing, which can be currency negative, while rising prices can mean that the economy is expanding, which can be good news for a currency.
Inflation data becomes interesting when it gets to extreme levels. So if a country’s prices are deemed to be rising too fast it may cause the central bank of that country to adapt its policy to try to get the prices back under control. Central banks like steady increases in prices, and if prices rise or fall too quickly they usually react. This can have implications for the direction of currencies (see the section on interest rates to find out more).
FX market examples
Example 1: US inflation and USDJPY
While a single inflation data point may not be a major market moving event, its change over time can have huge implications for monetary policy and thus the direction of a currency. Figure 1.6 for the period late 2010 to summer 2012 shows core inflation in the US and also USDJPY. As you can see, as inflation rises it tends to mean a strong USDJPY rate. In contrast, when inflation started to fall in spring 2012 it dragged USDJPY down with it.
The trend in inflation does not follow the currency cross perfectly, as you can see in this chart, so this data point is better for the long-term trader with a multi-month view. If you are a short-term trader, make sure you keep up to speed with inflation data and which direction it is going, but it will be harder (if not impossible) for you to trade off inflation data alone.
Figure 1.6: US inflation and USDJPY (late 2010 to summer 2012)
Example 2: Chinese inflation and AUDUSD
From April 2012 to November 2012 the Chinese inflation rate started to decline. This decline accelerated from July 2012. Declining inflation can be bad for a currency as it can suggest that the economy is slowing down. China does not have a free-floating exchange rate, so domestic economic data does not have a huge impact on the renminbi. However, the Aussie dollar has close trade links with China, and signs that growth and inflation were slowing in its important trade partner initially weighed on the AUDUSD, as you can see in Figure 1.7.
The Aussie sold off sharply from April to the end of May as the market digested signs of a Chinese slowdown. However, after that the Aussie recovered, but it didn’t manage to break above a key resistance level of 1.06. Thus, although the relationship between AUDUSD and Chinese data is not perfect, Aussie gains were capped while Chinese data remained subdued.
Figure 1.7: AUDUSD daily chart (April to November 2012)
Inflation data is also useful for trading other fundamental events including central bank meetings and GDP releases. This means that even if I don’t want to trade the inflation release itself I usually make a point of keeping an eye on the latest inflation release for currencies I am interested in.
4. Quarterly GDP
What is it?
This data is the ultimate snapshot of an economy’s health. The technical definition of GDP is the market value of all goods and services produced by a country. It is also considered to be a measure of a country’s standard of living.
The measurement of GDP was developed in the US in 1934 and the most common formula is:
GDP = private sector consumption + gross investment + government spending + (exports – imports)
Although it is reported quarterly, the data in the major economies usually includes an annual growth rate, so you can see how the economy performed in the past 12 months.
When is GDP data released?
GDP is reported quarterly for most countries in the world. Usually a GDP report is released in the first month of a new quarter, but consult an economic calendar to get the exact date and time. Also, there are usually a couple of subsequent revisions to GDP data after the main release, especially in the major economies.
Why is GDP significant?
GDP data tells the story of how an economy performed over a period of time – its change relative to previous quarters gives a good indication of which direction the economy is moving and where it may go in the future. A strong positive reading is good news for an economy, while the opposite is bad news. The annualised data is extremely useful for detecting changes in the economic cycle, which can have big implications for FX markets.
Since GDP data is used to determine a country’s position in the economic cycle, it is of use for a longer-term trader. Like inflation data, GDP data is of more limited use for the short-term trader – they would be watching to see if the actual figure exceeds or misses the consensus estimate by a large margin. Usually if GDP data is in line with estimates then it barely moves the FX market.
FX market example
GDP can cause volatility in the FX market if it is wildly different to consensus estimates. Let’s look at two examples of data surprises and see how it impacted FX.
Example 1: UK
Third quarter UK GDP in 2012 was much stronger than expected, rising 1% versus expectations of a 0.6% rise. This data was even more important than usual since it meant that the UK had exited recession for the first time in 2012. This was difficult to predict, so the better trading strategy, in my view, would be to digest the data and then make your move. This was my strategy:
Figure 1.8: EURGBP in the immediate aftermath of the UK’s Q3 2012 GDP
Example 2: Japan
Japan’s economy contracted sharply in the third quarter of 2012, in contrast to the UK. It contracted by 3.5% on an annualised basis in Q3, a sharp slowdown relative to the 0.3% expansion in the second quarter.
Japan’s economy was weaker than expected, but rather than cause the yen to sell off, it actually caused the yen to strengthen by 100 pips versus the USD in the immediate aftermath.
How so?
The yen is a safe haven currency and even when there is a negative domestic economic shock it can cause a flight to its perceived safety. However, it would not have paid to remain short USDJPY for long, as you can see in Figure 1.9.
The price action after the data release is circled, but in the following three weeks USDJPY rallied 300 pips. Thus, the rush to the safety of the yen was only temporary, and once the market digested the news the yen reacted as you would expect, and started to weaken.
Figure 1.9: USDJPY – 30-day chart
How currencies are affected by the various economic data
Some currencies are more sensitive to particular economic indicators than they are to others. Here is my very quick guide to which major economic data releases affect particular currencies.
Figure 1.10: GBPUSD (3 September 2012)
Figure 1.11: AUDUSD and Chinese GDP (late 2007 to 2012)
I have covered the most important indicators that I believe you need for effective fundamental analysis. Of course there are second, third and even fourth tier indicators that some traders follow avidly; such as terms of trade, factory orders and inventories. However, the purpose of this book is not to give you a step-by-step guide to all economic data because there are plenty of other books that will do that for you.
These include Richard Yamarone’s The Trader’s Guide to Key Economic Indicators, which is an easy to use and comprehensive look at most US economic indicators (but it can be applied to indicators used in other parts of the world).
You may have noticed that I did not include interest rates – and the central banks that set them – in the list of four economic indicators above. I like to think of these as a cousin of the monthly economic data statistics and use them in combination with all of the other indicators. Interest rates have a big impact on the direction of currencies and they are worth looking at in detail, so I will move on to this next.
Interest rates and central banks
Central banks control interest rates and interest rates are important for a currency. That is what you should take away from this section of the book. In the following section I will explain what central banks do, show using real-life examples why they are so pivotal to FX and thus why I watch them to inform my trading.
The major central banks
Most countries in the world have a central bank. They tend to meet monthly, or at least seven or eight times a year, to decide policy. The most important central banks in the G10 are:
The People’s Bank of China (PBOC) is also one to watch, even though it does not stick to a rigid timetable to announce policy decisions.
What central banks do
Central bank operations are complex, with a variety of different roles and responsibilities. I am going to give you a simplified version here and then explain what their work means for FX.
Central banks are the government entities involved in controlling a country’s money supply; they have the power to take money out of the economy or pump it back in. In doing so, they have a few main tasks:
Essentially central banks monitor the economy. They like nice, steady economic growth and when they see things moving too fast or slow they need to get involved to try and steady the ship.
So, if an economy is growing too fast there will be a fear of overheating. When this happens asset bubbles can form, which tend to pop and then cause recessions. A central bank wants to avoid this. Symptoms of an overheating economy include rising inflation and a fast pace of growth. When they see this the central bank can hike interest rates. By doing this they try to remove some of the heat from the economy by making money more expensive, thus trying to limit investment, cool consumption and cause a managed slowing down.
When central banks raise interest rates they make money more expensive. People prefer to save rather than spend because they earn more on their deposits. The amount of money in circulation tends to fall, which means that the value of money tends to rise.
Let’s say the economy starts slowing down sharply, as we saw during the financial crisis in 2008. Back then major central banks around the world cut interest rates as they wanted to make money cheap to disincentivise people from saving, instead encouraging people to spend and invest in the economy to try to boost growth. This means that central banks are putting money back into the system by making it cheap – this increases the money supply and tends to cause the currency to fall in value. In crude terms:
Central banks in action
The trader should always be interested in what the central banker will do next: what will be the next policy decision, will they tighten or loosen interest rates and will currencies go up or down? There are three particular things traders should watch out for when it comes to central banks:
There is also a bit of lingo that traders need to be aware of when it comes to central banks:
So, FX markets are sensitive to changes in monetary policy and also to minutes and speeches from central bankers that give an insight into their thoughts.
Here are a couple of examples of this.
Minutes from the RBA and AUDUSD
Figure 1.12 shows AUDUSD in the aftermath of dovish minutes from the RBA’s September 2012 meeting in which it sounded worried about economic growth, making a cut in interest rates more likely than a hike.
This caused an immediate dive in the Aussie. The circled area indicates the point of release of the dovish RBA minutes and the impact they had on AUDUSD – it caused the Aussie to sell off for most of the day. If I wanted to trade around the minutes there were a few things that I could do:
This would have made a nice intra-day trade: the market was taken by surprise by the RBA sounding so concerned about the state of the economy, so placing a short AUD trade could make a small profit. It could also work as a long-term trade, especially if you thought the RBA may cut rates later in the year.
In that case a short position could be entered with a much wider stop and lower profit target. A long-term trade would require more preparation: for example it would be worth looking back over recent economic data from Australia to see if the economic data had started to deteriorate and thus would justify a cut in rates by the RBA.
Figure 1.12: AUDUSD following dovish minutes from the RBA (18 September 2012)
Fed monetary policy and USDJPY
Some currency pairs are particularly sensitive to central banks’ monetary policy. For example, USDJPY is very sensitive to changes in stance by the Federal Reserve. Figure 1.13 shows USDJPY and US Treasury yields. Treasuries (US government debt) tend to move closely with changes in Fed policy and are a good way to gather the market’s view on whether the Fed is dovish or hawkish.
The first thing to note about government debt is that price moves inverse to yields: so when central banks are hawkish, Treasury bond prices fall and yields rise; and when banks are dovish, Treasury bond prices rise and yields fall. This relates back to the earlier section when I described how central banks control money: when the economy is strong they hike rates, which pushes up interest rates and pushes down the price of debt as fewer investors want to borrow money. When interest rates fall this pushes up the price of debt as more investors want to borrow, but it also pushes down interest rates.
The main thing you should know is this: falling Treasury yields (the Fed is dovish) tends to be dollar negative, while rising Treasury yields (the Fed is hawkish) tends to be dollar positive.
Figure 1.13: 10-Year Treasury yields and USDJPY (2011 and 2012)
Why is this relationship so close?
US Treasuries are very popular investments to hold and are the most traded government securities in the world. The Japanese are some of the world’s largest holders of US government debt, holding nearly 1 trillion dollars’ worth. Thus, when Treasury yields fall, as they had been doing since the first quarter of 2012, it means that the price of Treasuries rises. This means that the USD value of Japan’s holding of Treasuries rises, and to hedge themselves some Japanese traders start selling USDJPY.
Of course, the forex market is influenced by so many factors it can be hard to claim one group of people cause the movement in a currency cross, however this explanation is well known in the currency markets and I believe it goes some way to explaining the traditionally close relationship between Treasury yields and USDJPY.
Unconventional central banking
In 2012 the pace of global growth had slowed after the recovery from the financial crisis in 2008 had been weaker than expected. Since central banks in the UK, US, Japan and the euro zone had already cut rates to extremely low levels they then had to use unconventional measures to try to boost growth.
This included quantitative easing (QE), whereby the central bank buys government debt to try to depress long-term interest rates and interest rates on mortgages. The Federal Reserve in the US embarked on its third round of QE in September 2012 in another attempt to boost the US economy. This is a largely untested strategy in the history of central banking, and time will tell if it has an effect on the economy.
The intended impact of QE is to limit currency strength; however it depends on how aggressive the central bank is. As you can see in Figure 1.14 – where QE2 and QE3 are circled – the dollar is very sensitive to QE and it tends to lead the currency weaker.
Figure 1.14: Dollar index (the dollar vs. its major trading partners); QE2 and QE3 are circled
Interest rate differentials
Interest rate differentials are a fairly sophisticated strategy for the retail FX trader, but this is a popular technique with large investment banks and hedge funds so it is worth the retail trader being aware of it so they know how the big guys make decisions in the FX market.
Since two currencies are always traded together and interest rates can determine the value of a currency, a popular trading strategy is to buy a currency with a higher interest rate and sell a currency with a lower interest rate. This is called the carry trade.
For example, interest rates in Australia were 3.5% in June 2012; in contrast, US interest rates were at 0%. Due to this, the Aussie dollar was a more attractive currency to hold relative to the dollar. Indeed, this was the case for most of the period from 2010 to 2012 and as a result AUDUSD has been in an uptrend in that time, as you can see in Figure 1.15.
But you will notice that this pair has been extremely volatile, with some large swings up and down. The carry trade is volatile so traders need to be on their guard. Part of the reason for this volatility is that central banks can change policy unexpectedly and their movements can be hard to predict with accuracy.
Figure 1.15: AUDUSD, showing uptrend (2010 to 2012)
Here is another example. Although interest rates in the euro zone in autumn 2012 were higher than they were in the US, EURUSD did not present a good opportunity for the carry trade as the rate differential was only 75 basis points. However, changes in the difference between US Treasuries and German Bunds (using Germany as a benchmark for the entire currency bloc) can impact the direction of EURUSD.
As you can see in Figure 1.16, the difference between German and US bond yields had been trending lower at the start of the year and again from June to October. This means that German bond yields were lower than US bond yields, which weighed on EURUSD.
But how can that be when euro zone interest rates are higher than US interest rates? The currency market can also react to the expected change in rates – thus, as the euro zone economy deteriorated at a faster pace than the US economy in 2012 German bond yields fell, which weighed on EURUSD.
Figure 1.16: EURUSD and the difference between German 10-year bond yields and US 10-year bond yields
Central bank intervention
As you may have gathered, the US Federal Reserve is the most influential central bank. However, currency traders need to keep an eye on other banks as well.
The Bank of Japan (BOJ) and the Swiss National Bank (SNB) in recent years have directly intervened in the forex market to weaken their currencies and thereby protect their export sectors and boost growth. I will use two examples to show the different effects that central bank intervention can have on the FX market.
1. Bank of Japan intervention to weaken the yen in March 2011
The BOJ wanted a weaker currency to stimulate growth in the country after a major tsunami and earthquake caused an economic disaster in March 2011. The BOJ and other central banks decided to sell yen in a multilateral attempt to weaken Japan’s currency.
Although the exact amount of yen sold is unknown, it was not enough to keep the yen weak for long. Instead this type of FX intervention was more of a gesture to show solidarity with Japan in its hour of need. This was not deemed aggressive central bank intervention.
As you can see in Figure 1.17 where the timing of central bank intervention has been circled, although USDJPY jumped from 79.00 to 86.00 in a matter of days, it soon started to weaken again.
Figure 1.17: USDJPY (February and March 2011)
2. Aggressive intervention by the SNB
In contrast, the Swiss National Bank (SNB) embarked on an aggressive bout of intervention in August 2011 after EURCHF fell to its lowest ever level. This caused the SNB to worry about Switzerland’s export-dominated economy that relies on a weak exchange rate to make its exports competitive.
Thus, the SNB decided to instigate a floor in EURCHF at 1.20. That meant that it would buy EURCHF to ensure that the pair got back to this level and stayed there. The cost was that the SNB had to buy billions of euro, but the upside was that it helped to protect the Swiss economy.
This is extremely aggressive action from a major central bank and is very rare. As you can see in Figure 1.18 – which shows the aftermath of the intervention from December 2011 onwards – the FX market took the SNB’s action seriously and EURCHF has barely budged from 1.20 since the floor was put in place.
Figure 1.18: EURCHF (late 2011 and 2012)
Political risks
Politicians control the economy and their policies can change the future growth trajectory of an economy. Political risk that fundamental forex traders need to be aware of comes in a few forms:
The key thing to remember with political risk is that traders like certainty – they like to know who is in charge of an economy and that they will take the right decisions to boost economic growth. Thus:
Greece is a good example of political risk and how high levels of political uncertainty can weigh on a currency. In early 2010 a new government was elected and it uncovered a huge gap in the budget deficit – Greece had been borrowing more than it could afford to pay back and the country was nearly bust. The previous government had covered this up.
This sent the markets into shock and since Greece is part of the euro zone the price of the euro was sent tumbling from 1.45 to below 1.20 by mid-2010 (see Figure 1.19). Not since the end of the Second World War had a Western country defaulted on its debt, and now Greece needed to get financial assistance from its European partners, the International Monetary Fund (IMF) and the ECB to prevent this from happening.
The market’s view that the euro zone was stable and therefore a safe investment was shaken to the core. If Greece was in trouble, could it spread elsewhere? Indeed it did and Portugal and Ireland also requested bailouts.
Figure 1.19: EURUSD (2010)
Once a country is labelled as being politically risky it can be a difficult mantle to shake off. In the period April to June 2012 Greece had to hold two elections before the new government came to power. This heightened political risk yet again and also weighed on the euro as the markets fretted that Greece would vote in politicians who did not want to stick to the terms of its bailout loans, which could have seen Greece thrown out of the currency bloc.
Greece eventually did elect a political party who would comply with bailout terms, but this was a difficult period for the euro, as you can see in Figure 1.20. It sold off sharply from 1.34 in March 2012 to 1.24 during the second Greek election in June 2012.
Figure 1.20: EURUSD (2012)
Political instability can cause excess volatility in the FX market. When this happens investors put their money in the safest place possible – such as cash or cash equivalents like Treasury bonds – and sell risky assets that could fall in value.
The concept of safe havens and risky assets
An important trick of the trade in the foreign exchange market is the concept of the safe haven and the risky currency. Traders should acquaint themselves with risky currencies and safe havens since during periods of market panic – such as financial crash, a geopolitical event or a natural disaster – the market tends to divide the currencies into these two groups.
When the market panics there is typically liquidity flow out of risky currencies and into safe havens. Conversely when the markets are stable and growth is good, when there are no financial or geopolitical crises on the horizon and there haven’t been any natural disasters, then this can be an environment that allows risky currencies to appreciate.
Both risky and safe currencies can move on domestic factors that have nothing to do with the overall market environment, but when the going gets tough the herd mentality can take over in FX, so domestic fundamentals go out of the window and fear takes over.
The safe havens
Safe havens are the currencies that traders tend to buy in times of distress in the financial markets. Safe haven currencies have certain characteristics:
The most important safe havens are:
The US dollar is the ultimate safe haven for a couple of reasons:
The dollar is also the most widely owned currency in the world, which makes the dollar attractive to hold in a crisis. If you need money fast you want to own assets that are easy to sell, like the US dollar.
What this means for FX markets
When panic and uncertainty hit the markets traders want to buy the dollar, which causes it to rise. For example, when Lehman Brothers filed for bankruptcy in September 2008 the dollar sky-rocketed (see Figure 1.21). But how can that be, when Lehman Brothers was an American company? That is the funny thing about the dollar; it can rise even when the problem is the US economy.
Figure 1.21: Dollar index (September 2008 to February 2009)
Risky currencies
The opposite of a safe haven is a risky currency. This is a currency that tends to sell off in times of market panic. A currency can be classified as risky if it has one or more of the following characteristics:
It’s fairly easy to see why the first two points can lead to a currency being described as risky. This covers a lot of emerging market currencies like the Indonesian rupiah and the Indian rupee. South Africa may no longer be strictly an emerging market currency, but the rand is also considered risky due to continuing political uncertainty and also its economic reliance on commodities including platinum and gold.
That leads me to the impact of commodities on certain currencies. Australia and Norway are both politically stable and their economies are fairly healthy. However, the Aussie dollar and the Norwegian krone are considered to be at the risky end of the FX spectrum. This is because their economies rely heavily on their commodity sectors for growth.
Norway relies on its oil industry while Australia relies heavily on its minerals and mining sector. Commodity prices tend to be volatile and they are closely linked to the economic cycle – when the economy is booming commodity prices rise, when it slows down commodity prices tend to fall. Thus, countries that have large oil, mining, or other commodity sectors tend to suffer from extremes. This causes traders to worry as it gets harder to predict future growth, which can cause the currency to be volatile.
For example, during the financial crisis in 2008, the Aussie dollar sold off against the US dollar sharply as commodity prices crashed (see Figure 1.22).
Figure 1.22: AUDUSD (2008)
The same happened to the Norwegian krone, as you can see in Figure 1.23. Risky currencies tend to sell off particularly sharply against safe havens like the dollar during periods of market panic like the financial crisis in 2008.
Figure 1.23: NOKUSD (2008)
The concept of safe haven and risky currencies can make life a little easier for the FX trader as there is some certainty about what currencies will do when markets panic:
Fundamental analysis wrap-up
Let’s summarise what I have covered in this chapter:
This should give you a good overall taste for fundamental analysis, how it works and how it drives currencies. But my approach means that fundamental analysis on its own is not enough for you to become a successful trader – you need to fuse your fundamental knowledge with your technical insight.
Part B introduces the key concepts of technical analysis and how I use them to trade the FX market.