Forex trading for beginners Part 4: Fundamental analysis, Rates

FUNDAMENTAL FOREX MARKET ANALYSIS

Currency trading today has become a very common activity: the daily turnover of the global FOREX (FOREX – Foreign Exchange) market reaches about two trillion dollars, and at least 80% of all transactions are speculative operations aimed at making a profit from fluctuations in exchange rates.

This attracts many participants, both financial institutions and individual investors.

The reasons are pretty straightforward; for example, here is a phrase from an article in the magazine FUTURES (England, June 1996):

“A competent trader can receive more than $1,000,000 a year in the form of salary and commissions.”

The volume of transactions in the world currency market is constantly growing.

This is due to the development of international trade and the abolition of currency restrictions in many countries.

The daily volume of conversion operations worldwide in mid-1998 amounted to $1.982 trillion (the share of the London market accounted for about 32% of the daily turnover, New York exchanged about 18%, and the German market – 10%). Impressive is not only the volume of transactions itself but also the pace at which the market is developing.

In 1977, the daily turnover was five billion dollars; in ten years, it grew to 600 billion and reached one trillion dollars in 1992.

The daily volume of operations of the largest international banks reaches billions of dollars.

Typical transaction volumes in interbank trading are $10 million.

Due to the rapid development of information technology in the last two decades, the market itself has changed beyond recognition.

Once surrounded by an aura of mystique, the profession of a currency dealer has become almost mass.

Currency transactions, which were recently the privilege of only the largest monopoly banks, are now open to the public, thanks to electronic trading systems.

The largest banks themselves also often prefer trading in electronic systems to individual bilateral transactions.

Today, the share of electronic trading systems accounts for 11% of the total turnover of the FOREX market.

In recent years, the opportunities for small firms and individuals to participate in the FOREX market have expanded tremendously. Thanks to the margin trading system, market entry is available to individuals with small capital. Companies providing margin trading services require a security deposit and allow clients to make transactions for the purchase and sale of currencies in amounts 40 to 100 times greater than the deposit. The client bears the risk of loss, and the deposit serves as collateral to insure the company. The FOREX market is becoming accessible to almost everyone, and a vast number of different firms are trying to attract clients’ money to it.

At the same time, currency trading is quite accessible if you have, say, $1,000, since many banks and dealing centers offer their clients “leverage,” allowing an investor with small funds to participate in the FOREX market by investing $1,000 and making transactions for amounts exceeding $100,000. The attractiveness of the FOREX market for individual investors is connected, of course, primarily with the possibility of quickly obtaining large incomes. Indeed, currency charts show that a successful trade is a practical investment decision.

Of course, those who begin to engage in operations in the foreign exchange market should clearly understand that these operations are high-risk business. In addition to the possibility of obtaining large incomes, they also bear the possibility of significant losses and, with a gambling approach, complete ruin. The purpose of the FOREX market as a place to apply personal financial, intellectual, and mental power is not to try to catch the bird of happiness there. Sometimes, someone succeeds, but not for long. The main advantage of the foreign exchange market is that you can grow there precisely by the power of your intellect.

Another essential property of the foreign exchange market, however strange it may seem, is its stability. Everyone knows that the main property of the financial market is its unexpected falls. But unlike the stock market, FOREX does not fall. If a stock is worthless, then it’s a crash. If the dollar collapses, then it just means that the other currency has become more robust; for example, the yen, which became a quarter more expensive than the dollar in a few months at the end of 1998. Moreover, there were separate days when the fall of the dollar was measured by tens of percent (for comparison, in the example above, the change in the rate was 1.2%). But the market did not crash anywhere; trading continued.

The foreign exchange market operates round-the-clock; it is not tied to specific hours of operation of the exchanges, as trading takes place between banks located in different parts of the globe. The mobility of exchange rates is such that percentage changes occur very often, allowing for several transactions every day. If you have a proven, reliable trading strategy, you can build a business around it that no other can match in terms of efficiency. No wonder the largest banks invest heavily in electronic equipment and employ hundreds of traders operating in various sectors of the foreign exchange market.

The initial cost of entering this business today is modest. Indeed, it costs several thousand dollars to undergo initial training, purchase a computer, subscribe to an information service, and form a deposit. You can’t create any real business with that amount of money. With an excess of service offers in this area, finding a reliable counterparty is also a genuine challenge. The rest depends on the trader himself. As in no other field of activity today, everything here depends on you.

The main thing that the market will require for successful operation is not the amount of money you enter with. The key is the ability to constantly focus on studying the market, understanding its mechanisms and the interests of participants, continuously improving your trading approaches, and maintaining discipline in their implementation. No one has succeeded in this market by proceeding without diligent preparation. The market is more robust than anyone; it is even stronger than central banks with their vast stocks of foreign exchange reserves. The legendary currency market hero George Soros did not defeat the Bank of England, as many people think; he correctly predicted that the existing contradictions within the European financial system would create enough problems and conflicting interests to prevent the pound from holding its value. And so it happened. The Bank of England, having spent about $20 billion to support the pound, abandoned it, leaving it to the market. The market dealt with this problem, and Soros earned his billion.

So central banks don’t just command the market with their foreign exchange interventions; they think strategically. For example, Alan Greenspan, chairman of the US Federal Reserve System (FED – the world’s largest central bank), according to journalists, is a perfect technical analyst when it comes to studying economic data. He continues to analyze economic statistics, examining everything from scrap metal prices as he searches for clues to the future path of the economy. Moreover, we, with limited resources, need to be able to analyze market information and learn to extract indicators from it about what the market desires.

Today, it is clear to everyone that an inherent property of business activity in market conditions is risk; that is, the actual result of an operation, project, or specific transaction often turns out to be different from what was planned when the decision was made. However, it is believed that trading in financial markets (speculation) is a hazardous activity precisely because, due to the complexity and unpredictability of market behavior, losses can be incurred, and there is never a certainty of a positive outcome. This deters many people from the financial markets, despite the fact that it is becoming quite accessible thanks to electronic communication technologies and robust data analysis software packages.

In fact, everyone involved in any business is well aware that the discrepancy between plans and actual results is inevitable, not only in speculative transactions. Unexpected changes in the economic or political situation, weather factors, or even natural disasters, as well as simply the problems or inefficiency of your partner, can lead to unfulfilled hopes from your business plan.

Risk, that is, the discrepancy between the planned result and the actual one, is an integral part of economic activity in market conditions. The only way to avoid risk is to do nothing, which, however, is also associated with a completely understandable risk.

So, the problem is not the riskiness of certain operations but the wrong approach to their planning and execution. In itself, the presence of inevitable risk is the basis for the existence of an entire business industry – insurance, which is a very influential sector.

With the right approach, you can capitalize on risk. What is the correct approach if we are going to engage in transactions in the foreign exchange market?

All current approaches to organizing effective behavior in a changing economic environment can be grouped into two areas:

1. Forecasting,
2. Risk Management.

In the field of financial markets, there are insurance technologies, risk limitation, and control. They are discussed in separate guides on money management methods.

Here, we will deal with the first of these areas – forecasting, the essence of which is the hope that if you correctly predict the future and make the right decision based on this, then the result will be positive.

The main question is how to predict this future.

There are many approaches to solving this significant problem. We note right away that we use techniques to work on the foreign exchange market that are united by the concept of quantitative forecasting methods.

This means that we describe the behavior of the system of interest to us – the market – by a particular set of numerical indicators (indices), and for each of them, a method of measuring it is precisely specified.

In the process of observations over a sufficiently long period, the history (statistics) of these indicators is collected, and forecasting consists of deriving future (“tomorrow”) values of these indicators from this history, on the basis of which we make our decisions.

The presence of specifically defined and unambiguously measurable parameters is the difference between quantitative forecasting methods and others – intuitive, authoritative, astral, and psychic methods – which can also be used (and are used) by traders but are not the subject of this tutorial.

As applied to financial markets, quantitative forecasting methods are divided, as is known, into two groups of significantly different approaches:

1. Technical Analysis,
2. Fundamental Analysis.

Technical Analysis is based on the belief that “the market takes everything into account,” and therefore, price behavior is already based on the consideration of all significant factors.

If the market is indeed efficient, then its movements are the result of the decisions of a large number of participants, collectively using all available information in making decisions about their operations.

The result of these decisions is price action, and by observing them, you have access to all market information. In fact, a trader needs very little – to know the direction of movements.

Technical Analysis provides a vast number of tools that allow you to derive valuable predictions from price charts.

Many good books are devoted to Technical Analysis, and here, we will not dwell on it; we will be interested in just those phenomena that Technical Analysis does not account for.

Both Technical Analysis and Fundamental Analysis are market statistics. However, Fundamental Analysis looks at the market from the opposite side of Technical Analysis.

No matter how great FOREX is, it is still part of a larger universe, and much that happens in it affects exchange rates.

Changes in the economies of trading countries, political elections that regulate the actions of financial authorities, and natural disasters – all affect exchange rates.

If some of these events cannot be foreseen, others are quite planned (for example, the timing of economic news releases is scheduled months in advance) or entirely predictable.

Therefore, if you build reasonable and timely forecasts, you can also foresee future movements in exchange rates, from which you can benefit.

A legendary example of the correct understanding, timely foresight, and successful use of the current situation, which went down in the history and folklore of the foreign exchange market, is the operations of George Soros, who anticipated the imminent fall of the British pound.

Shortly before this, the pound re-entered the European Exchange Rate Mechanism (ERM), which united the main European currencies under a single mechanism.

In short, the purpose of the regulation mechanism (ERM) was to set central exchange rates for each pair of currencies, and from these designated rates, the currency could not deviate by more than a given percentage. Thus, the exchange rates operated within their corridors, fluctuating like a snake (hence the entire regulatory system was called the “currency snake”).

If the usual mechanisms of monetary regulation (primarily interest rates) were not enough for central banks to maintain currencies within these corridors, direct currency interventions were used. At the border of the currency corridor, each of the two central banks had to buy or sell its currency against the partner’s currency to correct the course, driving it back inside the corridor.

It so happened that (as is now apparent to everyone) the pound entered this currency system with too high an exchange rate in relation to other currencies. Regarding the German mark, its rate was set at 2.95 marks per pound.

The times were not easy for Europe; after the reunification of Germany and other well-known events in many economies, there were numerous problems.

In England, the economy was also at the bottom of the economic cycle, accompanied by high inflation and high-interest rates, falling production, high unemployment, and so on.

Fulfilling the agreed obligations to regulate exchange rates, central banks spent a lot of currency; the Bundesbank spent the most, tens of billions of dollars, as the pound continuously fell against the German mark.

As a result, the Bank of England (BOE) exhausted all possibilities to fulfill its obligations to maintain the exchange rate of the pound in accordance with the requirements of the European regulatory mechanism.

A further rise in interest rates was impossible – they were already too high, creating additional problems in the economy, particularly increasing unemployment.

So, in the end, the Bank made the inevitable decision to let the market regulate the value of the pound, which plummeted immediately afterward, and England withdrew from the European Exchange Rate Mechanism.

A correct understanding of the essence of the situation and foreseeing its outcome allowed Soros to make the right bets against the pound in time and earn his billion dollars.

Fundamental Analysis, as applied to the foreign exchange market, studies international economic, financial, and political factors, their relationships, and their influence on the behavior of exchange rates. Thus, it sees what is not on the charts.

Not today, but tomorrow, it will appear and become the subject of Technical Analysis; any price movement will then receive its graphical interpretation, which can be used in forecasts and for opening positions.

But the day after tomorrow. If you correctly and timely interpret the events taking place behind the chart today, then tomorrow, you can already make a profit.

A quite reasonable question: is it possible to trade without knowing and studying Fundamental Analysis? You can definitely say yes. Many people do that.

The abundance of fascinating (sometimes enticing) written literature on currency trading, the apparent simplicity of the basic principles of Technical Analysis, and the availability of computer services, specialized analysis packages that support an intuitive dialogue with the user (almost every one of whom considers themselves a computer professional) – all this makes it easy and painless to go through the stages of initial acquaintance with the subject and immediately begin practical operations.

It happens that a person then falls into a losing streak when everything seems to be understood correctly, you know everything, and know how to do it in accordance with the best methods, yet losses follow losses.

They start looking for reasons in everything: blaming the dealing center for poor service, the dealer for incorrect quoting of currencies, substantiating the concept that this whole business is a pyramid scheme to deceive people, etc.

Rarely does anyone in such a state have enough objectivity to ask themselves why they came to this market and honestly answer – to take money from others.

If you are now buying a currency with the expectation of a profitable trade, then you are able to do this only because someone is selling this currency to you, and their plans for this money are precisely the opposite of yours.

What if they have studied some aspects of market behavior better or know something about the market that you missed the opportunity to figure out in time? Isn’t that their advantage?

The ocean of information surrounding the currency trader is vast; it is information that is the object and instrument of trade in modern currency markets (as one textbook says, “a currency trader is an information trader”).

If you do not see any part of this ocean, then the opportunities you have missed are not only great; even worse is that you will never know about them.

And the Fundamental Analysis that you overlooked is a prime example of such a missed opportunity.

The study of Fundamental Analysis is, to a large extent, simply the study of the workplace of a currency trader, their trading floor, located across all time zones of the globe simultaneously.

Few people today have sufficient life experience to freely navigate what is happening on this trading floor in all its corners.

You need to know this and understand it in adequate detail; a superficial idea or intuition is not enough here.

Anyone who refuses to spend time studying that side of the life of the currency markets that operates behind the screens of monitors displaying exchange rate charts gives others a head start and profits from it.

It is unlikely that anyone will be able to appreciate their ethical integrity in such a scenario.

In addition, one must correctly understand that the foreign exchange market is only a part of the financial market.

Due to the absence of other components of the financial market in our country and other neighboring countries (government securities, shares, corporate bonds, etc.), the work of a currency trader has become the only option available to an individual investor.

This is the only opportunity now in our conditions to observe the market and participate in it.

Currency speculative transactions can bring substantial income in the shortest possible time, but they are rightly considered the most complex and risky worldwide.

Here, intelligence, knowledge, discipline, and the ability for creative work are most required.

Anyone who has established themselves as a currency trader will be able to work in any market; it just so happened.

Money and Interest Rates

All actions of state regulatory bodies, and in particular, central banks that affect finance and money circulation, are essential factors for exchange rates.

The price of a currency is determined primarily by the supply and demand associated with that currency in the international market.

Therefore, the exchange rates of major currencies are created by the market, but central banks have a range of tools through which they can significantly affect exchange rates.

Central banks use these tools based on the goals of their financial policy (the main one of which is the stability of the national currency) and the specific situation determined by the state of the economy, the country’s competitive position in the world market, and political factors.

Therefore, the markets are always very closely watching not only the economy but also the financial statistics of the leading trading countries, trying to predict the actions of central banks based on them.

Acquaintance with the principles of monetary science and understanding the meaning of the policies pursued by financial authorities is a must for every trader who wants to plan their work meaningfully in the foreign exchange market.

1. Indicators of Monetary Statistics

The amount of money in circulation (Money Supply) is one of the essential factors that shape the exchange rate.

An excess of one currency will create an increased supply of it on the international currency market and cause its depreciation in relation to other currencies.

Accordingly, a shortage of currency, if there is a demand for it, will lead to an increase in the exchange rate.

Indicators that measure the amount of money in circulation are the so-called Monetary Aggregates, which take into account the amount of money of different types, characterizing the composition of cash (the structure of the money supply).

The Monetary Aggregates themselves are defined somewhat differently in other countries, but their general meaning is quite similar.

As usual, we will consider here the variant adopted in the American banking system, where data are generated for four Monetary Aggregates:

– M1 – cash in circulation outside banks, traveler’s checks, demand deposits, and other checking deposits;

– M2 = M1 + non-checkable savings deposits, time deposits in banks, overnight REPO operations, overnight US dollar deposits, funds in mutual fund accounts;

– M3 = M2 + short-term government bonds, REPO transactions, Eurodollar deposits of US residents in foreign branches of US banks.

In the USA, another, broader Monetary Aggregate is used, but M2 is considered to be the leading indicator, highly correlated with the foreign exchange markets, so we omit further details.

US monetary aggregate data is released weekly, usually on Thursday.

The impact of data on Monetary Aggregates on currency cycles is assessed primarily through their relationship with the stages of economic cycles (the basic concepts of the cyclical behavior of financial indicators are discussed in detail below).

The behavior of various Monetary Aggregates in the economic cycle is quite similar: they all show maximum growth rates before the start of a recession and growth minima at the end of a recession.

For this reason, M2 is included in the composite leading indicator index, for example. All aggregates experience the most significant growth during the recovery stage; M2 has, on average, the same growth rate in the recession stage and the growth stage.

2. Interest Rates

None of the indicators of economics and finance is as essential for tracking the dynamics of foreign exchange markets as interest rates.

The interest rate differential (Interest Rate Differential), that is, the difference in interest rates for two currencies, is the main factor that directly determines the relative attractiveness of a pair of currencies and, consequently, the possible demand for each of them.

There are many types of interest rates in the money market of each country: the rate at which commercial banks borrow money from the central bank (Official Interest Rate), rates at which banks borrow money from each other (Interbank Offered Rate), interest rates that determine the yield of government securities (Government Bonds Yields), interest rates at which banks issue loans to their customers (Lending Rates), and interest rates at which commercial banks attract money in deposits (Deposit Rates).

All these rates are closely related and are ultimately determined by the official interest rate set by the central bank.

Thanks to the transparency of the boundaries for financial capital, an investor today can choose the most profitable option for investing their money.

Therefore, if a Japanese investor (investment company, pension fund, or insurance company) has trillions of yen in assets and can earn income on them in the form of interest on a deposit in a Japanese bank, in the amount of, say, 0.1% per annum, then this investor, of course, will prefer a dollar deposit at 5.5% per annum in an American bank, or they will buy American government bonds, which also pay high returns (and are guaranteed, which is especially important for structures such as pension funds that need highly reliable sources of income, from which they pay future pensions).

The higher the interest rate for a given currency compared to other currencies (significant interest differential), the more foreign investors will be willing to buy this currency to deposit funds at a high-interest rate.

Since interest rates are always closely linked, high banking market rates mean high government bond rates as well as high yields on riskier corporate bonds.

In short, high-interest rates make this currency attractive as an investment tool, which means that the demand for it in the international currency market is increasing, and the exchange rate of this currency is growing.

In general, the impact of interest rates on exchange rates is quite clear: the higher the interest rates for a given currency, the higher its exchange rate.

But many circumstances make accounting for interest rates non-obvious and by no means a simple matter.

First, it is necessary to consider not interest rates per se but actual interest rates adjusted for inflation (see paragraph 6) since there is a strong link between the foreign exchange market and the markets for government securities (fixed income instruments), which are very sensitive to inflation.

If inflation in a given country begins to grow at a high rate, this devalues government bonds since the income on them is paid at a fixed, predetermined rate, and inflation can erode this income.

Secondly, the market anticipates important events and prepares for them, rather than only reacting to already accomplished facts.

If there is a prevailing opinion that the interest rates for a currency will be raised, then traders will begin to bid up its rate in anticipation of its future increase.

The market can remain in this optimistic mood for a given currency for a long time, allowing its uptrend to form. When the rate increase finally takes place in reality, the currency will already be in an overbought state.

Since the factor of upward pressure on it has already diminished after the rate increase occurs, the first reaction to the actual increase may be a fall in the exchange rate, a directly opposite reaction.

Since the factor of upward pressure on it has already diminished after the rate increase occurs, the first reaction to the actual increase may be a fall in the exchange rate, a directly opposite reaction.

Since the factor of upward pressure on it has already diminished after the rate increase occurs, the first reaction to the actual increase may be a fall in the exchange rate, a directly opposite reaction.

This is all the more likely because such a pullback downwards serves well for the market’s adjustment.

Interest Rates of Central Banks

The market interest rates on loans, deposits, etc., do not arise by themselves in a market environment.
In each country, lending conditions and interest rates in the money market are regulated by the Central Bank.

Central banks use different types of interest rates as their instruments.
The discount rate characterizes the conditions under which the Central Bank (CB) provides funds to commercial banks.

Interest rates for interbank borrowing in many countries are the main policy instrument of central banks.

They go by different names, but the general idea is that at these interest rates, commercial banks borrow funds from each other for a short time to regulate their balance sheets.

Officially regulated interbank borrowing rates determine all other money market rates; rates on government debt securities, profitability levels on all other financial instruments, and interest on loans to bank customers depend on them.

Yields on Government Securities

The main thing to understand when analyzing the relationship between the foreign exchange market and government securities markets is that government securities are financial instruments with a fixed income, and it follows that their yield is inversely proportional to their market price.
Government bonds are issued for a certain specified period (ranging from 1 to 30 years), after which the bonds are redeemed at their nominal price (face value is the price written on the bonds).

During the bond’s circulation period, interest income is paid on it in accordance with the established interest rate.

If the purchase price of a bond is equal to its face value, then the yield is the same as the interest rate on the bond; the higher the purchase price of a bond, the lower its yield.

If the market expects the Central Bank to raise interest rates, it will expect new bond issues to have a higher interest rate.

In this case, the demand for bonds currently in circulation may decrease, and their price will fall, leading to an increase in yield.

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