More Forex Fundamentals

Before you start trading in the forex market you need to think about how to analyse the broad picture. Forex currency traders can look at two things to forecast the market:

1. Fundamental Analysis
2. Technical Analysis

Fundamentals are used to determine the theoretical value of an exchange rate and are good at determining long-term trends.

There are various factors to consider such as:

Macro-economic indicators – A country with a sound economy, low unemployment and solid GDP growth should see its currency strengthen. Central banks will set interest rates depending on the economic performance of a country and to keep inflation under control.

Money Supply - Increasing the level of money supply by using the printing presses will generally debase the value of a currency. From March 2006 the Federal Reserve will stop reporting the 'M3' money supply figure - this has many forex traders up in arms about the loss of this data.

Interest rate differentials between countries - countries with higher interest rates will attract more money and their currencies should increase. Many speculators will borrow money in a low interest rate currency (such as JPY) and purchase a currency with a higher rate of interest (such as NZD) in the hope of making money on currency appreciation as well as the rate differential. This type of trade is known as the “Carry Trade”.

Trade deficits/surpluses – The US carries a large trade deficit with China and this has caused downward pressure on the dollar. Usually when a currency weakens, a country’s exports become more competitive which helps correct the trade inbalance.

Levels of direct foreign investments – More investment from overseas means more local currency is purchased pushing up the exchange rate.

Central Bank Interventions – Countries often defend their currency level in the market. The Bank of Japan has stepped in many times to stop the JPY from appreciating too much and keep its exports competitive.

Geopolitical risks – Unforseen events such as acts of terrorism or the collapse of hedge funds can create sharp movements in the markets. If the market perceives a risk situation there is always a flight to safe-haven currencies such as the Swiss Franc and gold.

Commodity Prices – Commodity exporting countries like Australia and Canada should see their currencies appreciate during a commodity bull market. High oil prices can slow down economies which will also affect performance of a currency.

We will look briefly at technical analysis in the next post.