Welcome to my Masterclass.
In this lesson you will learn what the foreign exchange market is all about and how we are able to take advantage of the worlds biggest exchange.
The driving force
Trading on the fundamentals – also referred to as trading the news – is the study of news events and economic statistics to determine trading opportunities. Referred to as fundamentalists, these traders pay close attention to changes in economic indicators such as interest rates, employment rates, and inflation.
Forex Fundamental Analysis provides the additional information to Technical Analysis to give the forex trader a full understanding of the Forex Market – hence the importance of fundamentals.
A forex traders job is to determine the direction of a particular currency, then to decide which currency pair to buy or sell. To identify this, it is important to understand the ‘Cause and Effect’ of the Forex Market. The ‘Cause’ can be found in the fundamental economics of a particular country and the actions of the central banks to manage that economy. The ‘Effect’ is the subsequent reaction of the traders to this information, in the form of buying or selling that can be seen on the charts i.e technical analysis. Some traders believe that using both Fundamental Analysis and Technical Analysis gives the forex trader an edge.
However more often than not, the outcome of an important economic announcement is often time priced into price action of that currency, way before the actual announcement takes place itself. This is, amongst other things, caused by 'forward guiding' of central banks. This means that central banks give clues of things to come in their public statements and reports. This information is then picked up by traders alike and used to enter the markets early - in anticipation of the actual news announcement - and therefore moving the market towards to outcome, before the actual announcement.
Of course is helps to know for instance, that if the US Dollar economy is weak and the European economy is strong to look out for buy signals on the EURUSD and use Technical Analysis to find the key entry points to take the trade. We also believe that having a basic understanding of why markets move is important, but we as technical traders never let an upcoming news announcement influence our trading decisions. Except for one news announcement, which is the most important announcement in the FX market. It is called the US NFP or US Non-Farm-Payroll announcement. What this is we'll touch upon later in this chapter.
Whilst it is not crucial to have an economics degree, it is important to understand the basics. When a country has a good economic outlook or its economy is currently strong, the currency is most likely to increase in value. In the forex market we trade in currency pairs so it is vital to understand that we are comparing the relative strength of one economy against another i.e. if the US Economy was strong and European economy was weak, then we could expect the EURUSD to have a downwards trend.
But wait – remember because we are using currency pairs it is the relative strength of the economies – If the US economy was strong BUT the EURozone economy was stronger then the EURUSD would go up.
How does a country's economy work?
Yes you might need an economics degree to fully grasp this, however we are lucky as forex traders. We just need to know if an economy is strong or weak relative to another and what economic data dictates a strong or weak economy.
Strong Economy = Higher GDP, Lower Inflation, Higher Interest Rates, Greater Productivity, Good Political Stability
Weak Economy = Lower GDP, Higher Inflation, Lower Interest Rates, Lower Productivity, Weak Political Stability
Money Flow – Life blood of an economy
To ensure an economy can actually function, it needs money. No money, no economy. Money needs to flow in and out of the economy whilst maintaining a balanced level of money within the economy. The Central Banks of each country manage and control the flow and quantity of money in the economy to keep it healthy and sustainable. Think of the Central Bank as the heart of the economy ensuring money flows.
How is an economy managed?
Contrary to popular belief the economy is not managed by the government of that country, it is managed by its central bank, which is not influenced by government. The Central Banks have objectives and they are generally:
Maintain a stability
Provide sustainable growth
Each country may have specific objectives, however each Central Bank has its own ‘Monetary Policy’ that shows everyone in a transparent way, how that bank is going to achieve its objectives in the economy. A Central bank will also have a ‘Fiscal Policy’ that controls the money flow within that economy.
What metrics and tools do Central Banks have to manage their economy?
For the Central Banks to manage their economy, they need to be able to influence and monitor the metrics of a strong or weak economy. To influence and change those metrics they need some tools to do so.
Let’s take a look at the major metrics of an economy:
GDP – Gross Domestic Product – Economic Health Indicator
The GDP of an economy, is the total amount of goods and services produced. Released quarterly, this is the most important indicator of economic health and growth and is a so called Tier-1 Economic Data Release.
CPI – Consumer Price Index – Inflation Indicator
CPI is a measurement of prices for a range of consumer goods. Measuring price fluctuation is a good measurement of inflation. Released quarterly, this is the second most important metric and is also a Tier-1 Economic Data Release.
Retail Sales – Inflation Indicator
The Retail Sales metric tracks the dollar value of merchandise sold within the retail trade. Released monthly, this data release is monitored closely by traders as it may give an indication of what is to come in the next CPI as that is only released quarterly.
Central banks use a ‘Monetary Policy’ that outlines the objectives of the Central Bank and how they are going to manage their particular country’s objectives. Basically there are two types of Monetary Policy, known as "Expansionary" and "Contractionary". If a Central Bank wants to reduce unemployment, boost private sector borrowing and consumer spending, and stimulate economic growth they increase money flow and it is referred to as an "Expansionary Policy". If they want to control an increasing inflation rate then they reduce the money flow rate to slow the economy growth rate down, increase unemployment and put the brake on borrowing and spending by businesses and consumers, this is referred to as a "Contractionary Policy".
Interest Rates – Manages Inflation
Most Central Banks have a target inflation band of 2-3%. Interest rates are used as a throttle and a brake to control inflation. If inflation drops below 2% then central banks will cut interest rates to stimulate economic activity. When it approaches or exceeds 3% central banks raise interest rates to slow the economy down.
Quantitative Easing – Alternative way to manage Inflation
When interest rates are approaching (or are) zero and the economy needs a boost, under normal circumstances interest rates are reduced which encourages borrowing and spending which would boost the economy. When the Central Bank cannot reduce interest rates any more to encourage economic growth, the only thing they can do is introduce more money into the economy. Whilst they can print money, this is normally a last resort so the Central Banks introduce more money into the economy by buying Government bonds from the banks, this allows the banks to get more money into their account so they can lend more and effectively reduce interest rates, without the Central Bank having to do it. This process of buying Government bonds and loans is called Quantitative easing.
How an Economy works
A country’s economy is a dynamic and constantly changing cycle of events. Those events are:
Expansion and Growth
The economy is managed by the Central Bank of that country and they have essentially one tool to manage it – Interest Rates.
The Economic Cycle
Expansion and Growth – The economy is strong and growing the GDP growth Rate is positive
This means there is a good flow of money, businesses will grow, jobs and personal income will flourish.
Peak – When the economy reaches between 3-4% then it has most likely hit its peak.
At that point the bubble bursts and economic growth stalls and the economy starts to contract.
Contraction – The economy starts to slow down
Money is now expensive as Central Banks have risen interest rates.
Trough – Prices fall as demand decreases.
Central banks now decrease interest rates to stimulate growth.
The Central Banks
At the core of Forex Fundaments are the Central Banks. They have specific problems and objectives that are specific to their country. If we know what those problems and objectives are, then we can predict the effect on the currency when an important economic data metric is released. The Central Banks make this very clear and transparent in their ‘Monetary Policy’. They want traders to know what they are doing so they can control the value of their currency (forward guiding).
Global Central Banks
Below you'll a list of all the major economies central banks and their name and abbreviation.
U.S. Federal Reserve System - FED
European Central Bank – ECB
Bank of England – BoE
Bank of Japan – BoJ
Swiss National Bank – SNB
Bank of Canada – BoC
Reserve Bank of Australia – RBA
Non-farm payrolls are a monthly statistic representing how many people are employed in the US, in manufacturing, construction and goods companies. They can also be known as non-farms, or NFP.
NFP gets its name from the jobs that aren’t included: farm workers, and those employed in private households or non-profit organisations. The data is usually delivered on the first Friday of any given month, and can move several markets in a major way.
There are several other key pieces of data involved in the non-farms release, including the unemployment rate, detail on sectors, average hourly earnings and revisions of previous releases. These are all also important to the markets.
Various analysts release predictions for NFP figures in advance of the actual release, causing a great deal of speculation in the lead up to each report.
Since NFP can move the market in a significant way, we do not trade any USD derived pairs during the day of the NFP announcement. The time and date of this announcement is usually on the first Friday of the month at 14.30pm GMT. To find the definitive time of this - and all other FX related announcement - go to www.forexfactory.com
Summary of Forex Fundamentals
No doubt it is important to understand why economies move and why they are weak or strong. It helps to build a case for longer term opportunities and these economic events are the driver of price movement itself. However we do not trade the news. In fact what you'll frequently see, is that news will often push the trade into the right direction that you were already in. This happens because price action often is a "leading indicator" when it comes to important high-impact news releases.