Forex Analysis – Fundamental Analysis
Opposite the Forex technical analysis part, this Forex tutorial is created to show the way the major part of Forex Analysis – Forex fundamental analysis is held like, what are the advantages and importance of performing it and make a trader be little more familiar to this type of Forex Analysis – Forex fundamental analysis.
Two major parts of analyzing currency markets are technical analysis and fundamental analysis. One really great and clear difference between Forex fundamental analysis and Forex technical analysis is that first mainly studies the causes of market movements, while the other one is concentrating on the effect of market movements. The last one, Forex fundamental analysis, focuses on the economic and financial theories, developments of politics and determines the supply and demand forces.
Forex fundamental analysis examines the asset markets, macroeconomic indicators and political considerations for the evaluation of one currency in relativity to other. The indicators of macroeconomics consist of the figures like interest rates, unemployment, inflation, growth rates, foreign exchange rates, money supply and productivity. Asset markets include bonds, stocks and real estate. Political considerations are impacting the level of the nation’s government confidence and the stability climate. Government is used to stand in the way of forces of market sometimes. It’s performed with impacting the currencies, hence, intervening to keep the currencies from deviating from the unwanted levels. The interventions of currency have the notable, though temporary, impact on the FX markets and are conducted by central banks. On the other hand, some countries can manage the moving of their currencies, threatening to intervene or merely by hinting.
The basic Forex fundamental analysis theories are PPP (or Purchasing Power Parity), IRP (or Interest Rate Parity), Asset Market model and Balance of payment model.
Purchasing Power Parity
The PPP theory of Forex fundamental analysis claims the exchange rates to be determined by the prices (relative ones) of similar goods’ baskets. Inflation rates changes tend to be offset by equal but at the same time opposite changes with the exchange rate. The example can be shown on chocolates. In the USA, the chocolate costs $2, at the same time in the United Kingdom this chocolate is traded for 1 pound. So according to this theory, the exchange rate of pound to dollar should be 2 dollars for one pound. In the comparison, if the market rate is about $1.6 per pound, then the dollar is said to be overvalued when the pound is undervalued. The PPP theory means in itself that there will be an eventual movement to the 2:1 currencies relation.
In general, this theory has some points of major weakness. First one means that the goods this theory is assuming are easily tradable, with no tariffs, taxes or quotas given as the costs to trade. Another one is that PPP applies the good and ignores services only, with the room for difference in value staying significant. And of course there are some more factors besides interest rate differences and inflations, and these factors are impacting exchange rates too. They are economic reports and releases, political developments and asset markets. The main evidence of PPP’s theory effectiveness was last seen prior to 1990s. And after, PPP was seem to be working only during the long terms (3-5 years or more), when prices were eventually corrected towards parity.
Interest Rate Parity
Interest Rate Parity or IRP claims that the depreciation or appreciation of one currency towards another should be neutralized with the change in the differential of an interest rate. If Great Britain’s interest rates exceed those ones but US, then the euro will surely depreciate towards the dollar by an amount that can prevent arbitrage without risks. The exchange rate of future can be reflected into the forward exchanged rate that exists today. In the example shown higher, the euro can be claimed at discount, because it can buy fewer dollars in the forward rate than in the spot one. And the dollar is claimed to be at a premium.
Sadly this theory didn’t show any proof of working after the 90s. Not mentioning the theory, currencies that showed higher interest rates rather appreciated than depreciated due to the reward of future inflation containment.
The model of Balance of payments holds the fact that a Forex rate have to be at the level of equilibrium (so-called term that means the rate that produces the stable current account balance). A nation that suffers from trade deficit will surely experience the reduction in its Forex reserves, which depreciates the value of currency of this country ultimately. The cheaper currency is rendering the exports to be more affordable on the global market, when the imports become more expensive. When the intermediate period is over, imports force down and exports rise, stabilizing the currency and trade balance against equilibrium again.
As the PPP theory, this one is focusing mostly on tradable services and goods, ignoring the important role of global capital flows. Money are not chasing only good and services, but rather the financial assets like bonds and stocks. The increase in capital flows gave the rise of the Asset Market Model.
The trading of financial assets explosion reshaped the look the traders and analysts give to the currencies. Economic variables like inflation, productivity and growth are not the only currency movements’ drivers, not anymore. The proportions of Forex transactions coming from cross-border financial assets’ trading has dwarfed the extent of the transactions of the currency, generated from services and goods trading. So, currencies demonstrate the strong correlation to asset markets, equities in particular.
