ART OF CURRENCY TRADING

Chapter 5: Understand Fundamental Analysis

“In the short run, the market is a voting machine. In the long run, it is a weighing
machine”
The macro backdrop is inevitable no matter how short your trading time horizon.
Fundamental Analysis: It is the study of macroeconomic factors that drive the market.
I. Long – Run Determinants of Currency Values
1. Purchasing Power Parity (PPP)
 Example: The Bigmac Index
This is a faulty concept but it provides a starting point to assess whether a
currency is cheap or expensive
2. IMF FX Valuation
 These are not important for trading as a currency can stay overpriced or
underpriced for an extended period of time.
 You can determine though what can cause the currency to fall back to its
PPP or “fair value”
II. Global Drivers
Main Global Drivers of Currency Value
 Global Growth
 Commodity Prices
 Risk Aversion
 Geopolitics
1. Global Growth
 When Global Growth is Strong exporters like China, Korea, and Brazil
tend to do well.
 When Global Growth is Weak, money tend to flow into safe havens such
as JPY, CHF, and even USD.
2. Commodity Prices and Terms of Trade
Commodities are driven by:
a) Global Growth*
b) Climate
c) Supply / Production
d) Idiosyncratic Demand Factors
e) Popularity of Commodity as An Asset
Commodity exporters (AUD, BRL, CAD…) benefit from commodity
price strength, while importers like (TRY, INR…) are hurt by high
commodity prices.
3. Fluctuations in Global Risk Appetite and Risk Aversion
 When markets are nervous, traders generally aim for low-yielding safe
haven currencies like JPY & CHF.
 4. Geopolitics
 War, Elections, or Major Policy Changes can all be sources of geopolitical
volatility.
III. Domestic Drivers
Monetary Policy
The Federal Reserve commonly uses three strategies for monetary policy including:
a) Manipulating Reserve Requirements: Decreasing the Reserve Ratio (%
of reserves a bank is required to hold against deposits), allows the bank
to lend more thus increasing the money supply.
b) Changing The Discount Rate: Lowering the Discount Rate (the interest
rates the Fed charges commercial banks that need to borrow additional
reserves) encourages spending and vice versa.
c) Open market operations: If the Fed buys back securities from large banks
and securities dealers, it increases the money supply in the hands of the
public.
Interest Rates
 While the Central Bank controls the front of the interest rate curve via its
overnight rate, it generally has less and less control of rates as you go
further out from the curve.
 For trading purposes, higher rates attract capital and lower rates trigger
outflow of capital.
Growth
Key metrics for Growth:
a) GDP
b) Industrial Production
c) Retails Sales
d) Housing Statistics
Inflation
 In general, when inflation is high, it makes a currency weaker,
suppressing investment, and thus negatively impacting the exchange
rate. When inflation is low, a currency is stronger, improving its
exchange rate.
Central Bank Currency Preferences
Central Banks can directly and indirectly influence the value of their currency via:
a) Raising or Lowering Interest Rates
b) Direct Intervention
c) Signaling (This only works if the central bank is credible)
IV. Intervention and Reserve Cycling
 In order to maintain pegged or managed currencies, some central banks
intervene in currency markets
 Global central banks hold massive FX reserves that is dominated by
USD, but hold a portfolio of currencies
As a central bank’s reserve grows and shrinks, the central bank needs to buy
and sell euros (and other currencies) to maintain a steady percentage of their
reserves diversified.
  Whenever a large central bank intervenes in an EM currency, G10
currencies get affected (especially commodity currencies)
Capital Flows
 Capital Flows are not a primary FX driver (fickle and hard to predict)
Trade Balance and Current Account Balance
 These are practically useless in the Short Run
V. US Economic Data Release
Important Aspects of Economic Data
When the market ticks two or three of the following aspects, the market cares
about it:
- Timeliness
- Relevance
- Reliability
1. US Data
1.1 Nonfarm Payroll
 Importance:
5/5
 Release:
First Friday of the month 8:30 EST
 Key Takeaways:
Nonfarm payrolls (NFPs) are an important economic indicator related to
employment in the U.S.
Technical analysis can be employed in the NFP report using 5 or 15-
minute chart intervals.
 Analyzing NFPs Numbers;
a) A higher payroll figure is generally good for the U.S. economy citing
more job additions and more economic growth.
Forex traders and investors look for a positive addition of at least
100,000 jobs per month. (Which will help fuel USD gains)
b) An expected change in payroll figures causes a mixed reaction in the
currency markets. (Traders will then look for the unemployment rate &
manufacturing payrolls)
If the unemployment rate drops or manufacturing payrolls rise,
currency traders will side with a stronger dollar, which is a positive for
the U.S. economy.
If the unemployment rate increases and manufacturing jobs decline,
investors will pass on the U.S. dollar for other currencies.
c) A lower employment picture is negative for the world’s largest
economy and the greenback. If the NFP report shows a decline below
100,000 jobs or less, the U.S. economy is likely stagnant and forex
traders will favor higher-yielding currencies against the U.S. dollar.
 Trading Strategy:
a) Nothing is done during the first bar after the NFP report
b) Traders wait for an inside bar to occur after this initial bar (bar range
to be entirely inside the previous bar’s range.
 c) When a subsequent bar closes above or below the inside bar, market
participants take a trade in the direction of the breakout.
d) Place a 30-pip stop on the trade you entered.
e) Generally, most movement occur within four hours of the release.
1.2 Initial Claims
 Importance:
3/5
 Release:
Every Thursday 8:30 EST
 Key Takeaways:
Initial Claims refer to the number of workers applying for
unemployment benefits for the first-time following job loss.
Initial claims Rise before the economy enters a Recession, and Declines
before the economy starts to Recover.
1.3 GDP (Gross Domestic Product)
 Importance:
5/5
 Release:
Quarterly
 Key Takeaways:
GDP = C + I + G + NX
If an economy is healthy, GDP growth expands.
If an economy is in bad shape, GDP growth contracts.
Two consecutive quarters of negative GDP growth are referred to as a
recession.
There are three releases:
a) Advanced (most important, timeliest, causes high volatility)
b) Preliminary
c) Final
It's the relation between the three that is important, not just the individual
releases
1.4 Core PCE Price Index
 Importance:
2/5
 Release:
Same time as GDP
 Key Takeaways:
The Core PCE is and economic indicator that measures the change in
prices of goods and services purchased by consumers, excluding the
volatility of food and energy costs.
Importance:
a) Inflation Measurement (It serves as an essential gauge for inflation)
b) Monetary Policy (When PCE reaches 2%, it takes on added
importance)
c) Economic Health
 A Higher-than-expected reading should be taken as bullish for the USD,
a Lower-than-expected reading should be taken as bearish for the USD.
1.5 Consumer Confidence (CCI)
 Importance:
3.5/5
 Release:
Last Tuesday of every month
 Key Takeaways:
Consumer confidence measures how optimistic (or pessimistic)
consumers are about the state of the economy.
When consumers are optimistic, they spend more, and when they are
pessimistic, they save more. (Consumer spending represents ~70% of
GDP)
1.6 ISM Manufacturing PMI and Non-Manufacturing/Services PMI
 Importance:
4/5
 Release:
1st Day of every month
 Key Takeaways:
PMI is reported based on how companies feel about the current
economic climate.
The headline PMI is a number from 0 to 100. A PMI above 50 represents
an expansion when compared with the previous month. A PMI reading
under 50 represents a contraction while a reading at 50 indicates no
change. The further away from 50, the greater the level of change.
1.7 CPI (Consumer Price Index)
 Importance:
3/5
 Release:
Monthly
 Key Takeaways:
CPI measures the change in price for the average urban consumer.
It is a lagging indicator (reflecting economic conditions that have already
occurred)
When CPI is low and stable, it is easy to forecast, and surprises are few
and far between.
When CPI is volatile, the release is harder to forecast and tends to move
the market more.
1.8 Durable Goods Orders (MoM, ex-transportation)
 Importance:
3/5
 Release:
Monthly
 Key Takeaways:
 This measures the current industrial activity (It reflects new orders
placed by manufacturers for delivery of long lasting manufactured
good in the near term or future)
The number is very volatile (Ignore the headline number and focus on
the MoM change in Durable Goods ex-transportation)
1.9 Housing Data
 Importance:
Varies
 Release:
Monthly
 Key Takeaways:
If housing is an important driver of the economy, importance level is
4/5
If housing is no an important driver of the economy, importance level
is 2/5
1.10 Industrial Production (IP)
 Importance:
3/5
 Release:
Monthly
 Key Takeaway:
This covers manufacturing, mining, and electrical and gas ultilities.
The market does not focus on it greatly.

1.11 Retail Sales

 Importance:
3.5/5
 Release:
Monthly
 Key Takeaways:
It reflects the consumer spending, consumer confidence, and the
overall health of the US economy.
Most important data to watch is the MoM figure ex-autos and gas.
1.12 Chicago PMI, Philly Fed, and Empire State
 Importance:
3/5
 Release:
Monthly
 Key Takeaways:
These are regional surveys similar to ISM PMI
Chicago PMI is released to subscribers 3 minutes earlier than the
public
VI. Global Economic Data Release
The directional impact and half-life of Global Economic Releases ten to be smaller
and shorter than the market reaction to US economic numbers.
Europe
a) Germany ZEW Survey
b) Germany IFO Survey
c) Germany GDP
d) Germany Factory Orders
e) Germany IP
f) Germany Inflation (core CPI)
g) Germany Retail Sales
h) Euro Area PMI (Composite and Manufacturing)
i) Eurozone Inflation (core CPI)

United Kingdom
a) Retail Sales
b) CPI
c) GDP
d) Claimant Count Change (similar to US Initial Claims)
e) Manufacturing Production
f) Average Earnings
g) Manufacturing and Non‐Manufacturing PMI
h) Exports
i) Current Account Balance

Japan
a) Tankan Survey
b) Trade Balance
c) GDP
d) Machinery Orders
e) Industrial Production
f) CPI

Canada
a) Net Employment Change and Unemployment
b) CPI
c) Retail Sales
d) GDP
e) Ivey PMI
f) Building Permits
g) Manufacturing Shipments
h) Bank of Canada Business Outlook (Future Sales)

Australia
a) Net Employment Change
b) GDP
c) CPI (RBA Trimmed Mean)
d) Retail Sales
e) Trade Balance
New Zealand
a) Employment Change
b) Unemployment Rate
c) GDP
d) Retail Sales
e) CPI
f) Trade Balance

Norway
a) CPI
b) GDP
c) Retail Sales
d) PMI

Sweden
a) GDP
b) CPI
c) Industrial Production
d) Retail Sales
e) Manufacturing Confidence

Switzerland
a) CPI
b) GDP
c) KOF Leading Indicator
d) Manufacturing PMI