In a forex and the futures market, fundamental analysis attempts to measure the health of the economy by considering variables such as interest rates (term structure analysis), capacity utilizations, employment, GDP growth rates, leading and lagging indicators, housing starts etc. Normally a top down approach is used to analyzing currency markets, which entails a review of the prevalent macroeconomic conditions, and projecting outlook on inflation and interest rates and then discerning the expected currency movements against the available evidence. This methodology is akin to analyzing securities by developing a macro view of the economy after reviewing economic indicators and then narrowing the analysis down to the industry level before further break down to a micro level. A bottom-up approach would be to commence from a specific business or currency and proceeding outward to justify its outlook. So fundamental analysts, unlike technicians who state that market discounts price movements, express that market may misprice a security/commodity/index/currency below its intrinsic value allowing opportunities to arise. In currency analysis, this allows for an “arbitrage” opportunity for investors. For example if fair value differs from market value, fundamentalist view a discrepancy in market pricing and act to capitalize on this perceived price disparity. Fundamentalist view the market as weak-form efficient and reject that past prices can be used to forecast future movements.
Some Factors affecting Exchange rate movements:
Relative Inflation Rates:
Changes in relative inflation rates has a direct impact on international trade, which affects demand and supply of currency changing the equilibrium or parity between two currencies. Consider a situation whereby two transacting countries A & B relative inflation rate changes. We would assume purchasing power parity existed before the change in relative inflation rate. A surge of inflation in country A for a particular product would increase the demand for the same good in country B, causing an increased demand for currency of country B. Accordingly, an increase in inflation in country A would decrease the demand of its currency by B, and thus they would offer less currency for sale to country A. Therefore, a shift of an increase in demand for goods in country B would increase the demand for its currency, while country B would offer less of its currency for sale to country A, which would in turn decrease the supply function. In the process, the shift in supply and demand would bid up the equilibrium.
Relative Interest Rates:
Changes in relative interest rates affects the investment climate in foreign securities, which influences the demand and supply of currencies. It is important to consider how the real interest rate differs between two counties, as it leads to arbitrage.
Real Interest Rate = Nominal interest rate – Inflation rate
Because higher inflation would dampen real interest rate, foreign investors would have less incentive to invest in securities denominated in that currency. Thus, other things constant, there should be a high correlation between real interest rate differentials and currency value, if a currency is to appreciate relative to other(s).
Future expectations on the health of the market can lead to fluctuations in exchange rates as news unfolds. News on inflation, general business conditions, political events all have a bearing on currency fluctuations. A case in view would be the deleterious impact on the pound sterling in the aftermath of Brexit. Another example would be the presidential impact win of Trump, when the US dollar was strongly jolted when his success became evident. Then in the backdrop of strong economic fundamentals, it corrected back. It must be borne to mind that financial transactions are more responsive than trade-related foreign exchange transactions as decision to hold securities denominated in a particular currency are often dependent on the anticipated changes in currency values. To the extent that news affects anticipated currency movements, its implication on demand and supply on currencies for sale is very high. This is the main reason attributable to the volatility in the foreign exchange market.
Interest Rate Parity:
Foreign currency movements operate in a way so that interest rate parity prevails in the currency market. While this unfolds via covered interest rate arbitrage, profit-making opportunities arise during the process. Simply covered
interest rate arbitrage is purchasing a currency that is yielding a higher interest rate, and then buying back local currency, thus reducing the discrepancy between the spot and forward rates. If a discount exists between spot and forward rates, it makes sense to purchase foreign currency, which is offering a premium return, due to an interest rate differential, and then buying back local currency if the forward rate is at a discount with respect to spot rates. This mechanism would ultimately put an upward buying pressure on the forward rate, causing its demand function to increase, and accordingly causing the forward rate to go up. In due process the forward discount would diminish, which would make covered interest rate arbitrage no longer feasible. This process would bring two freely floating currencies back into a new equilibrium. The below graphical representation, shows under what conditions would covered interest rate arbitrage yield profitable results.
Limitations to the theory of Interest Rate Parity: Interest rate parity, only gives an ideal framework under which covered interest rate arbitrage could work, but this hypothesis works well in a freely floating market. While it does give a perspective on how currency movements may operate, it breaks down if government directly intervenes in the currency markets, or even if the interventions is indirect. A modern day example of direct intervention would be the decision of March 12th, 2009 of Swiss National Bank (SNB), when it announced to purchase foreign currency, given that the Swiss Franc appreciated and there was inflow of funds due to flight to a safe Swiss franc. Affected by the SNB purchase of euros and US dollars, the franc depreciated with a day from 1.48 to 1.52 against the Euro. Other governments may use foreign exchange controls, such as restriction on trade of currency, as a form of indirect intervention to maintain the exchange rate of their currencies. During 1990’s Venezuela had imposed foreign exchange controls on its currency. In April 1996, it removed its controls on foreign exchange, and the bolivar declined by 42% the next day. In the absence of governmental control, or indirect intervention, the market determined exchange rate of bolivar was much lower than its former valuation.
Yield Curve Analysis:
Another way to review the interest rates is by examining the yield curve. A yield curve normally foretells the state of the economy. A normal upward sloping yield curve is a sign of an expanding economy but an inverted yield curve is foretelling of an impending slowdown in the economy.
“The assumption of an economic upturn in conjunction with an upward sloping yield curve is the notion that interest rates will begin to rise significantly in the future. Consequently, the Yield to Maturity increases because of an associated risk of higher inflation on the longer horizon that is brought about by rapid economic expansion. Thus investors require a higher return over their investment horizon. Similarly, an inverted yield curve is a harbinger of recession, and the term structure inverts. It is based on the assumption that interest rates in the future would decline to spur the economy out of a slowdown. It would not be uncommon for yield curves to invert 12-18 months prior to an economic slowdown.”
Yield curve data analyzes the term structure of bonds. If the yield of long term bonds (or return on long term bonds) rises faster than short term bonds, then it shows a propensity of investors viewing the long term horizon more favorably. Thus, the ratio of short-term bond and the long-term bond begins to decline. This normally happens when economic slowdowns are in the forecast. On the other hand, an upward sloping curve exhibits that the economy is in the expansion mode. As seen in the below stated figure, the term structure ratio, reached a peak, just prior to the major US economic slowdowns, in 1990’s, early 2000 and then in 2008. Thus, using term structure data, more information can discerned via a ratio analysis, which seems to work quite well.
A form of fundamental forecasting would be to develop relationships between economic variables and exchange rates via a multiple regression analysis. This form of model building, based on historical data causal relationship between independent variables i.e., interest rate differentials, inflations differentials and dependent variables is established via a multiple regression equation, allowing for projections on future currency valuations. Thus from a statistical perspective a forecast could be established by quantitatively measuring impacts of factors on exchange rates.
Other Indicators Used in Fundamental Analysis:
Indicators decoding economic trends are also useful. Some of the common indicators under review are housing starts, Consumer Price Index, Consumer confidence, manufacturing data etc. The Conference Board issues leading, lagging and coincident indicators that as they focus on the health of economic performance
- Leading Indicators shed light on future events. For example, bond yields and term structure is understood a stable leading indicator of the stock market and thus the economy because it allows for a speculation of economic trends.
- Lagging indicators, follow events. For example if unemployment is on the rise, it shows that economy is underperforming by not utilizing all its resources.
- Coincident Indicators signify the prevalent conditions. Rather than having a forecasting value, they specify the current state of the economy. Personal income gain is a coincident indicator and high rates would signify a strong economy.