HOW TO TRADE FOREX USING FUNDAMENTAL INDICATORS?
12 Mar 2021
Inflation is a sustained increase in the amount of currency in circulation – which in turn increases the price of goods and services. With this in mind, inflation is one of the most important of all Forex fundamental indicators, as it demonstrates how healthy an economy is. It is important to understand that even through the power of central banks, governments can’t really control inflation.
The level of ‘healthy’ inflation’ is defined by each state according to the needs of their economy. Developed economies set their aim at around 2%, while developing economies can go up to 7% without causing any panic among investors. Depending on whether the actual inflation rate is above or below the set target, the country can be in a state of hyperinflation – whereby too much money has been introduced into circulation, or negative inflation – which means that there is too little in circulation.
In terms of Forex trading, the higher the rate of inflation, the quicker the currency depreciates, and the less reliable of an asset it is for foreign investors, with both resulting in weakness.
Interest rates are simply the value charged by central banks for lending money to private banks. They are a primary tool used to regulate inflation. Interest rates are set by central banks, usually notifying the public beforehand during press conferences, to avoid unnecessary market turmoil. Commercial lending rates walk hand in hand with central bank interest rates, since private banks can’t lend cheaper than they borrow.
It is this very connection that makes interest rates a power leveller of the economy, and therefore, a major Forex fundamental analysis indicator. In a well-regulated, well balanced economy, central banks may raise interest rates in order to cut the pace of money lending, and to ‘cool down’ an economy by decreasing inflation. This cuts consumer spending, helping to bring growth to a more manageable level.
For a Forex trader, interest rates are the best multi-purpose fundamental indicator, since an increase in interest rates generally forces a currency to appreciate, since there is a cut in supply. Conversely, when interest rates are lowered, the rate for borrowing increases and the currency depreciates. There are a few important things to note here.
Gross domestic product (GDP) measures the total value of all goods and services produced in a country within a given period. GDP is considered to be one of the best overall fundamental indicators of the economy for Forex. From an economic theory standpoint, it’s all very simple – growth in GDP indicates economic growth. However, the relation of GDP to inflation – and thus to currency – is a matter of debate.
As far as economic logic goes, an increase in GDP (basically an increase in the supply of goods and services) must be followed by an increase in the demand for these goods and services, otherwise it’s just a negative value. To facilitate that demand, an adequate amount of funds should be made available to consumers. Thus, a higher GDP means more money, which means more inflation within a central bank set limit.
Rather than an increase or decrease in GDP, for a Forex trader, it is more important to know if the GDP increase is in line with other economic indicators – such as the consumer price index – and within an anticipated range. If it is, it hints at economic strength and an appreciation of currency. A disparity in the pace of increase would hint at least a minor yet growing economic bubble.
Consumer Price Index (CPI)
The Consumer Price Index (CPI) measures the weighted average price of a household basket of goods and services (transportation, food, medical care), with 100 being the base value. For example, if today it costs X USD to purchase a set of goods and services the CPI will read 100. When in a decade it would cost 25% more, the index will have moved from 100 to 125.
This is an important fundamental Forex indicator, as it helps to measure changes in consumer buying power through the effects of inflation. Large rises in CPI during short periods of time hint towards high inflation, while short-term severe drops in CPI hint at deflation.
Producer Price Index (PPI)
The Producer Price Index (PPI) works much like the CPI, only instead of measuring the cost of ready goods, it measures production costs. PPI does not consider volatile items such as energy and food to receive ‘cleaner’ readings. Tracking production costs can assist in evaluating how production level prices may be affected, which in turn can help traders to understand the possible impact on an economy.
The percentage of the unemployed part of the population has a direct effect on the spending patterns – and by extension, on the economy as a whole. An increase in unemployment has a negative effect, as less people are getting paid regular wages. Unemployment can’t drop below a certain level, known as ‘aggregate unemployment’ – and for every nation it is different, usually between 2% to 6%.
Examples for the reasons behind increased unemployment include: companies downshifting gears, or adjusting their business models due to decreasing demand.
Trade Flow and Trade Balance
Trade balance reports the difference between total imports and total exports. If more goods are exported, then that represents a positive trade balance. It is an important Forex trading fundamental indicator if we are to measure the dynamic of change. Even if the trade balance is negative, an increase in exports would mean a higher demand for the currency.
Typically, a positive trade flow means that there is more money coming in, compared with money coming out, and it is a sign of a healthy economy, and an increased demand for currency.
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