FUNDAMENTAL ANALYSIS

Economic fundamental provide the most significant information to traders. The impact of economic data tends to be long term oriented. Nevertheless, not all economic data is significant for the Forex market.

Economic indicators are reports published at a fixed time intervals by government and private organizations. Economic indicators illustrate the detail of a country's economic performance whether it has improved or declined. This economic statistics are analyzed to predict the movement of the Forex trading market. An economic indicator that shows a strong country's economy condition will enhance the currency exchange rate to rise. Every economic indicator does not have the similar impact on the market every time. The date and time of release of economic data is very important to adjust a foreign exchange position. Information on upcoming economic indicators can be found in newspapers and business magazines. Besides, critical announcement or events can also be found at economic calendar as shown in table 1. Economic calendar mainly contains information of the date, time, type of events and the forecast impacts on the market.

Here are some lists of economic report that have most significant impacts on the market:

Table 1: Sample of the economic calendar

The Gross Domestic Product (GDP) is considered as a macroeconomic indicator. The GDP measures the sum of all goods and services produced either by domestic or foreign companies. Overall, the GDP is the market value of all goods and services produced within a country in a period of time. For GDP, it does not distinguish between country citizen and foreigners. The income is counted toward GDP as long as it is earned within the country's border.

This indicator consists, at macro scale, of the sum of consumption spending, investment spending, government spending, and net trade (exports - imports). Consumption spending is made possible by personal income and flexible income. Consumers have the decisions to save or spend. Investment spending consists of fixed investment and inventories. Government spending is very influential and has special role in country employment and economy. Net trade is a major component in the GDP due to worldwide internationalization.

Similar as GDP, the Gross National Product (GNP) is also a macroeconomic indicator. The GNP measures the economic performance of the economy and it is released on quarterly basis. The GNP is the total income earned by a nation's resident and it measures all the goods and services made by nation's resident throughout the world.

Although the nation's products are made in foreign country plants, it is counted toward that nation's GNP. The GNP does not include the investments from foreigner. Thus, the formula for calculating GNP differs from GDP in the way of including income earned by citizen outside the country and excluding income earned by foreigner within the country.

Industrial production measures the production change, industrial capacity and resources of a country's factories, utilities and mines. It is an important report which reflect the strength of economy and the strength of a specify currency. It is released on monthly basis.

This report also shows their capacity utilization. Capacity utilization is the degree of capacity of factories that is being used. It is useful for a nation to observe the increase of production whether it reached maximum or near maximum capacity utilization. High capacity utilization rates lead inflation, and the central bank is expected to raise the interest rates to avoid inflation.

Inflation measures the rate of prices rise in an economy. Inflation has direct relation to the purchasing power of a country within its borders and the country's standing on the international markets. Therefore, gauging inflation is a crucial macroeconomic task. The tool of fighting inflation is raising the interest rates and the higher interest rates tend to support the local currency. The examples of economic data that measures inflation are Producer Price Index (PPI), Consumer Price Index (CPI), Commodity Research Bureau's Index (CRB Index), and so on.

The PPI has been compiled since the beginning of twentieth century. The PPI gauges the average price level for capital, rent and materials required for producers to manufacture their goods. The PPI data is compiled from various sector of economy, such as manufacturing, mining and agriculture. The PPI measures the prices at producer level while the CPI measures the prices from consumer point of view. The sample used to calculate the index contains about 3400 commodities and the weight of each commodity used for calculation is different. This index is released on monthly basis.

The CRB index is made with the purpose of watching for inflationary trends easier. The CRB index consists of the futures prices of 21 commodities. Some examples are gold, silver, lumber, copper, cotton, oil, wheat and so forth. The rising of crucial commodity prices such as oil will start out inflation. When the oil price increases, many other items will increase in price because the production process consumes oil. Consumers and companies have to spend more compare with previous time to buy the same amount of goods. Thus, the rapid rise in oil price initiates inflation and inflation wear down the purchasing power of the particular currency.

The correlation of the crude oil price and the USD/CAD exchange rate is inversely proportional relation as shown in figure 1. Since United States is a highly industrialize country, the demand of crude oil is very high. In addition, Canada supplies most of the crude oil to United States compare to other oil-production countries in the Middle-East due to the shorter distance between the two countries and thus the cost is relatively lower. When the crude oil price increases, it brings large inflation pressure relatively to United States and wear down its purchasing power. High oil prices tend to cut into the US's ability to stay productive. Besides, Canada gained benefits from exporting the expensive crude oil. Therefore, the exchange rate of USD/CAD falls as the Canadian dollar appreciates its value or the US dollar depreciates its value in the situation when the crude oil price rises rapidly.

Figure 1: The effect of crude oil for USD/CAD

The merchandise trade balance is one of the most important economic indicators and its value may trigger long lasting changes in the monetary and foreign policies. The trade balance consists of the net difference of the imports and exports of an economy. Items that are traded may include food, raw material, industrial supplies, customer goods and other merchandise.

The merchandise trade balance is interrelated to the changes in foreign exchange market. For example, the US dollar was relatively high against other currencies. Then, the US exporters were in disadvantage. Their high price products lost competitive in the international market. In order to rebalance the economic disequilibrium, the US dollar was devalued in short term period.

The employment growth is measured by employment indicator. The employment indicator reflects the health of an economy. The job opportunities and unemployment are very important aspect to evaluate an economy condition.

Generally, the most commonly used employment figure is the monthly unemployment rate and it is released as a percentage. The report consists of two separate surveys: business firms and household. The business firms' survey consists of the payroll, workweek, hourly earnings and total hours of government jobs, manufacturing, services, retail and others. The households survey illustrate the unemployment rate, overall labor force and the number of people employed. Decrease in unemployment rate show fine economy condition wile increase in unemployment show that the economy is poor.

Retail sales are a significant consumer spending indicator for Forex traders. It shows the strength of consumer demand and confidence. If the consumer has enough flexible income, then more merchandise will be produces or imported.

This indicator is released on a monthly basis and is related to the seasonal aspect. Holiday season and back to school month are important period for Forex traders to watch the retail sales report. Retail sales are monitored to gauge the overall strength of economy and currency.

Currency exchange rates are greatly influence by financial factors, particularly the interest rates. Financial factors are vital to fundamental analysis. Changes in a government's monetary or fiscal policies are bound to generate changes in the economy, and will be reflected in the exchange rates. Financial factors should be only triggered by economic factors. However, financial factors may have priority over economic factors when governments focus on different aspect of the economy. Financial factors that affecting currency exchange rates are money supply and interest rates.

Changes in the money supply over time should lead to a predictable change in nominal economic output. Growth acceleration or growth retardation affect the real economy activity in short term. The money supply data is regularly released on a weekly basis. The money supply data is useful in revealing the cyclical phase of economy recovery. A larger money supply will reflect a strengthening economy.

Somehow, the money supply had lost some of its impacts since 1980s due to distortions created by newer types of bank deposits. By 1993, the Federal Reserve Bank found the money supply no longer useful for gauging the economy because of the statistical distortions.

Interest rates are the important role in the foreign exchange market because it has the capability to move the exchange rates of currencies. Therefore, the central banks are the most influential player in this case as the central banks set the interest rates. Different in interest rates have an effect on the relative worth of currencies in relation to one another. Overall, the higher interest rates generate a stronger currency and vice versa.

Forex market experience volatility when central banks change the interest rates. An accurate speculation of central banks' actions is important for most of the traders. A higher interest rate will encourage traders to invest in that currency and cause the demand for that currency to rise. As the result of increasing demand, foreign investments are drawn to the currency and thus causing the currency to increase in value. In opposition, fall in interest rates will discourage investors and the currency will depreciate due to weaker demand.

For an example, a US investor that wants to deposit a saving account of 1000 dollars with domestic or foreign banks. The US, Japan and Switzerland bank's interest rate are 4.5%, 0.5% and 5.5% respectively. Among all the options, deposit the money in the Switzerland bank is the best option that generates highest return for that investor. The high interest rate in Switzerland bank had attracted foreign investors and this will take effects into the growth of currency value.

Since Forex is the simultaneous transaction of two currencies, then the market must focus on two respective interest rates, which is the base currency interest rate and the quote currency interest rate. This will generate an interest rate differential and this is a basic factor in the Forex markets. Traders will react when the interest rate differential changes, not the interest rates themselves.

Traders approaches the interest rates based on trading expectation and facts. When there is rumor about changes in interest rate differential, traders will react before the fact. However, the quieter of the markets is before a news release will normally signify a huge movement in the market. Besides, the market expectations and actual new release will cause a potential breakout opportunity. The news that comes out as the market expected usually do not cause a strong market reaction. On the other hand, a sudden unexpected change in interest rates is then possibly to trigger a sharp currency move.

Political factors in this case include all the political events and crisis. Political events represent an open-ended category of the fundamental factors affecting the global currency market. Political events take place over a period of time while political crisis strike suddenly and unexpected. Political factors are very uncertainty and difficult to forecast. Traders need to adjust their reaction relative to each event. Here are the examples of real political events and the market reaction in Forex.

The invasion of Kuwait, which is also known as Persian Gulf War, was a major conflict between the Republic of Iraq and the State of Kuwait. This war started on 2 August 1990 and last until year 1991. The Iraqi invasion of Kuwait came as surprise. When the war occurred, the reaction in the Forex market was quick. The US dollar was heavily bought against the Japanese yen because the Japanese economy was perceived as worst due to a reduction of oil supply. The exchange rate of the US dollar against the Japanese yen reached 160 from 150 at that particular time [1]. However by the beginning of year 1991, the USD/JPY was quoted back to 125 with the Allied troops at the height of the operations against Iraq [1].

Japan was not directly involved in the military confrontation in the Persian Gulf but only contributed financially to the Allied effort. As a customer of Gulf oil, Japan was allowed to continue the oil transports. In addition, Japan had stockpiled large quantities of oil. Thus, traders turned around and started to buy the Japanese yen once they realized that the event just had little relation to the reality of the situations.

Mikhail Gorbachev, the last Soviet president, was kidnapped in August 1991. At that time, the US dollar was bought heavily against the Deutsche mark. Deutsche mark was the German currency before it was switched to Euro dollar and was the largest exposure to the Soviet Union at that time.

The US dollar rose sharply against the Deutsche mark as a result of the political uncertainty in the former Soviet Union. As it became obvious that Mikhail Gorbachev was alive and negotiations were on the move, the political crisis had quickly lost its impact and buying of the US dollar had turned into selling.