FUNDAMENTAL FACTORS

There are two basic forms of analysis used in currency markets: technical and fundamental. Fundamental analysis looks at the economic conditions that affect the value of a currency, trying to predict both where the currency may be headed and whether it is currently fairly priced. Given that exchange rates are priced as the value of one currency against another, so too economic analysis is relative.
In reality, most traders use a combination of fundamentals and technicals. Fundamentals provide direction while technical provides a guide as to entry and exit levels. Often fundamental analysis is considered more medium term in nature.

Macroeconomic Indicators
At its simplest, fundamental analysis attempts to measure and judge the health and outlook for an economy. Stronger growth should underpin a strong currency, while weaker growth would indicate a weaker currency. It is important to watch for shifts in the trend, but in the context of what a currency already is reflecting and how this compares with other economies (relative growth).

Official economic releases are reliable and regular indicators of the state of play in an economy and many private sector releases are also useful to follow. All major economies release data on the key parts of the economy, coming together with the release of the National Accounts (or GDP). Major releases watched by currency markets include:
•GDP
•Industrial production / durable goods order / Institute of Purchasing managers (both manufacturing and non-manufacturing)
• Retail sales / private income and spending / consumer confidence
• Employment , unemployment and wages
• Trade data, imports and exports and the current account
• Home sales, house prices, housing finance, construction spending
• Survey data such as business and consumer confidence, and data such as the US Federal Reserve’s Beige Book (which assesses various anecdotal indicators of economic activity)
• Inflation indicators – such as Consumer Price Index, Producer Price Index, import and export prices, and inflation expectations
Economic calendars are a critical guide to approaching data that could impact currency markets.
The influence of any particular indicator will depend on what issues investors are currently focused on, and this changes frequently. For example, if inflation is the concern then inflation indicators will be key, whereas if the market is worried about the state of housing –as is currently the case in the US - then the focus will be on housing data.

In addition to assessing the trends in these indicators, investors must also look at how each piece of data relates to expectations. Remember, expectations are a critical part of financial market trading. Thus a currency could strengthen even if a piece of data that shows a weakening trend but still beat expectations (and vice versa). In a similar vein, rumours can also impact currency markets.

In addition to growth, currencies are also highly correlated with interest rates and particularly relative interest rates (or interest rate differentials). Indeed, in recent years, this has become a key determinant of trends in currency markets.
Interest rates are the ‘price’ of money, and high interest rates encourage global capital to flow in to an economy, boosting the value of its currency. Currency markets look at both short term ‘cash’ rates as well as longer term bond yields. Rising interest rates – especially relative to interest rates elsewhere – indicate a stronger currency and vice versa. The most recent example of this is the strong appreciation of NZD/JPY in recent times, with Japan interest rates close to zero but NZ cash paying over 8%.
In major economies, the central bank sets the cash rate, which anchors the longer end of the yield curve. Central banks use the cash rate as the key policy tool to manage the economy, aiming to contain inflation and extend the business cycle. In most cases, central banks target ‘low and stable’ inflation, with many running explicit targets for inflation. Simply, when inflation is rising, monetary policy is tightened by raising the cash rate, and vice versa. As a result CPI data is critical.
However, policymaking is rarely this simple, as the central bank attempts to pre-emptively move against future inflation pressures. As such policymakers look at a whole range of factors – including economic growth, wages, the degree of resource utilization, unemployment and inflation expectations – and, given this, currency markets carefully monitor policy speeches by central bank members (such as Fed Governor Bernanke).

Current account balances also influence currency valuations. A country running a current account deficit is importing more than it is exporting and / or borrowing more than it is saving. Economic theory argues that this imbalance can be addressed by a weaker currency, which would make exports cheaper and imports more expensive. The opposite is the case for an economy running a current account surplus.
While correct in theory, this tends to be a longer term indicator of currency trends. Indeed, the US economy ran a significant current account deficit through the 1990s while the USD appreciated relentlessly courtesy of the productivity boom. Nonetheless, at times, financial markets still worry about these issues.

Other fundamental issues
There are many factors that can influence the overall health and outlook for any given economy and indeed the global economy. Currency markets, more than any other financial market, trade on the back of news from many sources.
Other issues that can impact:
• Politics – both within a country and in the international domain
• Central bank intervention (individual or collective) – recently, central bank intervention has been focussed on ensuring smooth functioning of the market, rather than defending a level.
• Risk appetite – when investors are seeking to extend ‘risk’, the response to changing fundamentals can be greater than usual
• Positioning – if investors have already positioned for improving fundamentals (eg are holding a long position) then the currency may not strengthen further on a robust economic report, and equally could fall more than expected on disappointing news. The opposite is true for a market positioned on the short side.
• Natural disasters – for example, a hurricane in the Mexican Gulf can impact the price of oil, which is negative for economies that rely on imported oil
• Commodity cycles / Global growth
• Purchasing Power Parity – an economic theory that the price of goods in one country should equal the price of those goods in another country, exchanged at the current fx rate (the law of One Price)

Conclusion
Fundamental analysis is looking at any factor that shifts the prospects of an economy, and thus its currency. There is a complex web of many factors that can impact, from economic indicators to policy speeches, and many are inter-related. Economic calendars and commentary are critical in assessing and monitoring fundamentals, and investors must bear in mind trend, expectations and relativities.