Key Factors for Fundamental Analysis

This list and summary of key fundamental factors for the USD currency pairs is intended to be more background than grist for your trading mill. This information hits the streets as a constant flow of standing news releases. It is in the application of that news to the market that the astute trader will use fundamental analysis.

Interest Rates

Money talks. Big money flows from currency to currency as a function of the return in interest it can get in relationship to the perceived asset risk in holding that currency.

If there is an uncertainty in the market in terms of interest rates, then any developments regarding interest rates can have a direct effect on the currency markets.
Generally, when a country raises its interest rates, the country's currency strengthens in relation to other currencies as assets are shifted away from it to gain a higher return elsewhere. Interest rate hikes, however, are usually not good news for stock markets. This is because many investors withdraw money from a country's stock market when there is an increase in interest rates, causing the country's currency to weaken. See Figure below.

[caption id="attachment_13136" align="aligncenter" width="467"]U.S. Interest Rates U.S. Interest Rates[/caption]

Knowing which effect prevails can be tricky, but there is usually an agreement among practitioners in the field as to what the interest rate move will do. The timing of interest rate moves is usually known in advance. It is generally known that these moves take place after regular meetings of the BOE (Bank of England), the Fed (U.S. Federal Reserve), the ECB (European Central Bank), the BOJ (Bank of Japan), and other central banks.

Balance of Trade

The trade balance portrays the net difference (over a period of time) between the imports and exports of a nation. When the value of imports becomes more than that of exports, the trade balance shows a deficit (this is, for the most part, considered unfavorable). For example, if Euros are sold for other domestic national currencies, such as U.S. Dollars, to pay for imports, the value of the currency will depreciate due to the flow of Dollars outside the country. By contrast, if trade figures show an increase in exports, money will flow into the country and increase the value of the currency. In some ways, however, a deficit is not necessarily a bad thing. A deficit is only negative if the deficit is greater than market expectations and will consequently trigger a negative price movement. See Figure below.

[caption id="attachment_13137" align="aligncenter" width="550"]U.S. Balance of Trade U.S. Balance of Trade[/caption]

Parity and Purchasing Power

Purchasing power parity (PPP) is a theory that states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price levels of a fixed basket of goods and services. When a country's domestic price level is increasing (that is, a country experiences inflation), that country's exchange rate must depreciate before it can return to PPP.

Gross Domestic Product

The gross domestic product (GDP) is the total market value of all goods and services produced either by domestic or foreign companies within a country's borders. GDP indicates the pace at which a country's economy is growing (or shrinking) and is considered the broadest indicator of economic output and growth.

GDPs of different countries can be compared by converting their value in national currency according to either exchange rates prevailing on international currency markets or the purchasing power parity (PPP) of each currency relative to a selected standard (usually the U.S. Dollar).

The relative ranking of countries may differ dramatically, depending on which approach is used: Using official exchange rates can routinely understate the relative effective domestic purchasing power of the average producer or consumer within a less-developed economy by 50 percent to 60 percent, owing to the weakness of local currencies on world markets.

However, comparison based on official exchange rates can offer a better indication of a country's purchasing power on the international market for goods and services.

Intervention

Another important fundamental influence on FOREX currency prices is called intervention. This occurs when an official regulatory agency or a financial institution with one government directly coerces the exchange rate of its currency, usually by reevaluation, devaluation, or by the manipulation of imports and exports in some way.

Such actions may cause broad and erratic changes in the exchange rate with foreign currencies. It is from such anomalies that the FOREX trader may profit, however, if the proper stop-loss safeguards are in place.

The spotlight on fundamental factors shift in a faddish way. At the present time, intervention is the hot item because of the two-headed EUR and USD debt crises.

But that will change, as do all fads. The author remembers in the late 1970s, during the Carter administration, brokers and traders hanging on the latest money supply figures. For a year or two it was the in thing—and then the music changed.

Industrial Production

Industrial production (IP) is a chain-weighted measure of the change in the production of a nation's factories, mines, and utilities, as well as a measure of their industrial capacity and how many available resources among factories, utilities, and mines are being used (commonly known as capacity utilization). The manufacturing sector accounts for one-quarter of the economy. The capacity utilization rate provides an estimate of how much factory capacity is in use.

Purchasing Managers Index

The National Association of Purchasing Managers (NAPM), now called the Institute for Supply Management, releases a monthly composite index of national manufacturing conditions, constructed from data on new orders, production, supplier delivery times, backlogs, inventories, prices, employment, export orders, and import orders. It is divided into manufacturing and nonmanufacturing subindexes.

Producer Price Index

The producer price index (PPI) is a measure of price changes in the manufacturing sector. It measures average changes in selling prices received by domestic producers in the manufacturing, mining, agriculture, and electric utility industries for their output. The PPIs most often used for economic analysis are those for finished goods, intermediate goods, and crude goods.

Consumer Price Index

The consumer price index (CPI) is a measure of the average price level paid by urban consumers (80 percent of the population) for a fixed basket of goods and services. It reports price changes in more than 200 categories. The CPI also includes various user fees and taxes directly associated with the prices of specific goods and services.

As of 2010, the CPI was not a major player to traders. The Federal Reserve concluded not only that there is little risk of inflation, but that a deflationary meltdown was the current risk. Food and gasoline, two components with which the average consumer measures inflation, is not in the core index because they are "too volatile." The commodities boom of 2010–2011 also had minimal impact on the CPI.

Durable Goods

The durable goods orders indicator measures new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods. A durable good is defined as a good that lasts an extended time (three years or more), during which its services are extended.

Employment Index

Payroll employment is a measure of the number of jobs in more than 500 industries in all 50 states and 255 metropolitan areas. The employment estimates are based on a survey of larger businesses and count the number of paid employees working part-time or full-time in the nation's business and government establishments.

Currently, the nonfarm payroll report (NFP), issued the first Friday of each month, is closely watched by traders of the USD. News traders much anticipate this report because the preliminary report consensus of the number is typically incorrect—resulting in short-term fireworks for the USD currency pairs.

Retail Sales

The retail sales report is a measure of the total receipts of retail stores from samples representing all sizes and kinds of business in retail trade throughout the nation. It is the timeliest indicator of broad consumer spending patterns and is adjusted for normal seasonal variation, holidays, and trading-day differences. Retail sales include durable and nondurable merchandise sold, and services and excise taxes incidental to the sale of merchandise. Excluded are sales taxes collected directly from the customer.

Housing Starts

The housing starts report measures the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is composed primarily of residential housing. Housing is interest rate–sensitive and is one of the first sectors to react to changes in interest rates. Significant reaction of starts and permits to changing interest rates signals that interest rates are nearing a trough or a peak. To analyze the data, focus on the percentage change in levels from the previous month. The report is released around the middle of the following month.

Fundamental factors are numerous for all currencies; there are dozens of them. The relationships between them are very complex—and also numerous. It is likely the ultimate network of these interconnections is what mathematicians call complex. Much like the weather, a small change in one of them can have manifest and unpredictable effects on the others.
By Michael Duane Archer
Michael Duane Archer has been an active futures and FOREX trader for more than 35 years. He has worked in various advisory capacities, notably as a commodity trading advisor, registered SEC investment advisor, and branch manager for Heinold of Hawaii. He currently trades FOREX and futures and is involved in several technical analysis research projects.

Copyrighted 2016. Content published with author's permission.

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