What Moves The Currency Market In The Long Term? Fundamental Analysis

There are two major ways to analyze financial markets: fundamental analysis and technical analysis. Fundamental analysis is based on underlying economic conditions, while, technical analysis uses historical prices in an effort to predict future movements. Ever since technical analysis first surfaced, there has been an ongoing debate as to which methodology is more successful. Short-term traders prefer to use technical analysis, focusing their strategies primarily on price action, while medium-term traders tend to use fundamental analysis to determine a currency's proper valuation, as well as its probable, future valuation.

Before implementing successful trading strategies, it is important to understand what drives the movements of currencies in the foreign exchange market. The best strategies tend to be the ones that combine both fundamental and technical analysis. Too often perfect technical formations have failed because of major fundamental events. The same occurs with fundamentals; there may be sharp gyrations in price action one day on the back of no economic news released, which suggests that the price action is random or based on nothing more than pattern formations. Therefore, it is very important for technical traders to be aware of the key economic data or events that are scheduled for release and, in turn, for fundamental traders to be aware of important technical levels on which the general market may be focusing.

Fundamental analysis focuses on the economic, social, and political forces that drive supply and demand. Those using fundamental analysis as a trading tool look at various macroeconomic indicators such as growth rates, interest rates, inflation, and unemployment. We list the most important economic releases in Chapter 10 as well as the most market-moving pieces of data for the U.S. dollar in Chapter 4. Fundamental analysts will combine all of this information to assess current and future performance. This requires a great deal of work and thorough analysis, as there is no single set of beliefs that guides fundamental analysis. Traders employing fundamental analysis need to continually keep abreast of news and announcements that can indicate potential changes to the economic, social, and political environment. All traders should have some awareness of the broad economic conditions before placing trades. This is especially important for day traders who are trying to make trading decisions based on news events because even though Federal Reserve monetary policy decisions are always important, if the rate move is already completely priced into the market, then the actual reaction in the EUR/USD, say, could be nominal.

Taking a step back, currency prices move primarily based on supply and demand. That is, on the most fundamental level, a currency rallies because there is demand for that currency. Regardless of whether the demand is for hedging, speculative, or conversion purposes, true movements are based on the need for the currency. Currency values decrease when there is excess supply. Supply and demand should be the real determinants for predicting future movements. However, how to predict supply and demand is not as simple as many would think. There are many factors that contribute to the net supply and demand for a currency, such as capital flows, trade flows, speculative needs, and hedging needs.

For example, the U.S. dollar was very strong (against the euro) from 1999 to the end of 2001, a situation primarily driven by the U.S. Internet and equity market boom and the desire for foreign investors to participate in these elevated returns. This demand for U.S. assets required foreign investors to sell their local currencies and purchase U.S. dollars. Since the end of 2001, when geopolitical uncertainty rose, the United States started cutting interest rates and foreign investors began to sell U.S. assets in search of higher yields elsewhere. This required foreign investors to sell U.S. dollars, increasing supply and lowering the dollars value against other major currencies. The availability of funding or interest in buying a currency is a major factor that can impact the direction that a currency trades. It has been a primary determinant for the U.S. dollar between 2002 and 2005. Foreign official purchases of U.S. assets (also known as the Treasury international capital flow or TIC data) have become one of the most important economic indicators anticipated by the markets.

Capital flows and trade flows constitute a country's balance of payments, which quantifies the amount of demand for a currency over a given period of time. Theoretically, a balance of payments equal to zero is required for a currency to maintain its current valuation. A negative balance of payments number indicates that capital is leaving the economy at a more rapid rate than it is entering, and hence theoretically the currency should fall in value.

This is particularly important in current conditions (at the lime of this book's publication) where the United States is running a consistently large trade deficit without sufficient foreign inflow to fund that deficit. As a result of this very problem, the trade-weighted dollar index fell 22 percent in value between 2003 and 2005. The Japanese yen is another good example. As one of the world's largest exporters, Japan runs a very high trade surplus. Therefore, despite a zero interest rate policy that prevents capital flows from increasing, the yen has a natural tendency to trade higher based on trade flows, which is the other side of the equation. To be more specific, here is a detailed explanation of what capital and trade flows encompass.

Capital flows measure the net amount of a currency that is being purchased or sold due to capital investments. A positive capital flow balance implies that foreign inflows of physical or portfolio investments into a country exceed outflows. A negative capital flow balance indicates that there are more physical or portfolio investments bought by domestic investors than foreign investors. Let's look at these two types of capital flows—physical flows and portfolio flows.

Physical Flows. Physical flows encompass actual foreign direct investments by corporations such as investments in real estate, manufacturing, and local acquisitions. All of these require that a foreign corporation sell the local currency and buy the foreign currency, which leads to movements in the FX market. This is particularly important for global corporate acquisitions that involve more cash than stock.

Physical flows are important to watch, as they represent the underlying changes in actual physical investment activity. These flows shift in response to changes in each country's financial health and growth opportunities. Changes in local laws that encourage foreign investment also serve to promote physical flows. For example, due to China 's entry into the World Trade Organization (WTO), its foreign investment laws have been relaxed. As a result of its cheap labor and attractive revenue opportunities (population of over 1 billion), corporations globally have flooded China with investments. From an FX perspective, in order to fund investments in China , foreign corporations need to sell their local currency and buy Chinese renminbi (RMB).

Portfolio Flows. Portfolio flows involve measuring capital inflows and outflows in equity markets and fixed income markets.

Equity Markets. As technology has enabled greater ease with respect to transportation of capital, investing in global equity markets has become far more feasible. Accordingly, a rallying stork market in any part of the world serves as an ideal opportunity for all, regardless of geographic location. The result of this has become a strong correlation between a country's equity markets and its currency: if the equity market is rising, investment dollars generally come in to seize the opportunity. Alternatively, frilling equity market could prompt domestic investors to sell their shares of local publicly traded firms to capture investment opportunities abroad.

The attraction of equity markets compared to fixed income markets has increased across the years. Since the early 1990s, the ratio of foreign transactions in U.S. government bonds over U.S. equities has declined from 10 to 1 to 2 to 1. As indicated in Figure 3.1, it is evident that the Dow Jones Industrial Average had a high correlation (of approximately 81 percent) with the U.S. dollar (against the deutsche mark) between 1994 and 1999. In addition, from 1991 to 1999 the Dow increased 300 percent, while the U.S. dollar index appreciated nearly 30 percent for the same time period. As a result, currency traders closely followed the global equity markets in an effort to predict short-term and intermediate-term equity-based capital flows. However, this relationship has shifted since the tech bubble burst in the United States, as foreign investors remained relatively risk-averse, causing a lower correlation between the performance of the U.S. equity market and the U.S. dollar. Nevertheless, a relationship does still exist, making it important for all traders to keep an eye on global market performances in search of intermarket opportunities.

Fixed Income Markets. Just as the equity market is correlated to exchange rate movement, so too is the fixed income market. In times of global uncertainly, fixed income investments can become particularly appealing, due to the inherent safety they possess. As a result, economies boasting the most valuable fixed income opportunities will be capable of attracting foreign investment—which will naturally first require the purchasing of the country's respective currency.

A good gauge of fixed income capital flows are the short- and long-term yields of international government bonds. It is useful to monitor the spread differentials between the yield on the 10-year U.S. Treasury note and the yields on foreign bonds. The reason is that international investors tend to place their funds in countries with the highest-yielding assets. If U.S. assets have one of the highest yields, this would encourage more investments in T.S. financial instruments, hence benefiting the U.S. dollar. Investors can also use short-term yields such as the spreads on two-year government notes to gauge short-term flow of International funds. Aside from government bond yields, federal funds futures can also be used to estimate movement of U.S. funds, as they price in the expectation of future Fed interest rate policy. Euribor futures, or futures on the Euro Interbank Offered Rate, are a barometer for the euro region's expected future interest rates and can give an indication of euro region future policy movements. We cover using fixed income products to trade FX further in Chapter 9.

Trade flows are the basis of the international transactions. Just its the investment environment of a given economy is a prime determinant of its currency valuation, trade flows represent a country's net trade balance. Countries that are net exporters—meaning they export more to international clients than they import from international producers will experience a net trade surplus. Countries that are net exporters are more likely to have their currency rise in value, since from the perspective of international trade, their currency is being bought more than it is sold: inclinational clients intended in buying the exported product/service mast first buy the appropriate currency, thus creating demand for the currency of the exporter.

Countries that are net importers—meaning they make more International purchases than international sales experience what is known as a trade deficit, which in turn has the potential to drive the value of the currency down. In order to engage in international purchases, importers must sell their currency to purchase that of the retailer of the good or service; accordingly, on a large scale this could have the effect of driving the currency down. This concept is important because it is a primary reason why many economists say that the dollar needs to continue to fall over the next few years to slop the United States from repeatedly hitting record high trade deficits.

To clarify this further, suppose, for example, that the U.K. economy is booming, and that its stock market is rallying as well. Meanwhile, in the United States , a lackluster economy is creating a shortage of investment opportunities. In such a scenario, the natural result would be for U.S. residents to sell their dollars and buy British pounds to take advantage of the rallying U.K. economy. This would result in capital outflow from the United States and capital inflow for the United Kingdom . From an exchange rate perspective, this would induce a fall in the USD coupled with a rise in the GBP as demand for USD declines and demand for GBP increases; in other words, the GBP/USD would rise.

For day and swing traders, a tip for keeping on top of the broader economic picture is to figure out how economic data for a particular country stacks up.

A good tip for traders is to stack up economic data surprises against price action to help explain and forecast the future movement in currencies.

Figure 3.2 presents a sample of what can be done. The bar graph shows the percentages of surprise that economic indicator have compared to consensus forecasts, while the dark line traces price action for the period during which the data was released; the white line is a simple price regression line. This charting can be done for all of the major currency pairs, providing a visual guide to understanding whether price action has been in line with economic fundamentals and helping to forecast future price action. Thus data is provided on a monthly basis on www.dailyfx.com, listed under Charting Economic Fundamentals.

According to the chart in Figure 3.2 in November 2004, there were 12 out of 15 positive economic surprises and yet the dollar sold off against the euro during the month of December, which was the month during which the economic data was released. Although this methodology is inexact, the analysis is simple and past charts have yielded some extremely useful clues to future price action. Figure 3.3 shows how the EUR/USD moved in the following month. As you can see, the EUR/USD quickly corrected itself during the month of January, indicating that the fundamental divergence of price action that occurred in December proved to be quite useful to dollar longs, who harvested almost 600 pips as the euro quickly retracted a large part of its gains in January. This method of analysis, called "variant perception", was invented by the legendary hedge fund manager Michael Steinhardt, who produced 24 percent average rates of return for 30 consecutive years.

While those charts rarely offer such clear-cut signals, their analytical value may also lie in spotting and interpreting the outlier data. Very large positive and negative surprises of particular economic statistics can often yield clues to future price action. If you go back and look at the EUR/USD charts, you will see that the dollar plunged between October and December. This was triggered by a widening of the current account deficit to a record high in October 2004. Economic fundamentals matter perhaps more in the foreign exchange market than in any other market, and charts such as these could provide valuable clues to price direction. Generally, the 15 most important economic indicators are chosen for each region and then a price regression line is superimposed over the past 20 days of price data.