Fundamental Analysis
Currencies represent barometers of the economic health of individual countries. Fundamental analysis is the study of how the economic and political factors affect global supply and demand and thus market prices. This analysis allows us to form an opinion of potential future currency movements and identify favourable outcomes.
Fundamental analysis focuses mainly on macroeconomic indicators, such as growth rates, monetary policy and interest rates, inflation and employment. In general, any news with economic impact is considered as a fundamental factor by economists.
In this section we take a brief look at a few key fundamental analysis topics followed by key economic data releases the market adheres to.
Interest Rates & Monetary Policy
Perhaps the single most significant fundamental factor in the world of currency markets is interest rates. Currencies, and their movements, are a reflection of future interest rate movements between two separate countries. A currency with a higher or increasing interest rate will tend to outperform that of a currency with a low, stagnant or falling interest rate as investors look to obtain a better return on their money. This leads to an investment strategy called the Carry Trade.
The Carry Trade occurs when traders borrow money at low levels of interest in certain currencies and invest it in currencies with a higher interest rate. They do this by selling one currency against the other. A classic example has been selling the Japanese Yen (because of its low interest rates) for higher yielding currencies such as the Australian Dollar (AUD), the New Zealand Dollar (NZD) and others.
Interest rates are one of the key tools of monetary policy control by the world’s central banks. This is achieved by setting short term interest rates which influence the time value of their own currency and thus its supply and demand in the global markets. Often, central banks also participate directly in the Foreign Exchange markets by buying or selling their currency through a reserve management process. Reserve flows tend to be significant, relatively infrequent and could have significant impact in the market. As they are not usually made public at the point of execution, they become important material of market chat and rumour. Often, because of that, their market effect is much more significant than the underlying amount would otherwise justify.
Inflation & Purchasing Power Parity
Inflation measures the rate of price increases in an economy. Ronald Reagan called it “as violent as a mugger, as frightening as an armed robber and as deadly as a hit man” for the effect that it has on money. Simply put it erodes the value of paper money. Inflation is controlled by interest rates (also known as monetary policy - see above) and a high inflation rate will lead traders to believe that interest rates are likely to rise for a certain currency which will lead to the value of currency increasing accordingly.
Inflation is directly connected with Purchasing Power Parity (“PPP”). PPP occurs when there is no difference in the price of an identical good between countries, when expressed in the same currency. Market theories assert that over the long term, currencies tend to revert to their PPP value. Fundamental analysts look into PPP models in order to estimate the variance of the market against the theoretical PPP valuation per currency pair in an attempt to predict the point at which the currency pair will revert back towards its PPP value.
For example, a can of Coca-Cola bought in London will be the same as one bought in New York, labeling aside, but will it cost the same? Let’s say a can of Coke costs 60p in London and $1.15 in New York and the GBPUSD rate today is 1.65. So, the UK can is cheaper than its US counterpart (60p vs. 70p). There are two factors that can make the US can more competitive; firstly were we to see a shift in the GBPUSD rate to 1.95 it would change the comparative costs to 60p vs. 59p. Equally a 10p increase in the cost of the UK can will make the US can more competitive. The point is that inflation will have an effect on where the ‘real’ price of a currency should be and there may be significant difference between that and the current market rate.
Employment
Employment is another key fundamental factor. Sometimes known as “a country’s heartbeat”, it is very important not least because of its social significance and implications when it runs at low levels. It reflects an economy’s production capacity; it influences demand and supply, GDP, inflation and monetary policy response. It is the matrix connecting to everything. It can move governments and certainly currencies. Steady levels of employment are important to long run growth and their effects spill over to increased consumer confidence and stronger demand for goods and therefore a positive feedback loop into further growth.
Market Sentiment
Market sentiment and the public’s perception of news and economic data releases is also a key factor one cannot ignore. Whilst strictly speaking not part of the Fundamental Analysis curriculum, it does relate to economic data and the reality vs. expectation of the market, so we include it here.
It is all very well tabulating economic data and its resulting consequences (i.e. higher Interest rates equal stronger home currency), but in reality the expectation of upcoming data releases (and the potential difference or surprise factor) greatly influences the market in the short term. This is never clearer than in the seconds after an important data announcement. Traders around the world will react in a split second to either a disappointing or encouraging number by selling or buying the currency concerned or adding the news to their beliefs as to the currency’s future course. There are rough ways of measuring sentiment towards certain currency pairs, but they are mostly based on empirical evidence. The Chicago Mercantile Exchange publishes weekly “interest numbers” showing how many futures contracts have been taken out backing or betting against a certain asset. Traders, especially on longer term horizons, often use these figures to validate the consensus of market sentiment and know how their positioning fares against the market.
Market sentiment is so significant that there is a tremendous amount of research currently going on with many large banks or institutional investors often dedicating teams of people to it. There is also a plethora of trading strategies on this topic alone.
Economic Data
In the sections below, we alphabetically list key economic releases and data points that influence currency markets. We provide an explanation of the individual data release and its importance for fundamental analysis. We cover economic data releases for four key economic areas; the US, the UK, the Eurozone and Japan. Together those account for 62% of the world’s GDP and lie at the heart of financial markets. The list, whilst not exhaustive, covers the key monthly and quarterly data that markets watch. Think of the below as an “economic dashboard” of sorts.
ADP Employment (US only)
ADP Employment Change is a private survey commissioned by Automated Data Processing that interviews 500,000 random Non-Farm businesses across the US. It reports on the number of new jobs created in the previous month, excluding farm related employment. It is published on the first Wednesday of each month, two days prior to the Non-Farm Payroll (NFP) data. There are only private firms in the census and those are split by size and by type; manufacturing, goods producing and services.
Average Hourly Earnings
The Average Hourly Earnings report provides a good indication of labour cost inflation and also spare capacity of the labour market. High numbers are expected to have a positive effect on interest rate expectations and thus the currency, but could also be highlighting decreased level of competitiveness. In the US, it is released along with the NFP report on the first Friday of the month by the Bureau of Labour Statistics (BLS). In the UK, the equivalent is the Average Earnings Index, which is released quarterly.
Beige Book (US)
This is an economic report published eight times per year in the US by the local Federal Reserve Banks across the country. It is a collection of regional economic data and provides a general country wide economic activity snapshot. Its aim is to help the Federal Open Market Committee (FOMC) decide on the path of interest rates. Market participants use it as a trend confirmation with a medium term outlook and it will rarely surprise the market.
Chicago PMI (US)
The Purchasing Managers Index (PMI) is a monthly measure of business conditions in the Midwest region (Illinois, Indiana and Michigan) of the US. It compares individual firms’ purchasing activity to the previous month. It provides analytical data on employment, inventories, prices, orders and output. It refers to a benchmark of 50. A reading of above 50 in the report shows there’s been expansion and below 50.0 indicates contraction. The report is released on the last business day of each month. Whilst less significant than the nationwide ISM report, the PMI precedes it and is therefore used as an indication for the broader ISM surveys.
Consumer Confidence Index (US)
The Consumer Confidence Index (“CCI”) is an indicator designed to measure consumer confidence, which is defined as the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending. In the US the CCI was started in 1967 and was benchmarked with 100 being in 1985, a neutral year. It is issued monthly by The Conference Board, an independent non-profit economic research organization, and is based on a monthly survey of 5,000 households.
GfK NOP Consumer Confidence Barometer (UK and Eurozone)
In the UK, GfK have been conducting the Consumer Confidence Barometer since June 1995. The survey is carried out on a monthly basis on behalf of the European Commission, who sponsors the same research in all European Union member countries. Like in the US, the main aim of this research is to monitor the general public’s confidence in the economy. Each month the survey tracks changes in personal finance, general economic situation, inflation, unemployment, current purchasing climate, consumer spending and saving. Quarterly research tracks car purchasing, home purchasing and home improvements. It is published on the last working day of each month at 00:01am.
Durable Goods Orders (US)
This is a government report measuring consumer spending on long-term purchases; products with a shelf life of more than three years.
It’s an indicator that is watched closely by the market, because it says a lot about the near future of the manufacturing industry and, by extension, of the economy. The report is published at 8.30am EST around the 26th of each month and is broken down by industry The Core measure excludes transportation equipment. The main reason for that is that orders for aircraft especially have a very high value and tend to skew the data upwards.
GDP Annualised q/q (All areas)
This is released quarterly, with revisions in the following two months. Gross Domestic Product is considered by most to be the broadest, most comprehensive barometer of a country’s overall economic condition. It measures the total value of all goods and services produced in a country in a specific time period.
Rising GDP shows an improving economy making foreign investors more likely to be looking for opportunities in the country’s bond and stock markets. Interest rates and the country’s currency would also be pushed higher following a rise in GDP. The process though, like the economic cycle altogether is a slow one.
In the USA, GDP is calculated and reported on a quarterly basis as part of the National Income and Product Accounts (NIPAs). These accounts comprise the most comprehensive set of data about US national output, production and distribution of income. The report contains detailed data on personal income, consumption and expenditures, corporate profits, and national income data. In the UK, the GDP and deflator data are published by the Office of National Statistics (ONS). In Europe, GDP is calculated and reported on a quarterly basis by Eurostat, who compile data from each member state and make sure it is harmonized across all comparative measures.
GDP Deflator Annualised q/q (All areas)
Along with the GDP report, the government also releases GDP deflator data. The GDP Deflator report publishes the difference between nominal and actual GDP. It does this by taking annualised quarterly inflation rates and applying them to all economic activity. Unlike regular CPI and PPI price reports, the GDP deflator is not based on a fixed basket of goods and services, rather it is allowed to change with people’s consumption and investment patterns.
House price data (UK)
There are many Housing Price Indices (“HPIs”) that track UK housing and price data.
The RICS House Price Balance is a report produced by The Royal Institute of Chartered Surveyors. It produces figures on whether house prices are rising or falling. It surveys members on price changes seen in their area. The House Price Balance gives a percentage as an indicator of increased prices. A report of 25%, for example, shows that 25% more chartered surveyors saw increase in house prices in their area than those who reported declining prices.
The Rightmove House Price Index is produced monthly by Rightmove, a property website in the UK and it publishes changes seen in the average asking price of residential properties. The data is a useful gauge for potential inflation that might be seen soon after in the housing market. This indicator is worth watching simply because it’s reported in the same month as the data gathered.
Other notable indices are produced by lenders Nationwide and Halifax, both of which use their own datasets compiled from their mortgage lending activities. They are useful as the time series is longer than all governmental HPIs. A last mention is the Department of Communities and Local Government (DCLG) HPI which compiles the index by mortgage completion data from a few of the largest lenders in the UK.
Home Sales (US)
These are effectively split into three monthly reports; Existing Home Sales, New Home Sales and Pending Home Sales. All three are published on different days during the last week of each month by the National Association of Realtors (NAR).
The Existing Home Sales report is based on the number of existing homes sold. The figures include all types of residence. Despite it being a lagging indicator, the market has paid more attention since the credit crisis especially as the mortgage market was largely to blame for the crisis. An increase in the number of homes sold is a sign of solid economic recovery.
The New Home Sales report is similar. It caters to newly built private homes, which are fewer than the existing ones and is generally subject to larger revisions on a monthly basis thus proving more inconsistent.
On the other hand, the Pending Home Sales report is considered a rather important leading indicator as it captures signed (but not completed) real estate contracts for existing single-family homes. The index not only provides a gauge for housing demand, but also economic strength. An increase in the index shows that people are in a good financial position to purchase new homes. Furthermore, this index has a powerful multiplier effect through the economy.
Inflation indicators
Consumer Price Index CPI (Core)
The Consumer Price Index is a fundamental indicator that shows the rate of price inflation. More specifically, it measures the change in price, over time, paid by consumers for a “market basket” of goods and services.
Energy, food, tobacco and alcohol are excluded from the basket of goods whose prices are measured in the Core CPI, because these commodities are considered volatile. Because of these exclusions, Core CPI shows a smoother trend than normal CPI. The CPI is a timely and detailed inflation indicator. Typically, it’s assumed that a rising trend in CPI will positively impact on a nation’s currency. Central banks are most concerned with price stability; if inflation is rising, interest rates are likely to be raised to bring prices back down again. On a global scale, increased interest rates are likely to attract foreign investment - and that in turn increases the demand and standing of the nation’s currency.
Retail Price Index (RPI)
This is similar to the CPI, but only looks at goods and services bought by private households.
Producer Price Index (PPI)
In a similar fashion to CPI, PPI shows the rate of price changes as seen by manufacturers who have to purchase goods and services.
PPI is broken out into two separate economic indicators - PPI Input (a measure of goods and services bought) and PPI Output (the measure of goods and services sold). Of the two, PPI Input is more closely watched by traders.
As with all inflation measures, a rising PPI number is likely to have a positive impact on a nation’s currency. PPI is perceived by the market as the leading inflation gauge. When manufacturers are forced to pay higher prices for goods and services, the increase is quite quickly passed on to the consumer. So PPI is seen as a flag that consumer inflation (CPI) is about to rise. However, despite the fact that CPI lags in release time as well as data observation, it usually makes the headlines.
Interest rate statement
In the US, interest rates are set by The Federal Open Market Committee (FOMC), the governing body of the Federal Reserve System (“the Fed”), effectively the US central bank. Setting short term interest rates is the key tool for the Fed whose main aim is to maintain price stability in the economy.
The Fed publishes an Interest Rate Statement eight times a year. The bulk of the statement is an explanation of the different factors affecting the short term interest rates. It also gives insight into what the next interest rate decision might be. Short term interest rates are hugely important to traders in any financial market and the statement is analysed and sifted through by the market participants literally on a word by word basis in their effort to understand even the slightest sentiment change.
In the UK, the Monetary Policy Committee (MPC) of the Bank of England (BOE) publishes the short term interest rate, otherwise known as the “bank rate” every month. A statement and Q&A session follows only when there is a change in the rate from the previous month. The minutes of the Interest Rate decision are published by the MPC two weeks after the rate decision and are also a focus of the market as they give a full account of the policy discussion, including differences of view. They also record the votes of the individual members of the Committee. In the Eurozone it is the European Central Bank (ECB) that is responsible for monetary policy interest rate decisions. Rate decisions are published every month, on the same date as the MPC, followed by a Q&A session.
ISM indices (US) & PMI surveys (UK & Eurozone)
These are monthly reports released by the Institute of Supply Management (ISM).
The ISM Manufacturing Index tracks the amount of manufacturing activity (production levels, new orders placed, inventory levels, supplier deliveries and employment) over the previous month. The values for the index run between 0 and 100. An index value of below 50 - showing decreased activity - indicates a likely recession, particularly if the trend continues over several months. A value over 50 indicates economic growth. The ISM Manufacturing Prices is a survey of 400 US firms to get a feel for price inflation seen within the manufacturing sector.
They’re asked if there has been an increase in the price of materials and services. Traders use this alongside the official producer price numbers to ascertain the near term path of inflation.
The ISM Non-Manufacturing Index focuses on the non-manufacturing portion of the services sector and is based on a survey of purchasing managers. They list out factors including new orders, inventories, production and employment. As before, a reading of 50 or below shows a lack of expansion. Above 50 indicates economic expansion. With the growing importance of the services industries in the western world, this index seems to be watched closed by traders in all of the major financial markets. It’s seen as a leading indicator into future data releases. In the UK, the equivalent reports are the Manufacturing and Services PMI. Both reports are based on surveys of purchasing managers and capture employment, inventories, prices, orders and output data. As with the US ISM, the index goes from 0 to 100 with 50 being the neutral point.
The Eurozone Manufacturing & Services PMI reports work in the same way. The figure is produced by collating the monthly surveys of Germany, France, Italy, Spain and Ireland, which together account for 80% of the Eurozone’s economic activity. Since services account for two thirds of total Eurozone GDP, the Services PMI is both a significant and timely indicator of the health of the economy. Higher Service PMI levels suggest upward future trends in output and employment of the industry.
Industrial Production (All Areas)
The US Industrial Production Index (IPI) is an economic indicator that is released monthly by the Federal Reserve Board in the Industrial Production and Capacity Utilisation (“IPCU”) report. The IPI measures the amount of output from the manufacturing, mining, electric and gas industries. The baseline reference year for the index is 2002 and the baseline level in 2002 was established at 100.
The other part of the report relates to Capacity Utilisation that in economic data terms refers to the extent to which an individual, business or a nation actually uses its total production capacity. In other words it shows the relationship between actual output and potential output. As demand grows, capacity utilisation increases and the output gap closes, leading to price pressure and inflation. Thus, economists and market participants use this data to gauge upcoming inflation or deflation pressures.
The equivalent data in the UK is part of the Industrial Trends Survey which is released by the Confederation of British Industry (CBI) and gives expert qualitative opinion from senior manufacturing executives, on past and expected trends in output, exports, prices, costs, investment intentions, business confidence and capacity utilisation.
The Eurozone data for Industrial production work similarly and are released by Eurostat on a monthly basis.
IFO & ZEW (Germany)
The ZEW or Zentrum für Europäische Wirtschaftsforschung is a German firm that surveys European financial experts to assess the medium-term prognosis for the German economic situation. The responses that the analysts can give are positive, negative or unaffected.
Much like the ZEW release, the German IFO is a key sentiment reading of German business sentiment and respondents are asked for their assessment of the current state of the German economy and what they believe its state will be in 6 months’ time.
As a result of Germany’s weighting inside the Eurozone both of these German economic data releases are hugely important indicators for the entire Eurozone as well as Germany and are closely watched by market participants.
MPC Treasury Committee Hearings (UK)
The Monetary Policy Committee of the Bank of England, along with Governor Mervyn King, speaks on the standing of the British economic picture. Testimony is given before Parliament’s Treasury Committee on a regular basis. MPC members also regularly speak to audiences throughout the country, explaining the MPC's policy decisions and thinking.
Nonfarm Employment Change (US)
This is a key monthly report released by the Bureau of Labour Statistics (BLS) like most employment data. It shows the total number of non-farming related new jobs created in the US during the previous month. It excludes general government employees, private household employment and employees of non-profit organisations as well as farm employment.
It’s seen by many as the most important of all economic indicators, in terms of its potential to have the most immediate impact on the markets.
Also referred to as the Nonfarm Payroll Report (NFP), the data has massive implications for the strength of the US economy. The number of new jobs created is closely connected to consumer spending. This in turn has a strong influence on the GDP.
The indicator is released on the first Friday of every month and contains data for the month before. The report is the first on labour statistics every month and does often surprise markets. Traders in every sector watch this release very closely and are often forced to adjust strategies depending on the results.
Nonfarm Productivity q/q (US)
This is a quarterly look at annualised growth in the non-farming sector. It’s essentially a measure of labour efficiency for the production of services and goods. It’s watched closely by traders. It gives a glimpse into the potential for inflation if manufacturers are forced to raise prices.
Retail Sales
This is a measurement of the total value of retail sales over a given period. Traders watch this indicator closely as it’s the first report of the month on consumer spending - which accounts for approximately half of GDP. Retail Sales are important to traders because they provide insight into consumer spending, which in turn provides insight into the GDP. In Europe the data is released by Eurostat and is compiled from the whole retail sector of the Eurozone. The UK’s number is released by the British Retail Consortium (BRC).
Tankan All Industry Capex (Japan)
The Tankan Large All Industry Capital Expenditure released by the Bank of Japan measures capital expenditure (Capex) of all the Japanese industries except the financial industry. The Capex is considered as an early indicator of productivity and growth and is thus one of the key pieces of data being released out of Japan.
Tertiary Industry Index (Japan)
The Tertiary Industry Index, released by the Japanese Ministry of Economy, Trade and Industry, measures the domestic service sector in Japan. Services measured in this sector include: information and communication, electricity, gas, heat, water, general services, transport, wholesale trade, retail trade, finance, insurance and welfare. Generally, a high reading is positive (or bullish) for the JPY, while a low reading is negative (or bearish).
Trade Balance
The Trade Balance is the difference between the monetary value of exported goods and services and imported goods and services in the economy. As it’s in the best interest of an economy to export more than import, a positive trade balance (trade surplus) is a period when more goods and services were exported than were imported. An increase in exports can translate into an increase in demand for the nation’s currency since other countries will be required to exchange currency to buy these exports. Trade balance also has a large impact on GDP. An increase in the demand for exports will increase the workload of domestic factories - which will lead to higher employment.
Unemployment rate
This measures the total number of people who are unemployed and seeking employment. Consumer spending is a huge part of economic growth - and people spend less when they haven’t got a job. So unemployment is an important indicator of the buoyancy of an economy and its currency. Unemployment is considered a lagging indicator. This means it doesn’t really give traders anything to build into future projections. So while it’s interesting - it’s not enormously useful.
Unit Labour Costs
Unit Labour Costs show the correlation between compensation per hour and productivity per hour. An increase in hourly compensation rates raises unit labour costs. The only way to offset these costs is to make working more efficient and raise productivity per hour.
Higher trends should positively affect a nation’s economy and currency. This is because when companies pay more for labour, consumers soon see an increase in cost.
This is an important indicator for traders because wage inflation is often a precursor to consumer inflation - which in turn affects GDP and interest rates.