The forex market is the market par excellence for fundamental analysis. Since currencies are the basic building blocks of all economic activity, all the developments in all the various sectors of an economy have implications for currency market trends. While this abundance of data may appear to complicate the task of the beginner, in fact, all the fundamental factors that influence the global economy are closely interrelated, and it’s quite possible to trace a path from the most general and basic concepts, such as interest rates on mortgages and CDs, to the most complicated ones, such as the balance of payments and industrial production of nations.
Now, as we move on to study its practical applications, we’ll examine the use of fundamental analysis in the form of a dialogue between a successful trader, and a beginner, which we’ll denote as ST, and B. If the reader is only looking for a discussion of the various indicators and their application, he can simply skip this dialogue.
B: I want to profit from currency trading. And I want to base my methodology on fundamental analysis. How can I do this?
ST: You can do so by following fundamental news and central bank statistics. But, before that you must also have an understanding of the era you live in. Each era has different dynamics driving its economic development.
B: What kind of dynamics? What do you mean by understanding the era?
ST: The characteristics of eras are complex, but for our purpose, let’s say that you, the trader, should at least know which part of the boom-bust cycle the economy’s going through.
B: And how can I do that?
ST: You should follow the loan statistics offered by central banks, such as the Senior Loan Officer Survey of the US Federal Reserve. Financial institutions tighten their lending standards leading into and during the bust phase of the cycle, then relax them leading into and during the boom phase. They don’t want to lend when firms are going bankrupt, and they want to lend a lot when everyone is making great profits, so they can generate interest income and dividends for their shareholders.
B: What will I gain by being aware of the phase of the cycle?
ST: All else being equal, during the bust phase of the economic cycle, reserve currencies appreciate against the currencies of most other nations, and during the boom phase, reserve currencies tend to depreciate. This is because booms are financed by lending, and most lending is conducted through reserve currencies, due to the nature of the global financial structure.
B: So you say that I can profit by simply identifying the boom-bust cycle correctly, and arranging my currency portfolio to reflect that knowledge?
ST: Yes. Boom-bust cycles are very powerful, high-level events that force everything else to move in tandem with them.
B: Once I identify the phase of the boom-bust cycle, how can I profit from news releases?
ST: The data they provide can be used to mentally create a “big picture” of the phase of cycle. This picture can help you understand what goes on in the economy.
B: How will I profit from understanding that?
ST: An economy’s attractiveness to global capital (in other words, the “big picture” of that economy) is the main driver of its currency’s value against others. By understanding the big picture, you can identify who is benefiting from it most, and then, as you place your trades in harmony with those who drive the main trends, you may turn great profits.
B: I don’t understand, how do I identify who benefits most from the big picture?
ST: It’s not that difficult. There are two kinds of actors in any market: speculators (financial actors), investors, hedgers and other commercial actors. In some situations, where lending standards are lax and money flows in abundance, speculators can easily overcome those who are involved in genuine economic activity, and become the main drivers of the price trends. In other cases, where money is not very cheap (in other words, interest rates are at levels suitable to the global economy’s condition), investors and non-speculative actors are the main power behind prices. By identifying what kind of actors drive the price trends, you can also understand the nature of the cycle, that is, if it’s driven by monetary expansion (easy money and speculation), or by innovation and increasing productivity, (in other words, technological or social advancement). But you must still keep in mind that even the healthiest and most meaningful fundamental dynamics can be utilized to create bubbles if there’s enough interest from the speculators.
B: And how do I profit from that?
ST: You can simply follow the currency trends. Even if your analysis doesn’t confirm the way the market acts, as long as you understand why it behaves the way it does, you can go along with it, and turn a profit.
B: I still don’t understand. If I use fundamental analysis simply to follow the trend, why not just follow the trend, while forgetting about fundamental analysis altogether?
ST: Because you will only follow the trend as long as the fundamental factors tolerate it. Speculative activity is prone to creating bubbles, and the bursting of bubbles sometimes happens very quickly and can be very destructive. But, bubbles only grow where there’s a decent and reasonable profit opportunity, and there’s nothing wrong about participating in them in the early stages. Through fundamental analysis, you will be able to avoid jumping on the train of speculation at the height of euphoria, and will be able to reverse your direction quickly when fundamental factors tell you that the benign economic environment has changed. Remember, fundamental analysis studies the causes of economic events.
B: So in other words, fundamental analysis is useful in exploiting long-term trends defined by the big picture, and also for avoiding bubbles as they burst or are close to bursting.
ST: Yes. Of course, even without detailed fundamental reasons, one can simply avoid a bubble once its price trajectory takes the form of a parabola.
B: Can you please show me how to construct the big picture?
ST: Sure. You must begin with the interest rates, and look at how they’re being channeled into the economy through big banks and other financial institutions. Then you must consider whether there are any new technological innovations, financial products, emerging nations, and so on, that can create the fuel for a period of healthy economic growth on a global scale. Then you must consider the political climate. Is there a lot of political instability in those nations that drive global growth? Let me help you with a chart:
B: How can I use it for success in forex trading?
ST: This is the first stage of fundamental analysis. Here you decide on the dynamism of the global economy. The health of the global economy can have a lot of bearing on such seemingly unrelated things as forex market volatility, carry trades, cross-border capital flows, and so on. It is also crucial when deciding whether one must be conservative or relatively optimistic in assessing high-frequency economic data (such as durable goods orders, weekly jobless claims, etc.).
B: So I should analyze the global economy at the highest level to decide on my forex strategy.
B: OK. Now, how will I decide on which currency I should buy and which I should sell?
ST: That is the second stage of fundamental analysis, although keep in mind that I will do my best to simplify matters for you. In deciding which currency to long or short, you will need to examine the fundamental health of the economy by considering the indicators which we will discuss shortly. You will then evaluate the attitude of the main drivers of forex market activity towards the nation’s fundamentals. In other words, you’ll need to consider whether the most powerful actors in the market align themselves with the nation’s economic choices. If the nation’s economic policies are credible and healthy, and the market also regards them favorably, you can buy that currency, but beware of bubbles. If the nation’s economic policies are credible and healthy, but the most powerful market actors do not support such policies, then you should not buy the currency, but you can sell it, provided that you’re very cautious about the risk you’re taking. If the nation’s economic policies are foolish, but the market is nonetheless supporting them, you should not trade that currency at all, long or short. Finally, if the nation’s economic policies are foolish, and the market regards them as such, you can short that currency.
B: Can’t I disregard the market’s opinion entirely, based on my fundamental analysis?
ST: Of course you can. But it’s much better to understand the causes of bubbles and the reasons behind the market’s delusions, and wait for the termination of those causes before jumping into a trade merely on the basis that the market is wrong. Fundamental analysis is always right. The imbalances and abnormalities defined by it will always be corrected by policy action or market developments. But it may not always be possible to guess how that correction will occur. If you choose to ignore the market’s emotional behavior entirely, you may have a long wait, because it may take a very long time for the anticipated correction to occur.
B: Thank you, is there anything you’d like to add?
ST: Do not participate in parabolic price action, unless you have exceptionally good reasons for doing so. Anything can create a bubble, regardless of how convincing the rationalizations and the proposed causes are. Also remember that our descriptions are valid for a highly integrated, trade-intense, non-protectionist global economy. Many events would develop differently in an environment where money doesn’t flow that easily across borders, but the major difference would be in the role of speculators. In a non-free, protectionist environment, speculators are unlikely to find the capital they need for popping bubbles of giant scale, and that will grant trade flows a greater role in determining price trends.
Fundamental analysis aims to characterize money flows in to and out of a country. In other words, fundamental analysis does not limit itself to examining the well-being of an economy, the soundness of its financial institutions or the opinion of academics or politicians, but merely uses them to decide on the best course for a nation’s economy, while analyzing the actual causes of price trends. Since the causes of price trends can sometimes be completely independent of the dictates of economic theory, fundamental analysis cannot present a complete picture by merely showing what is good or bad about an economy; if the market is in error over a period of years, successful analysis must also be able to show the powerful reasons for its errors.
We must also remember that the word “error” in all this discussion is only used on a macroeconomic basis. Choices that may eventually prove to be greatly detrimental to the well-being of the society at large may still be very lucrative for the individuals who make them. In other words, the errors fuelled by bubbles are errors only in the sense that they cause great harm to the majority of people. Many speculators have also crashed by their mistakes, but some of them leave the game with a large bounty of profits. (Note that we use the term speculator to denote an actor who ignores economic realities, is emotional and obstinate about his practices. Speculative activity can even absorb non-financial actors like construction firms or exporters, and in fact anybody else.)