The Fundamentals of Forex Fundamentals

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
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)
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.

Retail Sales
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.

Industrial Production
This report shows the change in the production of factories, mines and utilities within a nation. It also reports their 'capacity utilization's', 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.

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.

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.
• 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.

Conclusion
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. 

Check out the economic calendar from Trust Capital.

The U.S. Dollar and the Yen: An Interesting Partnership

Many find trading the Japanese yen against the U.S. dollar, USD/JPY, a complicated proposition. This should not be the case when the Japanese yen is understood in terms of U.S. treasury bonds, notes and bills. The main driver of this pair is not only treasuries, but interest rates in both Japan and the U.S. This means that the pair is a measure of risk that determines when to buy or sell the USD/JPY, in terms of interest rates. Knowing where interest rates are heading will determine the direction of this pair.

The USD/JPY Relationship
Traditionally, the USD/JPY has been known as a currency pair because of its close correlation with U.S. treasuries. When treasury bonds, notes and bills rise, USD/JPY prices weaken. This is a long position. The logic is that the U.S. would never default on its bond obligations, known as defensive assets, hence its safe haven status is secure.

This relationship can be viewed in two ways: through the U.S. dollar and interest rates. When interest rates are heading higher during the course of a trading day, or are suspected to head higher in the future, treasury bond prices will go down. This will send the U.S. dollar higher and, in turn, USD/JPY prices will strengthen. In this instance, the market is more in search of yields from treasury trades and a lower USD/JPY price. This is a short position. Yields are the rate of interest paid on a treasury instrument. Yields and bond prices have an inverse relationship. When yields slump, a flight to liquidity occurs, and this liquidity must find a home. This relationship is a measure of market risk.

Market Trends
Traditionally, the USD/JPY pair has been the market determinant of risk. When markets are in search of risk trades, treasury bond yields will rise as interest rates fall. Yields are also a market determinant of risk as this correlation is opposite to the USD/JPY prices because yield trades are risky due to the market's ability to turn quickly when panic occurs. If panic or fear hits the markets, treasury bond prices will rise, yields will turn lower, the U.S. dollar will turn lower and the USD/JPY will appreciate, a long position. This is due to the yen's status as the premiere funding currency. Selling a lower-yielding currency, such as the yen, with current interest rates below its major trading partners, such as the euro, UK, U.S., Canada, Swiss, Australia and New Zealand, allows the yen to be borrowed at a low interest rate to seek higher interest rate instruments within its major trading partners for carry trade purposes.

Carry Trades
Carry trades have been a major funding source for many years. Traditional logic means, sell the USD/JPY for U.S. dollars and use those dollars to obtain higher yielding instruments such as treasury bonds. This strategy has been a win for a Japanese society dependent on exports for its economic health and safe haven status for its currency. It's the tradeoff between interest income and capital gains or Treasuries versus yields.

As an example: a trader sells the USD/JPY at a 0.5 current interest rate in Japan and buys Treasury bonds, earning 3% interest with a 5% yield. This is a positive carry trade and very popular to earn higher interest with a risk-less trade.

U.S. stock markets, treasury bonds and the USD/JPY also have inverse relationships. When stock markets rise, bond prices fall, yields rise and the USD/JPY should be sold because investors are more willing to trade risky assets. Stocks are viewed as risky assets and not backed by a government with the ability to turn if fear grips the market. Liquidity here takes on risk rather than the safe status of treasuries.

Winning Strategies
These relationships are traditionally correlated, but do not always remain on a constant basis. The best measure is to watch the two-year Treasury bond and the stock market for shorter term traders and 10- and 30-year bonds for longer swing traders. If stocks and bonds change their inverse correlations, the USD/JPY will not trade based on the traditional correlations. Normally, these changes in bond/stock correlations are short term, yet short-term traders can find huge losses if not careful of these developments. If correlations change while in a trade, bail out and wait for the market to correct itself. Another hint may be to look at the S&P indexes for possible early warnings of change.

Changes in correlations may occur for many reasons. For example, the U.S. issues more debt by sales of treasury bonds and adds money to the system yet bond prices may dilute. Is this USD/JPY positive or negative? Probably JPY negative, but the market may have to decide. What if the U.S. buys back treasury bonds and adds money to the system? Is this USD/JPY positive? In good economic times the answers are easy, recessionary times are quite different. What if the U.S. dollar and the yen are both in a downtrend? Excess liquidity strengthens currency prices. Many other examples exist that change bond/stock correlations.

Because the USD/JPY pair trades in Asia, the same bond, stock and dollar correlations hold as they do in the U.S. Japanese government bonds are known as JGBs. When JGB bond prices are down in Asia trading, the USD/JPY is down, a short. This means bond yields and the Japanese stock market are up.

Parting Thoughts
We evaluate the supply and demand of dollars and yen as a measure of prices for this pair by the amount of liquidity in or out of their respective nations' markets, through government bonds. The positive carry trade is viewed by the market as a negative for Japan's economy because it deflates its currency. This is a USD/JPY short. Yet if Japan repatriated its yen home, this would be USD/JPY positive - a buy, because it weakens its currency and strengthen its economy.

Nations with trade surpluses that gained foreign reserves are a buy for USD/JPY, because the market traditionally views this as a greater buying power to seek higher interest. Deficit nations are a sell. The traditional correlative points are: bonds up; USD/JPY up; USD down; yields down and stock markets up.

Now that we've gone through how the yen and treasury bonds relate to each other, and how the markets affect that relationship, hopefully it's not as difficult to understand the correlation between the USD/JPY pairing. 

The German ILO: Why It Matters To Traders

The monthly economic release covering Germany's employment figures is called the German ILO. ILO is an acronym for the International Labor Organization, a specialized agency of the United Nations that has sought, since its founding and adoption by the Treaty of Versailles in 1919, to promote social justice, human rights and decent working conditions. The world adopted the ILO as a specialized agency of the League of Nations to keep peace and avoid social unrest in the workplace. Since 1919, and through many years of conventions and treaties adopted by European States, all states subscribe to the standards of the ILO, which cover categories such as collective bargaining, child labor, forced labor and other workplace issues.  

Critical Numbers
Why the German ILO reports in particular are so vital to economists, policymakers and traders is because Germany is the European leader in manufacturing and industry and was in some periods in history, leading the world. Germany sets the standard and tone regarding the business climate of all of Europe. Spain, France and Italy vie for the No.2 spot. So, the world watches German governmental policies as a gauge to future business climates in Europe.

Many will analyze German numbers to determine whether unemployment hit a bottom, or analyze the numbers based on a four-week moving average to determine trends and gauge future releases. This is because employment is a lagging indicator and is vital in determining the strength of an entire economy. Japan and the United States are just two nations of many that are major trading partners. If Germany's sneezes, the rest of the world is at risk of catching a cold.

Germany's Employment Statistics
Currently, the Federal Statistics Office, an agency within the Federal Interior Ministry in Germany, compiles, analyzes and releases monthly employment information that covers three categories: the economically active population, persons employed and the unemployed. This information is compared in a clear table to unemployment rates in other European States, Japan and the United States. With a current population of 82 million, Germany reported an employed workforce of 40.01 million in August 2009, a decrease of 216,000, or .05 percent, from the previous year. Overall, the unemployment rate in Germany decreased at a steady rate between 2006 and 2009.

Germany tracks its industries by a Production Index that covers six categories: total production industries, production industries excluding building services, mining and quarrying, manufacturing, energy supply and site preparation, and civil engineering.

Many statistics can be found using these numbers. For example, as of 2009, 4.5 million persons were employed through public services or government, but that number is decreasing as Germany continues its privatization of basic government services such as waste management.

For the monthly employment release, the Federal Statistics Office tracks those who are registered as unemployed, registered job offers, the apprenticeship market, employment integration, marginal work, persons employed subject to social insurance and recipients of benefits.

Until 2007, the Federal Statistics Office counted the number of persons in employment and employment divided by a population ratio; underemployment and unemployment rates were published on a monthly basis as part of the ILO economic release. The unemployment rates were broken down by sex and age for East and West Germany. Now, the Federal Statistics Office tracks seasonally adjusted unemployment figures and rates and breaks them all down by age and sex.

Conclusion
The effects for traders regarding the health of the euro in monthly ILO reports is of vital importance. For example, when the September 2009 reports were released and showed a rise in the unemployment rate to 8.3 and a loss of 20,000 more monthly jobs, the euro dropped against the United States, EUR/USD 87 points in seconds. On small measure, the health of the euro rests on a healthy German economy.

 Check out the economic calendar presented by Trust Capital here.

3 Factors That Drive the U.S. Dollar

When it comes to the decision of whether you should buy or sell dollars, it all boils down to how the economy is performing. A strong economy will attract investment from all over the world due to the perceived safety and the ability to achieve an acceptable rate of return on investment. Investors always seek out the highest yield that is predictable or "safe." Investment from abroad creates a strong capital account and a resulting high demand for dollars.

On the other hand, American consumption that results in the importing of goods and services from other countries causes dollars to flow out of the country. If our imports are greater than our exports, we will have a deficit in our current account. With a strong economy, a country can attract foreign capital to offset the trade deficit. The U.S. can continue as the consumption engine that fuels all the world economies even though it's a debtor nation that borrows this money to consume. This also allows other countries to export to the U.S. and thus keep their economies growing. This explanation is simplistic, but it illustrates a point.

Factors Affecting Dollar Value
The point is that when it comes to taking a position in the dollar, the currency trader needs to assess the different factors that affect the value of the dollar to try to determine a direction or trend. The methodology can be divided into three groups as follows:

• Supply and demand factors
• Sentiment and market psychology
• Technical factors

Let's take each group individually.

Supply Versus Demand for Dollars
When we export products or services, we create a demand for dollars because our customers need to pay for our goods and services in dollars and, therefore they will have to convert their local currency into dollars. Hence they sell their currency to buy dollars so that they can make the payment.

In addition, when the U.S. government or large American corporations issue bonds to raise capital, and if these bonds are bought by foreigners then again the bonds have to be paid for in dollars and the customer will have to sell their local currency to buy dollars so they can effect payment. Also, if there is strong growth in the U.S. and companies are expanding their earnings then the desire by foreigners to own corporate stocks in the U.S. also requires that they sell their currency to buy dollars to pay for the purchase of stocks.

Sentiment and Market Psychology
But what if the U.S. economy weakens and consumption slows due to increasing unemployment? Then the U.S. is confronted with the possibility that foreigners may sell their bonds or stocks and return the cash from the sale in order to return to their local currency. Hence they sell the dollars and buy back their local currency.

Technical Factors
As traders, we have to gauge whether the supply of dollars will be greater or less than the demand for dollars. To help us determine this, we need to pay attention to various news and event items, such as the release by the government of various statistics, such as payroll data, GDP data, and other market and economy measuring information that can help us to determine what is happening in the economy and to estimate whether the economy is strengthening or weakening.

In addition, we need to determine the general sentiment regarding what the players in the market think the outcome of events is likely to be. Very often, sentiment will drive the market rather than the fundamentals of supply and demand. To add to this mix of prognostication, besides the measurement of supply and demand factors and sentiment, we also have the historical patterns generated by seasonal factors, support and resistance levels, and technical indicators and so on. Many traders believe that these patterns are repetitive and therefore can be used to predict future movements.

Bringing Them All Together
Since trading relies on the ability of a trader to take a risk and manage it accordingly, traders usually adopt some combination of the three above methods to make their buy or sell decisions. The art of trading exists in stacking the odds in your favor and building an edge. If the probability of being correct is high enough the trader will enter the market and manage his hypothesis accordingly. To stack the odds in our favor we therefore need to take into account each one of the three methodologies and hopefully find them to be congruent, meaning that they all point in the same direction.

An Example
The economic conditions during the recession that began in 2007 forced the U.S. government to play an unprecedented role in the economy. Since economic growth was receding as a result of the large deleveraging of financial assets taking place, the government had to take up the slack by increasing government spending to keep the economy going. The purpose of their spending was to create jobs so that the consumer could earn money and increase consumption thereby fueling the growth needed to support economic growth.

The government took this position at the expense of an increasing deficit and national debt. It financed this increase by essentially printing money and by selling government bonds to foreign governments and investors - resulting in an increase in the supply of dollars. Hence the dollar depreciated as a result. Another concern for countries that rapidly issue debt is that the interest burden will increase and, therefore, more tax dollars will be allocated just to cover the interest rate.

One of the roles of the government is to create the conditions necessary to allow the markets to grow so that is the economy is as close to full employment as possible, but with controlled inflation. Thus when the economy deflates the government will try to do all it can to re-inflate it in a controlled manner.

The Bottom Line
It may be helpful for a trader to keep an eye on the Dollar Index chart to provide an overview of how the dollar fares against the other currencies in the index. By watching the patterns on the chart and listening to the sentiment in the market, as well as monitoring the major fundamental factors that affect supply and demand, a trader can develop a big picture sense of the flow of dollars and thus develop an insight to choose profitable positions in future trades.