Those trading in the foreign-exchange market (forex) rely on the same two basic forms of analysis that are used in the stock market: fundamental analysis and technical analysis. The uses of technical analysis in forex are much the same: price is assumed to reflect all news, and the charts are the objects of analysis. But unlike companies, countries have no balance sheets, so how can fundamental analysis be conducted on a currency?
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 the movement of a currency.
Economic indicators are reports released by the government or a private organization that detail a country's economic performance. Economic reports are the means by which a country's economic health is directly measured, but do remember that a great deal of factors and policies will affect a nation's economic performance.
These reports are released at scheduled times, providing the market with an indication of whether a nation's economy has improved or declined. The effects of these reports are comparable to how earnings reports, SEC filings and other releases may affect securities. In forex, as in the stock market, any deviation from the norm can cause large price and volume movements.
You may recognize some of these economic reports, such as the unemployment numbers, which are well publicized. Others, like housing stats, receive little coverage. However, each indicator serves a particular purpose, and can be useful. Here we outline four major reports, some of which are comparable to particular fundamental indicators used by equity investors:
The Gross Domestic Product (GDP)Some of the other major indicators include the purchasing managers index (PMI), producer price index (PPI), durable goods report, employment cost index (ECI), and housing starts. And don't forget the many privately issued reports, the most famous of which is the Michigan Consumer Confidence Survey. All of these provide a valuable resource to traders, if used properly.
The GDP is considered the broadest measure of a country's economy, and it represents the total market value of all goods and services produced in a country during a given year. Since the GDP figure itself is often considered a lagging indicator, most traders focus on the two reports that are issued in the months before the final GDP figures: the advance report and the preliminary report. Significant revisions between these reports can cause considerable volatility. The GDP is somewhat analogous to the gross profit margin of a publicly traded company in that they are both measures of internal growth. (Learn more about this important number in High GDP Means Economic Prosperity, Or Does It?)
The retail-sales report measures the total receipts of all retail stores in a given country. This measurement is derived from a diverse sample of retail stores throughout a nation. The report is particularly useful because it is a timely indicator of broad consumer spending patterns that is adjusted for seasonal variables. It can be used to predict the performance of more important lagging indicators, and to assess the immediate direction of an economy. Revisions to advanced reports of retail sales can cause significant volatility. The retail sales report can be compared to the sales activity of a publicly traded company. (Read more in Using Consumer Spending As A Market Indicator.)
This report shows the change in the production of factories, mines and utilities within a nation. It also reports their 'capacity utilizations', the degree to which the capacity of each of these factories is being used. It is ideal for a nation to see an increase of production while being at its maximum or near maximum capacity utilization.
Traders using this indicator are usually concerned with utility production, which can be extremely volatile since the utilities industry, and in turn the trading of and demand for energy, is heavily affected by changes in weather. Significant revisions between reports can be caused by weather changes, which in turn, can cause volatility in the nation's currency.
Consumer Price Index (CPI)
The CPI is a measure of the change in the prices of consumer goods across over 200 different categories. This report, when compared to a nation's exports, can be used to see if a country is making or losing money on its products and services. Be careful, however, to monitor the exports - it is a focus that is popular with many traders because the prices of exports often change relative to a currency's strength or weakness. (For further reading, check out The Consumer Price Index: A Friend To Investors.)
So, How Are These Used?
Since economic indicators gauge a country's economic state, changes in the conditions reported will therefore directly affect the price and volume of a country's currency. It is important to keep in mind, however, that the indicators discussed above are not the only things that affect a currency's price. There are third-party reports, technical factors, and many other things that also can drastically affect a currency's valuation. Here are a few useful tips that may help you when conducting fundamental analysis in the foreign exchange market:
- Keep an economic calendar on hand that lists the indicators and when they are due to be released. Also, keep an eye on the future; often markets will move in anticipation of a certain indicator or report due to be released at a later time. (You'll find more information in Trading On News Releases.)
- Be informed about the economic indicators that are capturing most of the market's attention at any given time. Such indicators are catalysts for the largest price and volume movements. For example, when the U.S. dollar is weak, inflation is often one of the most watched indicators.
- Know the market expectations for the data, and then pay attention to whether or not the expectations are met. That is far more important than the data itself. Occasionally, there is a drastic difference between the expectations and actual results and, if there is, be aware of the possible justifications for this difference.
- Don't react too quickly to the news. Oftentimes, numbers are released and then revised, and things can change quickly. Pay attention to these revisions, as they may be a useful tool for seeing the trends and reacting more accurately to future reports.
There are many economic indicators, and even more private reports that can be used to evaluate the fundamentals of forex. It's important to take the time to not only look at the numbers, but also understand what they mean and how they affect a nation's economy. When properly used, these indicators can be an invaluable resource for any currency trader. (For a complete guide to the releases that move the market, check out our Economic Indicators Tutorial.)