The Basics of Fundamental Analysis
Foreign exchange trading is driven by several forces, including that of basic economics. The focus for many currency traders falls on central bank policies and the economic readings that drive those decisions. Ideally, a trader will try to find a currency pair that has a central bank that is trying to control inflation during the early stages of an economic expansion and pair it against a currency that has a central bank that is trying to get the economy out of a contraction.
Most notably, central bank rate decisions are one of the primary drivers that move the forex markets. Central bank officials track many economic indicators, with a greater emphasis on factors that predominantly focus on both inflation and economic growth. Traders should have an understanding of these factors and be aware of changes.
- Understanding the goal of central banks
- Recognizing how inflation swings impact monetary policy
- Potential leading indicator on how prices might behave
- Key indicator that tells the overall health of a country’s economy
- Understanding the NFP report
- The strength of the consumer
- Understanding which parts of the economy to follow
Central Bank Mandates
If you are looking to trade major currency pairs, you will notice that some central banks have different mandates.
Congress states that The Fed’s goals should be “maximum employment, stable prices, and moderate long-term interest rates.”
The ECB’s mandate only focuses on one objective: maintaining price stability.
The Bank of Canada’s (BOC) main role is “to promote the economic and financial welfare of Canada.”
The BOC has a commitment to the 2% inflation target, which is the centerpiece of their inflation targeting framework.
The BOE has a dual mandate that aims to keep the whole UK financial system strong while keeping price rises low and stable.
The RBA’s obligation is to contribute to the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people.
The BOJ’s primary objective is to maintain price stability.
The RBNZ has a dual mandate of promoting price stability and supporting maximum sustainable employment.
Wall Street always pays attention to gross domestic product (GDP) readings, as they provide an accurate indicator of the size of an economy while outlining the general health of the economy. Two or more consecutive quarters of economic growth is considered an expansion. When the economy has declined for two or more consecutive quarters, then a recession has occurred.
The nonfarm payroll report, or NFP, shows how many jobs in the US, excluding those employed by farms increased or decreased in the prior month. The US jobs report is typically released on the first Friday of each month. If the labor market is expanding, that typically is associated with economic growth. When job losses are occurring, that could mean the economy is recession-bound. The NFP report also contains the unemployment rate and an update on average hourly earnings (wages).
The strength of the consumer could be measured across a plethora of economic releases that include automobile sales, retail sales, consumer sentiment, existing home sales, and earnings results or guidance across several major retailers.
Manufacturing and Service Reports
The overall health of an economy can be determined by how the manufacturing and service sectors are performing. In the US, the service industry accounts for roughly two-thirds of the economy. In Germany, the service sector makes up 69% of the economy, while the production industry is 23.5%, and construction is 6%.
At the start of every month, the purchasing managers index (PMI) is released for both the manufacturing and service sectors in all the major economies. The PMI index shows whether market conditions are expanding, holding steady, or contracting.
In the US, many traders also pay close attention to the ISM Manufacturing and Services index, as both reports give a detailed look at prices paid, employment, new orders, and commentary from various sectors about their respective outlooks. For countries that depend on exporting goods, the manufacturing report might carry more weight than the services report.
The impact of inflation trends and expectations will greatly influence what central banks do. If pricing pressures remain hot and are rising, a central bank might consider tightening monetary policy by raising interest rates. Some economists believe that during recessions, lower interest rates can help spur economic growth and speed up inflation.
The monthly consumer price report, or CPI, measures changes in a multitude of goods and services prices. The annual level is focused on, as traders will compare that level to each central bank’s inflation target. The monthly level provides insight on the trends associated with the current pricing pressures. The core inflation readings exclude food prices, fuel prices, income tax, & financial investments for the more volatile components.
The change in price for the raw material which domestic manufacturers pay to produce the goods they sell can provide a sign on when the economy is adjusting. The US producer price index, or PPI, is released typically the day after CPI report, but is still important as it can provide an indication if the consumer will see higher costs over the coming months. Wall Street pays close attention to PPI, as it will greatly influence margin expectations for the upcoming earnings season.
Why Macroeconomic Indicators Matter to Forex Traders
Macroeconomic indicators can sometimes be the key catalyst to extend or end a currency trend. Currency traders should understand that market reactions not only depend on whether an economic release prints above or below the consensus estimate but on how the market is positioned beforehand.
Finding the right strategy requires testing and lots of practice, which is why many FX traders start off by using OANDA’s demo account.
This article is for general information purposes only, not to be considered a recommendation or financial advice. Past performance is not indicative of future results.
It is not investment advice or a solution to buy or sell instruments. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading in foreign currency contracts or other off-exchange products on margin carries a high level of risk and may not be suitable for everyone. We advise you to carefully consider whether trading is appropriate for you in light of your personal circumstances. You may lose more than you invest. We recommend that you seek independent financial advice and ensure you fully understand the risks involved before trading. Trading through an online platform carries additional risks. Losses can exceed deposits.