|Evaluating Fundamental Analysis|
Step number two includes the evaluation process of fundamental and technical analysis. Understanding the importance of the fundamental data and the technical charting are key to knowing when to enter and exit your positions.
If fundamental analysis tells us what to buy, then technical analysis indicates when to buy. When most people think about fundamental analysis, they think about reading balance sheets and income statements. Unlike the stock market, where this data is critical to understand the strength of a company, the currency market relies on macroeconomic events to show the strength of a currency. In the currency market, it is the study of other factors that might dictate what the price of a currency ?should? be. As mentioned above, evaluating the fundamentals of the currency market involves more of a macroeconomic view and looking at major international and national events. Evaluating interest rates, economic strengths or weaknesses, politics, and other news events of different countries helps identify the strength of the currency. As with other markets, the basic principle of supply and demand drives the currency market. If the demand for a specific currency increases, that currency will rise in value. If the demand decreases, the value of that currency will decrease. When a currency price moves, there should be fundamental reasons to explain why the price moved in a certain direction. Here are some of the fundamental factors that can influence the price of a currency.
Different interest rates between countries can affect the exchange rates between currency pairs. For example, if the Japanese government raises its interest rate, then foreigners might flock to the Yen denominated investments to earn a higher return on the Japanese Yen than what they can earn in their own country. This will raise the price of the yen relative to other foreign currencies. If Japan lowers its interest rates, then the opposite effect might take place. Regardless of the country or currency, if a currency has a higher interest rate or rates are increasing, it will have a positive effect on the value of that currency.
The strength or weakness of a certain country's economy will lead to a longer-term trend in the price of its currency relative to others. If the U.S. economy is strong, then you will see the USD strengthen. If it is weak, the dollar will weaken.
A country?s political environment can move the price of its currency. A political crisis (such as war) can lower the price of a country?s currency because of uncertainty surrounding the crisis. As people flock to safer currencies, the value of its currency will go down.
One factor that simplifies the fundamental process of the currency market is the readily available information. Most of the information we need, fundamentally speaking, is announced on a set schedule. Professional currency traders are constantly analyzing the upcoming events and are already trading as if the announcements have been made. What we need to look out for, is the occasion when the announcement is made and it is different from what the analysts expected. In those cases, there can be a dramatic move in the currency market. Below is a screen shot of the economic calendar that is available on our website. You can see that it gives you the date and the time that an announcement is coming out. It also shows you the currency affected and what the event is that will be announced. Because there can be volatility associated with some announcements, you may want to avoid them altogether.
Clearly, a change in the balance of payments has a direct effect on currency levels. Therefore, FX traders should keep on top of economic data relating to this balance and understand the implications of changes in the balance of payments. For example, recall the trade flow between the U.S. and Canada during 2004. During this time, the U.S. imported more goods from Canada than it exported to Canada. This caused a trade deficit with Canada. In this case, the deficit caused the U.S. dollar to decrease in value since the U.S. needed to sell the dollar to buy the Canadian dollar. This added a supply of USD which caused the value to go down.
Capital flow shows the impact of capital being moved from one currency to another to increase the return on investment. Capital flow measures the net amount of a currency that is being purchased or sold due to capital investments. If this is positive, it means that foreign investments coming into a country exceed investments going out. If this is negative, it implies that foreign investments coming into a country are less than those going out.
Interest rates are a primary force for moving investments into or out of a country. For example, if a certain country is lowering their interest rate and another is raising interest rates, money will move out of the currency that is being lowered and into the one that is being increased.