How Currency Market Moves - Learn Fundamental Analysis
Fundamental Analysis provides additional information besides technical analysis to give the Forex trader a complete understanding of the Forex market - hence the importance of fundamental analysis.
The task of forex traders is to determine the direction of a particular currency, then to determine which currency pair to buy or sell. To determine this, it is very important to work with the 'cause-and-effect' principle. We can find the "cause" in the underlying economy of a country and the actions of central banks to manage that economy. "Impact" is the reaction of traders as a result of this reason and this comes in the form of buying or selling and it can be found in charts, or what is known as technical analysis. Therefore, the use of technical and fundamental analysis gives the Forex trader an advantage. For example, if the US economy is weak and the European economy is strong, the trader will be looking to buy EUR / USD and use technical analysis to find key entry points.
It is not necessary to obtain a degree in economics, but it is important to understand the basics. When a country has good economic prospects or its economy is strong today, the value of a currency is likely to increase. In the Forex market, we trade currencies in pairs, so it is necessary to understand that we compare the relative strength of one economy to another, that is, if the US economy is strong and the European economy is weak, then we can expect the EUR to decline against the US dollar.
But wait - remember that we use currency pairs, this is the concept of relative strength of economies - if the US economy is strong and the Eurozone economy is stronger, then that means the Euro will rise against the US Dollar.
How does a country's economy work?
Yes, you may need a degree in economics to fully understand this, but we are lucky that forex traders just need to know whether the economy is strong or weak compared to others and what economic data makes an economy strong or weak.
Strong economy = high GDP, low inflation, high interest rates, increased productivity, and good political stability
Weak economy = low GDP, high inflation, low interest rates, low productivity, and weak political stability
Money flow - the lifeblood of the economy
To ensure the economy can actually work, the economy needs money, without money there is no economy. Money needs to flow in and out of the economy while maintaining a balanced level of money inside the economy. The central banks in each country manage and control the flow of funds and their quantity in the economy to maintain their health and sustainability. Think of the central bank as the heart of the economy that guarantees the flow of money.
How is the economy managed?
Contrary to the prevailing belief that the economy is not managed by the government of a country, it is run by its central bank, which is not affected by the government. Central banks have goals which are generally:
Providing sustainable growth
Each country may have specific goals, but each central bank has its own "monetary policy" that shows everyone in a transparent way how that bank achieves its goals in the economy. The central bank also has a "fiscal policy" that controls the flow of money into this economy.
What are the metrics and tools that the central bank has to manage the economy?
In order for central banks to manage their economies, they must be able to influence and monitor the measures of a strong or weak economy. To influence and change these metrics, they need some tools to do this.
This part of the article is divided into metrics and tools, we will start with the most important main metrics and then move on to the tools:
Gross Domestic Product - GDP - Economic Health Index
It is released every three months, which is the most important indicator of economic health and growth and is a release of level I economic data (i.e. any difference in expectation will cause a significant change in price). This indicator represents the total output of goods and services produced.
Consumer Price Index - CPI - Inflation Index
It is released every three months, which is the second most important measure and is also a release of Tier 1 economic data. It is a measure of the prices of a group of consumer goods and a good measure of inflation.
Retail Sales - Inflation Index
The data for this indicator is released monthly, and is closely monitored by traders, as it may give an indication of what will come in the consumer price index, which is issued only every three months. The Retail Sales Gauge tracks the dollar value of goods sold in retail trade.
Central banks use a "monetary policy" that defines the central bank's goals and how they manage their country’s goals. There are basically two types of monetary policy, known as "expansionism" and "deflationary". If the central bank wants to reduce unemployment, increase opportunities for private sector borrowing and consumer spending, and stimulate economic growth, they "increase the flow of money and this is referred to as expansionary policy." As for if they want to control the rate of increased inflation, they reduce the rate of money flow to slow the rate of economic growth, increase unemployment and place restrictions on borrowing and spending by companies and consumers, and this is referred to as deflationary policy.
Interest rates - to control inflation
Most central banks have a 2-3% inflation target. Interest rates are used to control inflation. If the inflation rate drops below 2%, they will reduce interest rates to stimulate economic activity. When approaching or exceeding 3% they raise interest rates to slow down the economy.
Quantitative easing - an alternative way to manage inflation
When interest rates approach or equal to zero and the economy needs a boost, interest rates are reduced under normal circumstances, which encourages borrowing and spending, which strengthens the economy. When the central bank cannot lower interest rates to encourage economic growth, the only thing they can do is to put more money into the economy. While they can print money, it is usually the last resort, so central banks provide more money in the economy by buying government bonds from banks, and this allows banks to get more money in their accounts so that they can lend more money Thus they can effectively cut rates, without the central bank having to do so.
How does the economy work?
The country's economy is a cycle of constantly changing events. These events are:
Expansion and growth
The economy is managed by the central bank and they essentially have one tool to manage it - interest rates.
Expansion and growth - the economy is strong and the rate of GDP growth is positive.
This means that there is a good flow of money, companies will grow, jobs and personal income will increase.
Summit - when the economy reaches between 3 to 4%, it is likely to reach its peak.
At this point, the bubble bursts, economic growth stops and the economy begins to contract.
Deflation - the economy begins to slow
Central banks start raising interest rates.
Bottom - prices drop as demand falls.
Central banks are now cutting interest rates to spur growth.
At the heart of Forex fundamentals, each of the central banks has its own country specific problems and goals. If we know what these problems and goals are, we can predict the impact on the currency when releasing important economic indicator data. Central banks make this clear and transparent in their “monetary policy”. They want traders to know what they are doing so that they can control the value of their currency.
Let's take a look at one of the most important banks that the US Federal Reserve calls "the Federal Reserve."
The Federal Reserve has three goals set by Congress (the government)
Prices are stable
Moderate interest rates in the short term
In future articles, we will look at how to build a sound forecast based on a fundamental market analysis.
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