When it comes to analysing currencies on a fundamental level, many traders feel overwhelmed by the number of factors that impact currency exchange rates. This can easily lead to overanalysing, which in turn creates trading losses and missed opportunities in the market. This article will explain some of the most important factors and economic indicators, which are serious market-movers in the Forex market.
What are economic indicators?
First, let’s explain what economic indicators are. Economic indicators are statistical measures that give valuable information about a country's economic activity. They’re important to Forex traders as they give important clues about the trend and economic performance in a country, which directly impacts the value of its currency.
Economic indicators can be grouped according to business cycles. A business cycle is a periodic fluctuation in a country’s economy, due to regular expansions and contractions in its economic activity. This way, economic indicators are classified into three major types:
- Leading economic indicators: they predict future changes in economic activity
- Coincident economic indicators: they reflect the current economic state as they change in line with the state of the economy
- Lagging economic indicators: they lag behind changes in economic activity and are used to confirm coincident and leading indicators
In addition to the factors mentioned in this article, you should start to follow Forex economic calendars, and get a picture of all important news releases scheduled for the coming few days. This way, you’ll be prepared when important news hits.
Inflation rate
One of the most important economic indicators for FX traders is the inflation report. Currency pairs tend to be very volatile around the time inflation data is released. The inflation rate is simply a measurement of the price change in goods and services over a period of time.
Many central banks, such as the Federal Reserve, usually have an inflation rate target that they need to keep an eye on. If the inflation rate is too high or too low, central banks need to react in order to stabilise the economy. A small amount of inflation is considered healthy for the economy, but hyperinflation (extremely high inflation) and deflation (the fall of prices in goods and services) are a nightmare for policy makers, as these situations can easily lead to a drop in economic activity.
While inflation pressures can also be tracked through the implicit price deflator released in the GDP report, many traders follow more frequent reports that are released monthly, such as the Consumer Price Index (CPI) and Producer Price Index (PPI). These reports are published by the US Bureau of Labor Statistics around the 15th of the month (for data from the previous month) at 8:30 a.m. ET.
Traders can try to anticipate the inflation numbers by following the change of commodity and material prices which are used as production inputs, such as aluminum, gas, or oil. This is known as a cost-push inflation, where a rise in production input prices results in an increase in price of the final products.
Interest rates
Interest rates are considered one of the most important indicators that affect the Forex market. In fact, economists have tried to build a model of long-term currency valuation based on interest rates differentials between countries, and have noticed that the difference in interest rates equals the expected change in the spot exchange rate (called the International Fisher effect).
Without digging too much into theory, traders need to know that an anticipated interest rate hike by central banks usually causes the currency to appreciate, while an anticipated fall in interest rates usually causes the currency to depreciate. Global money is always looking for the most profitable investments and it flows from countries with lower rates into countries with higher rates, increasing the demand for the higher-yielding currency which in turn appreciates.
Countries also change their interest rates to spur economic activity (by lowering rates), or to cool down an overheated economy (by increasing rates). By following the economic conditions in a country, traders may be able to anticipate interest rate changes and profit on them. However, bear in mind that this is usually a long-term trading strategy.
Current account and balance of payments
The balance of payments monitors all international transactions of a country over a period of time, taking into account both the public and private sector. The balance of payments is further divided into three main categories: the current account, the capital account, and the financial account.
The current account, as a part of a country’s BoP, measures the inflows and outflows of goods and services into a country. A current account deficit occurs when a country imports more than it exports, while a current account surplus forms when a country exports more than it imports.
Traders use the current account figures to determine whether a currency will rise or fall. Basically, a deficit country needs to sell its domestic currency in order to pay for foreign goods and services, which increases the domestic currency’s supply and puts downward pressure on it. On the other hand, a surplus country experiences increased demand for its currency which puts upward pressure on it, as foreign countries pay for the surplus country’s goods and services. The exchange rate between the US dollar and Japanese yen illustrates this concept well, as Japan historically had a high trade surplus with the United States.
As the chart shows, the Japanese yen tends to appreciate against the US dollar with a rise of the current account surplus. The balance of payments is released quarterly for most countries, and traders should follow this report closely.
Terms of trade
Aside from the country's trade balance, its terms of trade can also impact the currency's exchange rate. The terms of trade show the relationship of a country’s export and import prices, which can give an early sign of appreciation and depreciation pressures on a currency. Basically, a rise in export prices relative to import prices causes the terms of trade to improve, which can eventually lead to a positive trade surplus. Similarly, a drop in export prices relative to import prices may have a negative impact on a country’s trade balance even further, leading to a deterioration in the terms of trade and eventually negatively affecting the trade balance. As covered in the trade balance section of this article, changes in the trade balance leads to changes in the exchange rate in order to restore the balance of payments equilibrium.
The terms of trade are especially important for major commodity-producing countries. For example, countries of the Gulf, Canada, and Russia are major exporters of oil, and a rise in the price of oil will lead to positive changes in their terms of trade and trade balances. Ultimately, this will lead to an appreciation of their currencies.
Political stability and performance
Just as stock traders analyse the performance of a company’s management and CEO, Forex traders are interested in the political stability and performance of a country. Political stirrings can have a major impact on the exchange rate of currencies, as investors pull their money out of politically unstable countries and regions. For example, the debt crisis in Greece had a detrimental impact on the value of the euro, and more recently, a wave of anti-EU campaigns in Europe led to a depreciation of the euro against all of the major currencies. Those and other similar examples are proof that traders need to be aware of the political situation in a country, and be prepared to wait the market out at the first sign of political instability.
Speculation
Speculation in any financial market is the act of trading with the expectation of significant gains, accompanied by a significant risk of loss. As the largest financial market in the world, the Forex market is especially attractive for speculative traders. With the high leverage that is available in Forex, speculators can make huge profits in a very short period of time. Although the term speculator is sometimes deemed as having a negative connotation, the truth is that they add a lot to the overall liquidity of the market and narrow spreads. On the other hand, speculation can also increase the volatility of exchange rates, and negatively impact countries with limited foreign exchange reserves, especially in the case of large speculative orders.
Retail Forex traders account for around 5% of the overall Forex daily turnover, and the majority of them speculate on the rise and fall of currencies through day trading. However, large institutional investors also use speculative orders to profit, but they do so over a larger period of time based on fundamentals, such as the ones discussed in this article.
Conclusion
The above-mentioned factors have some of the highest impacts on the Forex market, and traders can try to anticipate most of them in order to position themselves in the market. Some of the most effective ways of obtaining an edge in trading is via cost-push analysis of commodity prices, monitoring changes in the of terms of trade, following the political situation in a country, or taking into account long-term speculative orders from large institutional investors.