The Most Important Fundamentals to Watch When Trading FX Pairs

Fundamental analysis and technical analysis are like the yin and yang – they’re totally different approaches to define and anticipate market trends, but they both can and should be used interchangeably. While technical analysis makes sense for short-term price movements, the general trends are ultimately defined by economic updates and relevant events and news, whether they’re scheduled or unexpected.

Thus, it is essential to keep an eye on the most important events that can impact the forex market. While you cannot be ready for the unexpected news, there are many economic updates that are released on schedule, and the currency pairs can react before and after those events.

You can use an economic calendar to track the most important scheduled events, or, better still, you can check our ‘weekly calendar’ posts where we publish the most important announcements for the week ahead.

In the following lines, we’ll discuss three main types of fundamentals that affect the forex market, which are interest rates and anything related to central bankers’ decisions, economic updates, and political events.

Interest Rates and Monetary Policy

Interest rates are the main approach through which central banks try to control the economy by keeping an optimal balance between the economic actors. A currency’s interest rate is one of the essential factors, if not the most important one, that defines its perceived value.

In a nutshell, the central bank decides the rate banks should pay for borrowing money from the central bank for a single day. Eventually, banks set their own interest rate based on the rate required by the central bank. Thus, when the latter increases or cuts the interest rate, High Street banks act accordingly.

The logic behind adjusting the interest rate is that a higher rate means people would eventually see better returns on their savings, which would encourage saving rather than spending, while a lower rate would encourage investment and consumption. Central banks usually cut the rates to stimulate the economy following a major crisis.

As a rule, when the interest rate goes higher, the national currency strengthens because it becomes attractive for deposits. On the other hand, lower rates are putting pressure on the national currency, as investors would be interested in moving to currencies or assets generating better returns.

When the economy needs even greater support, the central bank may also increase the money supply by purchasing bonds, and this also sends a bearish message to investors. It’s because the expansion in money supply is devaluing the currency’s purchasing power.

The interest rate decision, bond-buying, and other measures taken by the central bank to control the quantity of money available in an economy are part of the monetary policy.

The central bank officials meet several times during a year to adjust the interest rate and the monetary policy. The US Federal Reserve has eight regularly scheduled meetings, and it may also hold emergency meetings.

All in all, knowing how a central bank sets its monetary policy is essential for traders.

Economic Updates

Another major factor affecting the perceived value of a currency is the health of the national economy. The thing is that the economy of a country is not static, and institutional and retail investors would be interested in moving their funds to currencies related to economies that perform well.

Government and private agencies are releasing important economic updates on a regular basis, and traders monitor them to get hints about economic health. Here are some of the most important indicators you should pay attention to:

  • GDP performance – the gross domestic product (GDP) of a country represents the total market value of all goods and services produced within the legal boundaries of that country. In the US, this indicator comprises four main parts, which are consumption, investment, government spending, and exports. Usually, economists expect that the GDP of developed economies to grow at a pace between 2% and 3% per year. Slower growth would need support from the government and the central bank, while faster growth could lead to inflationary pressure. Anyway, when the GDP growth figure exceeds expectations, this is most often a bullish signal for the national currency.
  • Inflation – inflation is one of the most important aspects of economic health, and the central banks are carefully monitoring it to decide the next steps related to their monetary policy. When inflation is going too high, the central bank would be forced to raise the interest rate, and vice versa. Usually, central banks of developed economies like the US have an annual inflation target of about 2%.
    There are several inflation indicators that economists track on a monthly basis, but the most important of them is the consumer prices index (CPI) and the Core CPI, which excludes the volatile prices of food and energy goods. In the case of the US, other inflation indicators worthy of consideration are the Personal Consumption Expenditures (PCE) – this one is preferred by the Fed in particular – and the Producer Price Index (PPI), both coming with their Core versions. Here is the difference between the CPI and the PCE:

  • https://www.brookings.edu/wp-content/uploads/2021/06/How-does-the-PCE-weigh-items-compared-to-the-CPI.png
    As a rule, when some of the inflation indicators are higher than predicted, the national currency increases against counterparts on expectations that the central bank would become more hawkish, i.e., it would tighten the monetary policy either by raising the interest rate or by reducing the pace of bond buying.
    Unfortunately, today, inflation has almost gotten out of control in most developed nations because the economic recession caused by the COVID-19 pandemic has forced central bankers and governments to take unprecedented measures in stimulating their economies by boosting the monetary supply. Recently, we reported that the US annual CPI surged to the highest in three decades, and it remains to be seen how the Fed addresses this.
  • Employment – in the best-case scenario, everyone should have a fulfilling job and contribute to the economy. However, there are many factors that prevent this from happening, but the sure thing is that higher employment points to a healthier economy and thus a consolidating national currency.
    For most countries, the unemployment rate performance is a good measure to track the job market trends, but in the case of the US, the most-watched indicator is the Nonfarm Payrolls report released by the Labor Department every first Friday of the month.
    If the nonfarm payrolls come in higher than expected, this is a very strong bullish signal for the US dollar. In fact, this is one of the most impactful economic reports that you should watch, along with the Fed’s interest rate decision and inflation data.
    Historically, the changes in the nonfarm payrolls have moved in tandem with quarterly GDP changes, suggesting that the former indicator could be used to anticipate GDP trends.
    Besides the Nonfarm Payrolls report, the US government also releases the weekly change in initial applications for unemployment benefits, which is published every Thursday.
  • Purchasing Managers Index (PMI) – the PMI measures the business conditions in the services and manufacturing sectors of a country. In the US, the services sector accounts for about two-thirds of the economy, so it makes sense to monitor the services PMI. The Composite PMI touches upon both sectors.
    A PMI reading above 50 points suggests growth, while a reading below 50 refers to contraction for a given period (usually, it’s released on a monthly basis).
    The PMI analyzes the change in the spending of business firms and has five sub-indicators, including new orders, inventories, production, supplier deliveries, and employment.
    Since upbeat PMI data points to a better economy, you should expect the national currency to strengthen whenever the PMI reading comes in higher than expected.
    The UK, Australia, and the European Union have a PMI version for the construction sector.
  • Retail Sales – if people buy more goods, it’s a solid sign of a healthy economy, right? This is the main logic behind the retail sales index, which measures the value of all goods and services sold by retailers. The indicator, which is released on a monthly basis, can have a positive impact on the national currency when it exceeds expectations and vice versa.
    The Core Retail Sales indicator in the US excludes auto and gas sales.
  • Housing market – in the case of the US alone, the housing market can contribute to about 20% of the GDP during periods of strong economic activity, which makes housing data quite relevant. Basically, heightened construction activity positively affects the GDP and thus leads to the strengthening of the national currency. Homeownership is essential for most people, which is why the real estate market is at the core of any economy.
    The most important housing market indicators, most of which are released on a monthly basis, are new home sales, pending home sales, existing home sales, housing starts and building permits, and the mortgage rate as well as mortgage applications.
    In the UK, you can keep an eye on the Halifax house price index, which affects the British pound.
  • Consumer and business confidence – there are many private surveys tracking the changes in the consumer and business sentiment, and you can monitor them to understand in which direction the whole economy is going.
    In the US, the two most important surveys are the Consumer Confidence Index by the Conference Board and the Consumer Sentiment Index by the University of Michigan.
  • Trade indicators – the trade balance is also an important indicator of a country’s economic conditions. The trade balance is dictated by the changes in the country’s ratio between exports and imports. If the country exports more goods and services than it imports, it has a trade surplus. Otherwise, prevailing imports result in a trade deficit. Over the long term, a higher surplus or lower deficit is beneficial for the economy and thus supports the national currency.
  • Commodity prices – if a country is a major producer or exporter of particular commodities, such as oil and gold, their price changes may directly affect the national currency. For example, the Canadian dollar and the Russian Ruble are very sensitive to oil price changes, given that Canada and Russia are major oil producers. Recently, the surging prices of crude oil, with WTI hitting the highest in about seven years, helped the CAD stay strong against the US dollar in the October-November period, while EUR and GBP have dropped by over 3%.

Politics and Geopolitics

While the perceived value of a national currency is closely tied with the economic conditions, it can also react to political and geopolitical events, as the globalization trend has led to intercorrelations between markets at all levels.

Internally, major political events like presidential elections, referendums, and policy changes can directly influence the business and consumer sentiment and thus impact the value of the national currency. This could be observed during the US elections in 2016 and 2020, both of which were quite dramatic.

Elsewhere, the British pound has tumbled following a national referendum held in 2016 that saw people voting to leave the European Union (so-called Brexit).  

On a global level, geopolitical and other events with political and social impact are causing volatility across currency pairs. Think about trade wars, corruption scandals, or government reactions to unexpected events like the pandemic.

As a rule, in times of global turmoil, investors usually favor so-called safe-haven assets and currencies that can stay strong against volatility. Swiss Franc (CHF) is one of the most popular safe-havens, but the USD is also regarded as a good refuge. When the global economy goes back to normal, investors are ready to take more risk and favor the currencies of emerging markets to achieve higher returns. Thus, you will often hear that the risk appetite has increased, putting pressure on the USD or vice versa.

The Final Note

Understanding how the main fundamentals work is essential for becoming a good forex trader, and we hope this concise compilation helps you get the picture.

It’s important to note that currency pairs may not necessarily react to economic updates and interest rate changes as you expect. It often happens because institutional investors have already priced in the potential moves before data is even released. That’s why you should make sure that the actual data is either significantly better or worse than expected.

To recap, here are the most important economic events and indicators that define the trends in the US dollar:

  • Fed’s interest rate decision and monetary policy changes;
  • Nonfarm Payrolls report;
  • Consumer Prices Index (CPI) and Core CPI, as well as the Personal Consumption Expenditures (PCE);
  • Quarterly GDP data;
  • Retail sales;
  • ISM non-manufacturing PMI;
  • New home sales;
  • Initial jobless claims;
  • Consumer confidence. 

 

 

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