Technical analysis and fundamental analysis are mainly used methods to analyze financial markets. The fundamental analysis predicts future price movements based on fundamental economic conditions, but technical analysis uses past price data and chart.
Controversy has continued over which methodologies are more successful since technological analysis began to be used. Traders who focus on short-term trading prefer to use technical analysis because the main strategy focuses on prices. Traders who focus on medium-term tradings, on the other hand, tend to use fundamental analysis to evaluate the future value of any currency as well as its appropriate value.
Before implementing successful trading strategies, it is important to understand what causes currency movements in the foreign exchange market. The best strategies may be a mixture of fundamental and technical analysis. This situation occurs in both technical patterns and fundamentals.
There can be drastic changes in price movements, especially with economic news releases. Therefore, technical traders should be aware of important economic indicators and situations in which the announcement is scheduled, and fundamentals traders should be aware of the critical technical levels that the market is largely focused on.
Using Fundamentals Analysis
Fundamental analysis focuses on analyzing economic, social and political influences that drive demand and supply. Using fundamental analysis as a trading tool implies to take account of various macroeconomic indicators such as growth rates, interest rates, infrastructure, and unemployment. Fundamental analysts will combine all of this information to evaluate current and future price movement sand combining all the information requires a lot of work and analysis.
Traders using fundamental analysis should be constantly aware of news and announcements that could lead to potential economic, social, and political changes. All traders must be thoroughly familiar with the overall economic conditions before trading, which is particularly important for traders making trading decisions based on news events. Although the Federal Reserve’s monetary policy decisions are always important, the impact on EUR/USD may not be significant if the movement of interest rates is already fully reflected in the market.
The exchange rate is basically driven by supply and demand. In other words, most fundamentally strong currencies are due to demands. Regardless of whether demand is for hedging, speculation, or currency conversion, the exchange rate’s actual movement is based on the currency’s need. When the supply exceeds, the value of the currency decreases. Supply and demand are the real determinants in predicting future price movements.
However, predicting supply and demand is not as simple as many people think. Many factors affect the net demand and supply of a currency, such as capital flows, trade flows, speculations, and hedgings. For example, from 1999 to 2001, the Internet and stock market boom in the United States led to foreign investors’ inflow, and the U.S. dollar strengthened against the euro. Depending on the demand for U.S. assets, foreign investors would sell their currencies and buy U.S. dollars.
When geopolitical uncertainties rose since late 2001, the U.S. began to cut interest rates, and foreign investors sold U.S. assets to move toward higher yields. As a result, the dollar’s supply increased, while the dollar’s value fell compared to other major currencies.
The intention to buy a currency or the possibility of funding for that currency is a major factor that could affect the direction of that currency’s value. These were the main determinants of the U.S. dollar value between 2002 and 2005. The capital outflow trend announced by the U.S. Treasury Department is one of the most important economic indicators for market forecasts.
The Factors to Consider!
1. The Flow of Capital and Trade
Capital and trade flows form the balance of payments, which allows entities to measure the size of demand for a currency over a period of time. Theoretically, the international balance of payments must be zero for a currency’s current value to remain the same. A negative balance of payments indicates that capital outflows from a country’s economy are faster than inflows, so its currency value should theoretically fall.
This is especially important in the current situation where the U.S. continues to record a huge trade deficit without sufficient foreign capital inflow to bridge the trade deficit. The Japanese yen could be another good example.
Japan is one of the largest exporters in the world that has a huge trade surplus. As a result, despite the zero interest rate policy, which hinders the increase in capital inflows, the yen tends to remain strong on the other side due to the trade surplus.
Capital Flows measure the net size of the currency purchased or sold on an equity investment. Capital account surplus means that foreign capital inflows of real investment or portfolio investment in a country exceed outflows. The capital account deficit indicates that real investment or portfolio investment into overseas assets by domestic investors outweighs capital inflows by foreign investors.
The Flow of Real Investment is a corporate investment in real estate and manufacturing. It also includes foreign direct investments, such as local business acquisitions. These factors are causing foreign companies to sell their own currencies and buy foreign currencies, resulting in changes in the foreign exchange market.
This is particularly important in global acquisitions because it has more cash flow than stocks. The real investment flow represents a fundamental change in actual direct investment activities. And direct flows can change each country’s financial health and growth potential.
Changes in local laws to attract foreign investment can also accelerate the flow of real investment. For example, China’s entry into the World Trade Organization eased laws on foreign investment. Global companies are flooding into China, seeing China’s cheap labour and attractive investment revenue opportunities. From the foreign exchange market perspective, it is recommended that foreign companies sell their currencies and buy Chinese yuan to raise funds for Chinese investment.
2. A Comparative Measure of Exports and Imports
Trade flows are the base of all international trade. A country’s investment environment is the main determinant of its currency value, and its net trade balance is calculated according to its trade flow. Net exporters whose exports exceed imports will have a net trade surplus.
The currency value of net exporters is likely to rise because the demand for their currencies is higher than the demand for selling in terms of international trade. Overseas customers interested in purchasing exported products and services must first purchase the currency, which increases the demand for the exporting country’s currency.
Countries with imports exceeding exports will show a trade deficit, which serves as a potential factor in lowering the currency’s value. For import purposes, the importing countries must sell their own currencies to buy the countries’ currencies that sell goods or services. For this reason, if the size of imports increases, this can serve as a factor that leads to a fall in the value of the currency.
3. The Stock market
With the development of technology, capital movement has become very easy, making it possible to invest in stock markets worldwide.
Therefore, the stock market, which is strong anywhere globally, offers ideal investment opportunities for everyone regardless of their geographical location. As a result, a country’s stock market and its currency have a strong correlation. If the stock market rises, investment funds will flow in. On the contrary, a fall in the stock market would allow local investors to seek overseas investment opportunities by disposing of their domestic investments.
However, this correlation has changed since the Tech Bubble burst in the United States. The reason is that the correlation between the U.S. stock market and the U.S. dollar has decreased as foreign investors continue to be relatively hedging. Nevertheless, because these correlations still exist, all traders continue to monitor the global market’s performance and find cross-market revenue opportunities.
4. The Bond Market
Just as the stock market correlates with the foreign exchange market, the bond market also correlates with the foreign exchange market. In times of high uncertainty worldwide, the bond investment can be beautiful due to bonds’ inherent safety. As a result, foreign investment will be made into a country with attractive bond investment opportunities, leading to its currency appreciation.
A valid way for recognizing capital flows to the bond market is the short-term/medium-term return on government bonds. It may need to keep an eye on the spread difference between the yield on U.S. 10-year government bonds and foreign bonds yield. This is because international investors tend to invest their capital in assets in countries with the highest return. If U.S. assets were one of the highest-yielding assets, more investment would occur in U.S. financial instruments, which would soon result in a rise in the U.S. dollar. Investors may also use short-term returns, such as a two-year national spread, to measure the short-term flow of international capital.
In addition to the yield on long-term government bonds, short-term government bond futures prices can also be used to predict the movement of U.S. funds. This is because short-term government bond futures reflect expectations for the Fed’s interest rate policy in the future. Meanwhile, the Euro Interbank Offered Rate (EURIBOR) interest rate futures indicate future policy movements as well.
5. PPP, Purchasing Power Parity
Relative prices determine the exchange rate by constructing a similar basket of goods between the two countries. On the very basis of this idea, the theory of purchasing power assessment is established. Changes in the country’s inflation rate should be balanced by the opposite change in the country’s exchange rate. Therefore, according to this theory, if a country’s prices rise due to inflation, its exchange rate must fall.
The basket of goods and services priced for purchasing power assessment is a sample of all goods and services included in gross domestic product. These goods and services include consumer goods and consumer services, government services, facilities and construction projects.
To take a closer look, consumer goods include food, beverages, tobacco, clothes, shoes, monthly rent, water supply, gas, electricity, medicine and services, furniture, home appliances, personal transportation equipment, fuel, transportation services, entertainment and cultural services, telephone services, home appliances and repair services.
One of the most famous examples of PPP is the Economist’s Big Mac Index. The Big Mac PPP is an exchange rate calculated by assuming that the Big Mac hamburger’s price in the United States is the same as that of other countries. The comparison between the PPI exchange rate and other countries’ actual exchange rate indicates whether the country’s currency value is undervalued or highly valued.
The OECD releases a more formal index. The OECD issues a table showing the price levels of major developed countries. Each column represents the number of monetary units required by each country on the list specified to purchase the same representative consumer goods and service basket. The cost of purchasing 100 units of each representative bundle in a country is stated in that country’s currency.
It publishes a chart that compares a country’s PPP with its actual exchange rate on a weekly bases to reflect the current exchange rate. Also, it reveals predictions in PPP approximately twice a year. Although PPP forecasts come from studies conducted by the OECD, they should not be considered conclusive. Due to differences in different computational methods, the PPP exchange rate will be different among various entities.
6. Interest Rate Evaluation
The theory of interest rate evaluation says that if there is a difference in interest rates between the two countries, the difference is reflected in premium or discount on the leading exchange rate to prevent risk-free trade.
For example, if U.S. interest rates are 3 per cent and Japanese interest rates are 1 per cent, the U.S. dollar should fall 2 per cent against the Japanese yen in calculating the forward exchange rate to prevent risk-free trading.
This future exchange rate is reflected in the forward exchange rate calculated today. The forward exchange rate of the dollar is called the discount. This is because buying the yen at the leading U.S. dollar exchange rate can buy the Japanese yen less than buying it at the spot exchange rate. This state of the yen is called the premium.
The theory of interest rate evaluation has not been working well lately. This is because high-interest currencies have frequently risen due to the central bank’s decision to slow economic activity through interest rate hikes, regardless of risk-free profit-taking.
7. Real Interest Rate Difference Model
In the theory of real interest rate differences, the movement of exchange rates is determined by a country’s interest rate. The currencies of countries that maintain high-interest rates should remain strong, while those that maintain low-interest rates should remain weak.
If a country raises interest rates, foreign investors will be attracted to the currency in terms of return and buy the country’s currency. One of the key factors in determining the strength of the exchange rate’s response to changes in interest rates in the model is the expectation of the continuation of changes in interest rates. When the interest rate hikes, which is expected to last for the next five years, has a greater impact on the exchange rate than it is expected to last for a year.
There has been debate among international economists over whether there is a strong and statistically significant link between a country’s interest rate change and currency prices. The main weakness of this model is that it does not take into account a country’s current account and instead relies on capital flows through its capital account.
The interest rate model tends to overemphasize capital flows at the expense of numerous other factors such as political stability, inflation, and economic growth. Assuming that these factors are absent, the interest rate model can be very useful. This is because there is an extremely logical reason that investors will naturally be attracted to invest that pay higher rewards.
8. Currency Model
The Currency Model is the theory that the country’s monetary policy determines the exchange rate. According to the model, the currencies of countries that have been implementing stable monetary policies for a certain period of time are strong and the currencies of countries with inconsistent or excessive expansionist policies show a decline in value.
1. The volume of money in a country’s currency.
2. The nation’s future monetary volume.
3. The growth rate of the country’s monetary volume.
These factors are key to understanding currency trends that can change the exchange rate. For example, Japan’s economy has been in recession for the past decade. The interest rate level was almost zero, and the fiscal deficit prevented the government from increasing spending to get out of the recession. As a result, there was only one way that the Japanese government could revive Japan’s economy. It’s printing more money! By buying stocks and bonds, Japan’s central bank increased its currency volume, resulting in inflation that caused the exchange rate to change!
This is an example of implementing an excessive policy of increasing the money supply that the currency model can most successfully be applied. One of several ways a country can prevent a sharp decline in its currency value is by implementing a monetary tightening policy.
Another example is when the Hong Kong dollar was under attack by speculators during the Asian financial crisis. Hong Kong authorities have raised interest rates to 300 per cent to keep the U.S. dollar-linked. This method worked perfectly. Skyrocketing interest rates have allowed speculators to be kicked out. On the other hand, the downside was the risk that the Hong Kong economy could fall into a recession. Eventually, however, the U.S. dollar peg system was maintained, and the currency model worked.
9. Currency Substitution Model
The currency replacement model should be considered an extension of the currency model because it considers the investment flow of a country. It is assumed that the movement of the private and public sector portfolios from one country to another has a significant impact on the exchange rate. The act of individuals changing assets from their own and foreign currencies is called currency replacement.
Combining this model and currency model shows evidence that changes in expectations for a country’s currency volume can have a decisive impact on its exchange rate. Investors will be looking at the currency model data carefully and expect changes in the flow of funds, resulting in changes in the exchange rate, which results in investment execution, making the currency model predictable on its own. Investors who support this theory use a currency replacement model as a complement to the currency model.
The importance of economic indicators, for both fundamental and technical traders, should never be underestimated. There are many people who claim to be technical analysts, but in the foreign exchange market, almost every pro-traders has included economic indicators as an important factor in their trading strategies.
For example, a good technical analyst who focuses only on range trading (a strategy to buy at a low price and sell at a high price) will probably choose to leave the market without trading on the day of the release of economic indicators that trigger a very large movement in the market, such as Nonfarm payrolls (NFP).
Traders who focus on technical breakouts (a strategy to trade on top or bottom breakthroughs) will, on the contrary, want to trade only on the day when important economic indicators that trigger price movements are released. For those who trade in automated systems, it is especially important to add a fundamental analysis.
This is because turning on or turning off their strategies based on the economic indicators to be released could potentially have a significant impact on the overall performance of their trading strategies. Fundamental traders tend to perform better when economic indicators are released. The economic indicators that have the greatest impact on the exchange rate are, of course, the U.S. economic indicators. Nearly 90% of all currency tradings are made in exchange for US dollars.
In other words, the U.S. dollar is the benchmark or relative currency for most transactions. However, not all economic indicators affect it. Some economic indicators are very important and may have a lasting effect on the exchange rate, while others may not be of general importance.