FUNDAMENTAL ANALYSIS

The Trade Balance

The Trade Balance is a measure of net exports minus of net imports. This tends to be a negative figure in the US in recent years, in that the US is above all a nation of consumers. A growing disproportion in the trade balance could indicate a fair amount about the current account balance and on the situation of excess spending on imported goods and services in the US. Traders expect a decline in the trade balance deficit to cause a “bullish” or upward movement for the dollar and vice-versa for a contrary result.

The trade balance is one of the most misunderstood indicators of the US economy. For example, many people believe that a trade deficit is negative. However, in order to establish whether a trade deficit is negative or not is relative to the current economic cycle. In a recession, countries aim to export more, creating jobs and domestic demand. During an economic boom, countries want to import more, bringing in competition for domestic prices, which limits inflation and, without increasing prices, assists in providing goods in excess of the nation’s economic capacity in order to meet consumer demand. Therefore, a trade deficit is not a good thing in a recession, but it can be helpful during an economic boom.

The US trade balance refers to the difference between net exports and net imports in the USA. It is one of the major components of the Balance of Payments which impacts heavily on the dollar.
The reason why the trade balance is important to a trader on the FX market is that the demand for US goods and the demand for the US dollar are directly linked. Foreigners must pay US dollars to purchase US products. Therefore, more exports = a tendency for more demand of the currency. The demand for exports also impacts production and prices as domestic producers try to equalize domestic demand by increasing domestic production.

In the Balance of Payments there also appear investments reflected in the TIC (Treasury International Capital). This data is published every month by the Treasury Department. The TIC shows the difference in the value of long-term financial assets purchased by US citizens and the amount of long-term US financial assets purchased by foreigners. The result shows the balance of domestic and foreign investments. For example, if foreigners buy $60 billion of US equities and bonds, while US residents purchase $30 billion of foreign assets, the TIC result would be $30 billion.
This data is as important for traders as the trade balance, because when foreigners buy US assets they have to pay in US dollars, thus increasing the demand for the USD.
In addition there are the concepts of Order Flow and Capital Flow.

Trade Flows

Trade flows represent the purchases and sales of goods and services between countries. They measure the scope of the trade balance (exports – imports). This is the amount of goods and services that a country sells to another country, after deducting the amount of goods and services that the country purchases from overseas. This calculation includes all international goods and services and represents the country’s trade balance. Countries with net exports are those that export more than they import from international producers.

Net exporters have a surplus trade balance. This is because they sell more than they purchase. The demand for the country’s currency, therefore, rises due to international clients having to buy the country’s currency in order to purchase their goods and services. Therefore, the national currency may be subject to appreciation.

Countries that are net importers, on the other hand, purchase more than they sell. Net importers have a trade balance deficit. This is because they buy more goods and services from overseas than they export. In order to buy these goods and services from foreigners, they must convert their currency into the foreign currency, which is as if they are selling their currency. This can cause a depreciation of the domestic currency.
Let’s take a look at Japan, for example, that relies on exports and therefore usually has a trade balance surplus. This means that Japan typically exports more than it imports and is one reason why the Yen remains stable despite the extreme economic weakness of the country.
The Japanese trade balance surplus is about 3% of the GDP. This creates an international demand for the Japanese Yen in order to buy Japanese products.
It’s clear that the balance of payments has a direct effect on the currency levels, so it is therefore important for traders to keep an eye on economic data relative to the balance of payments.

Capital Flows

Capital Flows are funds exchanged with foreign countries and used to carry out investments in foreign countries. Capital Flows measure the net amount of currency that is bought or sold for this purpose. The key concept behind the flows is the net amount. For example, a country may have a positive balance or a negative balance. A positive net capital flow implies that the incoming investments exceed those that are outgoing. Basically, there is more demand for domestic investments.

The moment in which the income exceeds the outflow of any country, there is a natural increase in the demand for the currency of that country. This demand pushes the value of the currency to rise. A negative net capital flow implies that the outgoing investments exceed the incoming investments. Basically there is more demand for foreign investments.

When the outflow exceeds the revenue of a country, there is a natural decline in the demand for that country’s currency. This lack of demand pushes down the value of the currency.
Countries that offer the highest returns through interest rates, economic growth and a growth in the financial sector tend to attract the most foreign capital (such as Australia in 2010, when they started the cycle of raising interest rates, while other countries remained stuck).
These countries , therefore, retain a constant rate of inflow. Then, if the financial markets are healthy, there tends to be higher interest rates, which in turn attracts foreign flow causing the currency to appreciate.

Let’s take for example a boom economy in the UK and a decline in the USA. In the UK the share market is strong, while in the USA there is a reduction in investments. This would be the scenario:
USA residents sell US dollars to buy GBP, so taking advantage of the strengthening economy.
There is an outgoing capital flow from the USA, directly to the UK.
The demand for GBP rises and the demand for the US dollar falls.
The value of the USD decreases in relation to the GBP.

With this introduction to the Trade Balance, to the Treasury International Capital and to Capital Flows, you have more information on the importance of following the macroeconomic data as it emerges and are able to interpret the data in a practical manner.

Interest Rates

If there was one factor that dominates all others in the Forex markets, it is Interest Rates. The Central Bank of a country or an economic group imposes the interest rate for the relative currency. These rates are adjusted with the intention of encouraging trade and seeking to keep inflation under control. Lower interest rates encourage economic growth as credit is easier to obtain, whereas higher interest rates will slow down economic growth due to the “price of money” rising. Changes in interest rates can also influence the value of a currency.

It is vitally important to understand the movement of the USD when following the tax decisions of the Federal Reserve’s Open Market Committee, who implement the Fed Fund target. When the Fed raises interest rates, the return offered by financial assets that are denominated in USD rises. This generally attracts more traders and investors because there is more incentive to invest in the USD. Another important factor for the USD is the statement that accompanies the decision on rates. Sometimes the change in rates is already taken into consideration in the markets and therefore we don’t see any extreme movements. In this case, analysing the statement can offer important insights. The actual decision therefore loses significance soon after the move because the market shifts the focus onto the future decision.
Every kind of money carries an interest rate. This is almost like a barometer for the strength or weakness of the economy. As the economy of a nation strengthens over time, prices tend to rise due to consumers being able to spend more of their income.

In other words, the more demand there is for the same quantity of goods, the more this leads to higher prices for such products. The rise in prices is called inflation and the central banks keep it under close observation. If inflation is not kept under control, our money would lose much of its purchasing power and the common elements like bread could rise in one day to incredibly high prices, such as a hundred dollars for a loaf. That may sound like a far-fetched scenario, but that is exactly what happens in nations with extremely elevated inflation rates, like Zimbabwe. To stop this from happening, the central bank raises interest rates to the point of containing inflationary pressures before they lose control. High interest rates renders loaning money more expensive, which in turn deters consumers from buying new homes, using credit cards and taking on additional debt. Expensive money discourages companies from expanding because many activities are paid through the credit circuit, which always includes interest. In the end, higher rates will have their effect via the economy slowing down, up to the point where the central bank will again be forced to cut interest rates, this time to promote economic growth and expansion – and so the cycle continues.

With interest rates on the rise, a nation can also increase the desire of foreign investors to invest in that country. The logic is identical to that behind every investment: The investor seeks the highest possibile return. With rising interest rates, the yield available to those who invest in that country increases. As a result, there is an increase in the demand for money as investors invest in countries whose rates are higher. The countries who offer the highest returns on investments thanks to higher interest rates, economic growth and growth in financial markets, tend to attract more foreign capital. If a country’s stock market is healthy and offers a high interest rate, foreign investors can invest in that country. This causes an increase in the demand for that country’s money and also a surge in the value of the currency.

Money always follows productivity. If a country raises interest rates, we will see the general international interest in that currency increase. Recently, the Reserve Bank of Australia (RBA) raised the interest rate on the Australian dollar by 25 basis points. The AUD was already strong compared to other currencies and this move will only serve to strengthen it further. As a result, pairs like AUD/USD, AUD/JPY and GBP/AUD increased in value. Conversely, if the central bank of a country pushes down the interest rates, we will see capital outflow of that particular currency.

Some characteristics of Central Banks are:
They have access to huge reserves.
They have specific economic goals.
Regulation of the currency supply and interest rates.
Setting of rates on overnight loans.
Buying and selling government activities to increase or reduce the supply of money in the country.
Sometimes they buy and sell the domestic currency on the open market to influence exchange rates.

Clearly interest rates and their and the changes to them can have a major impact on capital flows into and out of the country.
As you can appreciate, it is important to follow carefully the changes in interest rates because they can influence the fate of a currency in the medium to long term. Any movements or statements by the central banks are followed with great interest and are capable of changing the trend of the currencies involved.

The major central banks involved in the process are: Bank of Canada, Bank of England, Bank of Japan, European Central Bank, the Federal Reserve, Swiss National Bank, the Reserve Bank of Australia and the Reserve Bank of New Zealand.
Banks decide individually on a regular basis, every 4-6 weeks.

Inflation and CPI

The CPI is the most widely used index to measure inflation and is also seen as an indicator of the effectiveness of the country’s economic policies. It provides information on price changes in the economy of a country that influences the government, business, workers and individuals. It is generally used as a guide for making economic decisions. In addition, the President, Congress and Fed use trends in the CPI to formulate fiscal and monetary policies.

The Consumer Price Index (CPI) measures the average change over time in the prices paid by consumers for a “market basket” of consumer goods and services. The CPI basket is developed from detailed data on household consumption. Most of the specific indices of the CPI in the USA have a reference date of around 1982-84. So the Bureau of Labor Statistics (BLS) sets the average level for the reference period of 36 months for the years 1982, 1983 and 1984 equal to 100. The BLS then measures the relative changes to that value. An index of 110, for example, indicates a 10% rise from the reference period; in a similar manner, a figure of 90 means there was a decrease compared to the reference period. For the current CPI, information was collected from Consumer Expenditure Surveys from 2005 and 2006. This gives us a more or less accurate idea of household spending and the changes in the purchasing power of families after inflation.

The CPI is composed of all the goods and services purchased for private consumption.
Macrocategories of the CPI basket are:
Food & Beverage
Housing Sector
Clothing
Transport
Medical Assistance
Free Time
Education & Communication
Other goods & services

The monthly or yearly change is usually expressed as a percentage; for example, “consumer prices rose by 0.3% from last month”.
This variation rate is often renamed “inflation rate”.
So, if an annual inflation rate was 2.5%, a basket that used to cost $400 a year would now cost $410.

Many investors and the Fed constantly monitor this figure in order to get an idea on the future of interest rates. Interest rates are significant because, in addition to having a direct impact on the quantity of capital inflow to the country, it also says a lot about Carry Trade relative to the USD. If the data on inflation is higher than expected, traders should interpret it in the sense that an increase in interest rates is more likely in the near future and in doing so, purchase the currency, whereas a figure that falls below expectations may cause traders to wait “on the bench” until the central banks make an actual decision. Basically, trading on a negative change in CPI is much more difficult than trading on a positive result, due to the variation of interpretations. A significant increase in the CPI will result in a bullish fervour, but a decrease or negative result is not necessarily going to result in a bearish fervour. The measurement of inflation refers to consumer prices at the retail level, while the PPI (Producer’s Price Index) measures inflation at the wholesale producer’s level. In the United States, figures on the CPI are released once a month. When the results come out (around the middle of the month), they reflect what happened in the previous month. The CPI is also released in Europe, UK, Canada and Japan. Other countries tend to release this data every quarter.

Geopolitical events can have a considerable effect on the FX markets.
The other fundamental announcements, that have been previously discussed, could all fall under “programmed events”. Each of them has a date on the calendar for when the figures will be released, which makes them easy to follow and to plan for our trading. The key point to remember is that money abhors uncertainty. It flees first then asks questions later.

Political events, like war, local conflicts, elections or terrorist activity, together with climate-related disasters such as hurricanes, tsunamis etc, can have a fairly dramatic impact on currency pairs in the markets and how they move.

In the case of presidential elections in the United States, if it appears that there may be a change of political party, the election campaign can remain “flat” for a long time because traders want to keep their balance trying not to take a precise decision in one direction or the other. If a new party takes office, the first few months can be a difficult time, until the new president shows his approach towards the financial markets. Nothing too dramatic will take place until investors and traders feel that they have a grasp on what the economic position is likely to be in the long term.

Weather conditions can be correlated with events, such as the case of a hurricane that develops near the Gulf of Mexico, where there are numerous oil platforms. Clearly this would reduce the supply of oil and because the Canadian dollar is correlated with crude oil, the CAD would most likely see some movement. Given the unpredictability of world events, along with the complete lack of a “calendar”, which is available for other major events, a trader can never be too sure of the possibile movements of associated assets.

Non-Farm Payrolls and Trading on the News

Every trader knows (or should know) the impact of economic data on the markets. Economists gather and announce to the press their estimates of what the data will be. If their estimates are in line with the actual data, the market is said to “discount” the numbers and there will often be little effect following the news.

However, if estimates and actual figures do not match, the market can have extreme movements in an attempt to regain lost ground in the misinterpretation. Basically, the market tries to reset itself to be more in line with the actual figures. No economic data represents this concept better than the USA Non-Farm Payroll.

First of all, let’s be clear on what the number actually represents.
The number of those employed in the non-agricultural sectors is a figure released monthly by the Department of Labor Statistics at 8.30am EST on the first Friday of each month. The report estimates the total number of paid workers in the United States, except for those who work in: Government, the Private Sector, Non-Profit Organizations and the Agricultural Sector.

All together, the employees gathered from the NFP produce about 80% of the US Gross Domestic Product.
To obtain these statistics, the Department of Labor Bureau of Labor Statistics carries out a survey of around 160,000 businesses and government agencies representing approximately 400,000 employers, in order to provide detailed data on employment, hours worked and worker remuneration.
The NFP has been one of the most important factors in recent US history. Given the importance of the data, traders can move instinctively and decisively. A better than expected figure is typically very positive for the USD, while in the case of a negative result you need to take into account the psychological fall back on the data usually released at the same time as the NFP; the rate of unemployment.

The rate of unemployment measures the amount of people who are out of work, but actively searching for employment. Politically it tends to be the most important number. If this figure is reduced, it means that those who are seeking employment are finding jobs and possibily that companies are having success in a growing economy. The NFP is a number, usually 5 or 6 figures, while the unemployment rate is a percentage. If the NFP data released is better than expected, traders tend to buy dollars. If, however, the figures are negative compared to expectations, then it is necessary to examine the result for the unemployment rate to see if the change is positive, negative or unvaried. If it is on the rise, the bears will start to jump on the dollar. If it has dropped, then there will be purchases of the USD. Should there be no change, the bears could render the situation immovable and exercise some pressure. It is difficult to trade on the NFP and the unemployment rate because traders often do not focus on the important aspects of the data, but rather on the things that support their own way of interpreting the market. The release of the data typically causes a significant amount of market volatility. In addition, there are often revisions of the previous month’s figures that come out at the same time and can also vary greatly.

While some traders eagerly await the first Friday of each month, others close their positions on the Thursday night before the release, in order to avoid all the volatility.

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