A currency exchange rate incorporates interest rate policies and macroeconomic data such as economic growth, inflation, and unemployment.

 

Basic fundamental conditions in the Foreign Exchange Market

 

Majorly, an exchange rate reflects a combination of the following fundamental conditions:

(i) growth, inflation, and unemployment

(ii) monetary policies, and especially the interest rate policy of the central bank

(iii) fiscal policies & government spending

(iv) political stability (political risk)

(v) legislation regarding capital taxation & the openness of the domestic economy

 

New macroeconomic conditions can create trading opportunities in the Foreign Exchange market

The Foreign Exchange market is so efficient that the impact of news is instantly incorporated into all exchange rates. However, when there is a major shift in the general macro circle, there can be tremendous opportunities for Forex traders. A macroeconomic shift is behind all key Forex trend reversals.

 

The Role of Interest Rates

Interest rates work as a balance between growth, inflation, and unemployment. A serious and unexpected interest rate cut by a Central Bank can have a dramatic impact on the domestic currency. A significant interest rate adjustment can change the rules of the game, and that is especially true for carry traders.

• The CME FedWatch provides useful insight into the future level of US interest rates.

 

Forecasting the future Interest Rates in the US -The FedWatch Tool

 

The CME FedWatch tool reveals the market expectations regarding the future level of the USD interest rate. The target rates are based on scenarios that occur at scheduled FOMC meetings.

• The probabilities are based on Fed Fund futures contract prices

In the following chart, the market anticipates a 275-300 bps target rate (at the end of the year).

 

Chart: Targeted US Rates (CME Group)

 

An effective way to forecast an exchange rate is by analyzing the goals of the two central banks.

 

Stay in line with the goals of major central banks

 

Understanding the long-term goals of major central banks is extremely important for Forex investors.

For example, the Bank of Japan (BoJ) in December 2013 made it clear that aims to implement a flexible monetary policy regarding the Japanese yen. In other words, a yen depreciation against other majors. By that time, ECB and FED applied a conservative monetary policy regarding their currencies. In the mid-term, this was the perfect signal to go long on USDJPY and EURJPY. Indeed, in the following months, the Japanese yen aggressively depreciated against the US dollar and the euro.

 

Decoding Monetary Policies

 

Analyzing monetary policies is helpful for decoding what happens next in the Foreign Exchange market. There are three main monetary policies:

 

(i) Flexible-Currency Monetary Policy

• Mission: achieving higher growth by targeting lower unemployment
• Interest Rates: decreasing
• Impact: the domestic currency will depreciate

(ii) Hard-Currency Monetary Policy

• Mission: achieving economic stability by targeting lower inflation
• Interest Rates: Increasing
• Impact: the domestic currency will appreciate

(iii) Balanced Monetary Policy

• Mission: achieving a balance between growth, unemployment, and inflation
• Interest Rates: remain unchanged (or minor changes)
• Impact: Neutral 

 

Summarizing Forex Fundamental Analysis

 

What matters most in Forex trading is spotting the phase of the Macroeconomic Circle. Each phase will dictate the monetary goals of the central banks, and consequently, the level of interest rates for the months or years to come.

Central banks such as the European ECB, the American FED, the Japanese BoJ, and the Swiss National Bank (SNB) are extremely powerful and have access to almost unlimited monetary resources. Never trade against these four central banks. Understand, what these decisive market players aim to achieve and always trade in line with them. Ride long-term trends that serve their goals.

Furthermore, the comments of central bank executives during meetings are very important. When an executive says something, anything, it is for a very good reason.

 

Forex Overnight Rates Create Opportunities

Forex currencies are the subject of overnight rates (SWAPs). Every day, at midnight, all Forex positions either pay or get paid an overnight rate.

• If you ride a strong trend offering a positive SWAP, you can earn overnight rates for a long period of time, especially, if you use reasonable trading leverage between 2:1 and 4:1
• Carry trading is one of the most profitable trading styles for retail Forex traders

Forex currencies trend well, and the only thing you have to do is to enter the correct phase of the macro circle.

 

 

Economic Indicators

An economic indicator is a statistic that is used for interpreting the current or future conditions of the economy. Economic indicators are widely followed by every major player in the economy including Foreign Exchange investors, corporations, and of course central banks.

 

There are three (3) main types of economic indicators:

(a) Leading Indicators

Leading indicators are very important as they can signal the future conditions of the economy. For example, bond yields are key indicators of future stock market performance.

(b) Coincident Indicators

Coincident indicators occur at the same time as the economic conditions they signify. For example, national income coincides with the overall economic performance.

(c) Lagging Indicators

Lagging indicators follow economic conditions. These indicators are used for confirming economic patterns. For example, unemployment is a lagging indicator.

 

Main Categories of Economic Indicators

 

These are the main categories of economic indicators:

1. Output, Income, and Spending

2. Production, Business, and New Construction Activity

3. Employment, Unemployment, and Wages

4. Prices (consumer/producer)

5. Money and Credit

6. International Statistics

 

(1) Output, Income, and Spending

■ INDICATING: Broad measures of economic performance

■ RELEASED: Quarterly | Statistics include:

• GDP (Gross Domestic Product), Real GDP, and Business Output

• National Income & Domestic Investment

• Implicit Price Deflator (for GDP)

• Consumption Expenditure

(2) Production, Business, and New Construction Activity

■ INDICATING: Businesses' performance and level of new construction

■ RELEASED: Monthly | Statistics include:

• Industrial Production & Capacity Utilization

• Manufacturers' Inventories, and Orders

• Business Sales and Inventories

• New Construction & New Private Housing
  

(3) Employment, Unemployment, and Wages

■ INDICATING: The conditions in the labor market

■ RELEASED: Monthly | Statistics include:

• Payrolls (Jobs Creation) & Unemployment Rate

• Average Earnings (Wages) and Labor Productivity

(4) Prices

■ INDICATING: Consumer and producer prices

■ RELEASED: Monthly | Statistics include:

• Producer Prices (PPI)

• Consumer Prices (CPI)
  

(5) Money and Credit

■ INDICATING: Interest rates and the amount of money in the economy

■ RELEASED: Monthly | Statistics include:

• Interest Rates and Bond Yields

• Money Stock (M1, M2, and M3)

• Consumer Credit & Bank Credit

(6) Federal Finance

■ INDICATING: Government spending, deficit, and debt

■ RELEASED: Yearly | Statistics include:

• Federal Receipts (Income) & Federal Outlays (Spending)

• Federal Deficit/Surplus & Federal Debt
  

(7) International Statistics

■ INDICATING: The country's exports/imports

■ RELEASED: (-)  | Statistics include:

• International Trade (Goods & Services) & International Transactions

• Industrial Production of Major Industrial Countries

• Consumer Prices of Major Industrial Countries

 

■ Forex Fundamentals and Economic Indicators

Forex-Investors.com (c)