A Step-by-step Guide to Fundamental Analysis of the Currency Market
Updated: May 16, 2013 at 8:07 AM
In this brief guide we will try to provide you with a step-by-step plan for analyzing the global economic environment and deciding on which currency to buy or sell.
1st Step: Study the macroeconomic era
To build our wealth, we must create an analytical structure. To create the structure, we must first establish its basis. The basis of our analysis will involve the study of macroeconomics at the global scale. We must establish the background at the highest level to be able to filter the data and reach at the dynamics of currency pairs at the lowest level. In doing so, we will examine cyclical dynamics, the monetary policies of major central banks and a few other indicators. Past behavior of monetary institutions has great relevance to their future choices, which is why we must keep historical data in mind while analyzing the future direction of the markets. The first phase is relatively straightforward, since during a boom volatility falls, and liquidity becomes abundant on a global scale; during a bust the opposite happens. Nonetheless, it’s very important that the trader know how to isolate the noise from the data, otherwise he will be a victim of political or media spin, and his analysis will fail.
Decide on the phase of the cycle.
We must first determine the phase of the economic cycle on a global scale. By examining global default rates, international reserve accumulation and bank loan surveys of major economic powers it is possible to notice the changing phase of the global economic cycle, even though these are second-tier indicators, and are a bit late in signaling the phase of the cycle. But they are still safe, because market actors often refuse to acknowledge the importance of these data until they are confirmed by falling industrial production and rising unemployment — developments that come quite late in the phase of the cycle.
Examine technological innovations, political environment, emerging market fundamentals
Upon deciding the phase of the cycle, we will try to determine the dynamics that can enhance productivity and create a period of non-inflationary economic expansion on a global scale. When emerging economies adopt the new technologies of the developed world, and create a new basis of industrial production, productivity will increase, and will sustain growth without creating inflation. Similarly, when new technologies like air travel, mass production, or the Internet are implemented for the first time, productivity will increase, and wealth and demand will be generated, leading to a period of non-inflationary growth everything else being constant. The details of this subject can be studied further in our section on fundamental analysis.
The global political environment also has a great influence on international currency fluctuations for obvious reasons. The high inflation era of the 1970s, for instance, was caused by a number of political events influencing economic fundamentals. Similarly, hyperinflation in Germany in the aftermath of the first World War was also caused by political developments that perverted the natural course of economic events.
Conclude the first Step: Productivity gains will ensure a growing global environment (a boom phase) until the technological innovations are fully absorbed; but they are greatly prone to creating bubbles. If the cycle is going through the bust phase, all speculative activity must be curbed. Carry trades and aggressive emerging market plays must be reduced, leverage must come down and long-term positions must be established as currency pairs reach bottom. If the cycle is going through the boom phase, it is time to build our risk portfolio and manage our risk allocations through correlation studies and money management methods. Once we decide on this aspect of our trades, we can move to the second step, and have a closer look at the monetary environment.
2nd Step: Study global monetary environment
In the second step, we move from the generalized studies of the first step to a more specific discussion of the developed world economies. In the first step we examined the factors that influence the economic state of all nations. Now we will take a closer look at the monetary policy, and attempt to determine the length and depth of the current phase of the cycle.
Study the interest rate policies of major global powers
In light of their past behavior we will examine the policy biases of major central banks, such as the Bank of Japan, the Federal Reserve, and the ECB. Our study will take into account the policy biases and legal mandates of these institutions, along with their independence. By studying and clarifying their policy biases, we can have an idea on money supply growth, which will help us decide such variables as emerging market growth potentials, stock market volatility, and the
Compare money supply expansion and credit standards with the previous period
Once we understand the policies of global central banks, we must compare these policies with their precursors, and decide on their possible impact on the global economy. Easy money coming out of a recession is normal, and if credit channels are functioning, it should alert us to increase the risk tolerance of our portfolio. Conversely, tight monetary policy, following a period of economic boom, would mean that the global economy will go through a period of reorganization, which would lead us to reduce the risk tolerance of our portfolio. A continued period of lax monetary policy (low rates) would imply that the forex market will develop risk bubbles, that is, currencies of nations with weak fundamentals will appreciate way beyond their equilibrium value, which is a contrarian trade opportunity for shorting them. A continued period of tight monetary policy by a majority of the developed world’s central banks will force speculators to reduce leverage, and hence reduce the impact on the currency markets. So, as currencies of nations with strong fundamentals appreciate way beyond their equilibrium value, we will have another contrarian trade opportunity for shorting their currencies.
Exploding bubbles, commodity shocks and major political events can create exceptions to the above scenario.
Analyze the VIX, developed market loan default rates of corporate and private sectors
We are aware of the phase of the cycle, but we must also find a way for determining the volatility tolerance of our portfolio. Stock market volatility and the loan default statistics of corporations have an important role in determining forex market volatility, as low risk perception in the economy at large allows all actors to increase leverage and liquidity, which leads to a generally safer environment for forex traders. Of course, like everything else in the markets, low or high volatility are temporary phenomena. The trader must not only analyze present volatility but also its causes, the actors that help reduce it, and the factors that can neutralize their impact on the markets. Knowledge of these will allow us to react quickly to market shocks, and help us reduce our losses when they inevitably occur eventually.
Conclude the second step: This step will allow us to understand where in the cycle we are. Toward the peak of the boom phase, VIX, default rates and interest rates will all be quite low, allowing us maximal profit from the risky positions we had assumed (for example by longing the AUD, while shorting the yen.) Conversely, towards the peak of the bust phase, all those value will register extremes; and by expressing a negative view of risk in our portfolio, we will be able to protect our capital; and while pocketing good profits as other financial actors reach the same conclusions with us.
Finally, in the third step we will decide on the actual currencies we will buy or sell, and on how long we’ll maintain our positions. We will simplify the process here, but the most important indicators that must be studied are:
Examine the interest rate differentials of nations
In light of unemployment statistics, capital expenditure and output gap, since most of the time markets attach the greatest importance to interest rate differentials between currencies, we must form an opinion on the direction of central bank interest rates. This can be done by studying unemployment statistics and the output gap. As capacity constraints in an economy increase and unemployment falls, labor market shortages create wage pressures which are eventually translated into higher prices and inflation in an economy. To combat this development, the central bank will raise rates, and will keep it high until there are visible signs of cooling in the economy, as demonstrated by rising unemployment and fewer capacity constraints. Similarly, by following these values the trader can form an opinion on where the interest rates will go.
Compare the balance of payments of the currencies
The balance of payments of a nation is like the balance sheet of a company. The healthier the balance of payments, the stronger the nation’s currency will be in times of economic turmoil. We will study the balance sheets of nations in terms of current and capital account situation. Is the nation’s external position maintained by bank deposits and asset sales (which can be revised easily), or by long term developments such as foreign direct investment or reserve accumulation? We discussed these matters in previous texts, and the reader can examine them for a better understanding of balance of payments dynamics.
Trade the third step: During the growth phase of the cycle, economic actors favor risk, thus currencies with stronger fundamentals are prone to be sold in favor of those who choose to attract capital through higher interest rates. Thus, during the boom phase or at the beginning of it, we will sell currencies with strong fundamentals offering low interest rates, and buy the currencies offering high interest rates to compensate for weaker fundamentals. During the bust phase, we will buy currencies offering low interest rates with a strong balance of payments, and sell currencies that offer high interest rates but are built on a weak balance of payments situation.
Thus, we will choose currency pairs which offer the greatest imbalances to the trader, and will either enter long-term counter trend positions with low leverage, or we will await the market to confirm our analysis with its actions.
Are you a beginner? Read our forex for dummies here.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.
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