An Intern Learns – Fundamental Analysis –Inflation and Interest Rates
Hello again and thank you for coming back to An Intern Learns. The last blog was quite a hefty introduction to fundamental analysis! This essential part of trading is concerned with how the broader social, political and economic factors shape a country’s economy. The better the outlook for a country’s economy is, the more investment it will attract. People want to have this currency and it becomes a valuable asset. This is turn will drive up demand, and therefore price. You can understand why this is such an important factor for our trading! A fundamental analysis is typically used in longer trading strategies, so that a bigger picture of a trend can emerge (Remember your SMA’s from previous blogs – if you are trading over a longer period, set the SMA to a long period such as 20 - 40 to see a more general trend line).
Today I’d like to look a little deeper into fundamental analysis so that we are better prepared to deal with whatever the news may throw at us! Last blog I discussed some specific news events to look out for that tend to have a great impact on price movement. Remember you can find these events on a forex calendar and that you should make notes of the ones that affect your currency pairs. I’m going to go through some of the more common examples and just explain a little bit about them. Just a quick little definition before we dive in, if you ever see YoY or MoM in any reports, this refers to Year on Year (an annual report) or Month on Month (a monthly report) respectively.
As I mentioned in my previous blog, speeches by important people in the economic and trading world tend to have quite a big impact. For example, a speech by Mario Draghi, the president of the European Central Bank, would be considered big news. The ECB is responsible for the Euro and the monetary policy in the EU. This is quite a big deal as the EU incorporates some 27 European countries – with Germany, France and the UK being major players even on a global scale. Often a speech will involve topics such as changes to interest rates, economic outlooks, monetary policies or what may come in the future. However it can be quite hard to quantitatively measure these speeches and often the market will react more through sentiment. All traders and economists will scrutinize the speech and try establish which way the price will move based on the contents of the speech. These do not only have to come from the ECB but can come from other institutions such as the Federal Reserve in the USA (FED), the Bank of England (BOE), the Reserve Bank of Australia (RBA), Swiss National Bank (SNB) etc. When the content of these speeches is considered to be more ‘Hawkish’ than was expected this result would be good for the economy. ‘More animal terminology?!?’ I hear you cry. Yes, just like knowing your bears from your bulls, this is quite important. A hawkish outlook on the economic situation means that a central bank will want to increase the interest rate to fight inflation. This approach can be harmful to growth and employment as everything becomes more expensive. A Dovish approach is the opposite and the leaders will be looking to lower interest rates. I will cover more on interests rates and inflation a bit later.
The reason why interest rates are important to traders is because a higher interest rate attracts investors, and more investors equals a more valuable currency.
It works in the same way as if you were looking to put some money in a savings account at your local bank. The option that has the highest interest rate is the one that will be the best prospect for your investment. Investors think the same, and if a country has high interest rates this is a suitable environment for their investments. Before you cry for huge interest rates to attract investors, bare in mind that really high interest rates are not great because they tend to cause less spending and so dampen economic activity.
To recap the Non Farm Payroll (NFP) from last blog, this is a report on the unemployment of the country. As you may recall, it is called ‘non-farm’ because it excludes all data pertaining to agriculture. The reason for this is that agricultural sectors vary according to seasons and so this erratic factor has been removed to keep the data consistent over time. This is a monthly measurement and shows the change in employment and, as I previously mentioned, is a very important indicator of a healthy economy as more jobs means more consumer spending. This data is released as numerical data – a whole number, and doesn’t necessarily have to be higher than the previous month for it to be a favourable result. The trick is to look at the forecast for that release and see rather how it compares to that. If it is higher than the forecast then that might lead to a bullish trend. However note that although this does refer to the level of employment, if you look at another report that shows the actual employment level this will be measured as a percentage and will be related to the previous release. For example if the unemployment was at 7.8% and now is at 8.5%, this is bad for the economy as more people are now without jobs.
Another very important aspect that has a great impact on a country’s economy is the Trade Balance. This is the balance between export and import. If I could use the analogy of a regular goods store – you will make a good profit at the end of the month if you have sold more goods (export) than you have had to buy for stock (import). A country’s trade balance is basically the same thing and measures the demand for the country’s goods and services and therefore it’s currencies. This global trade is what assists in managing the flow of currencies around the world. A trade surplus happens when you have exported more and this leads to a positive trade balance and to a gain in the currency’s value. The reason for this is that an importer must pay in the domestic currency of the country they are buying from; this leads to higher demand for that currency. The stats are either positive or negative number, such as 1.4B or -3.2B and this indicates a trade surplus or deficit respectively.
Now all these economic events don’t necessarily affect the charts immediately. Although an event such as a new NFP stat can have a really quick effect, a new interest rate policy can take some time before any changes are seen. The best thing to do is try stay informed and keep up to date with news events. These are often good indicators of shifts in sentiment and this will give you clues as to where the price direction may be heading.