Fundamental Analysis of the Financial Markets

I think we shall completely devote this lesson to the topic of fundamental analysis. We will talk about its importance and point out the events we should track and the ones we can ignore. Another thing to discuss is whether the adherents of technical analysis must also watch the news.

If currency pairs are our main trading instrument, I find it quite difficult to ignore the fundamentals. Even if we deliberately choose to be out of touch with the news except for only to track some certain patterns of price behavior, we would still hear some news inattentively such as “euro/dollar currency is rising against the background of…” or “the pound is rising after the statement by…”

The key knowledge we should gain is that there are not only technical patterns but also fundamental (news) patterns, which we will learn more about in this lesson.

Main Categories of Fundamental Analysis

The financial market is extremely sensitive to macroeconomic events, which is why you should never dismiss a fundamental analysis of the market. Nevertheless, an analyst does not spend all day checking out the news feed. I should remind you, once again, that everything you read on this website results from my own experience and practice.

I divide fundamental analysis into the following categories.

Analysis of The Main Macroeconomic and Political Trends

An analyst does not keep close tabs on the economic statistics day in and day out in this case. The main data sources necessary for understanding the global balance of power are as follows:

• View and opinions of the international experts. Ratings and assessments given by the independent publishers;
• speeches by national leaders, heads of the key political and economic institutions, and the scientists; and
• news bulletins.

Such an approach provides a trader with the general idea of the prospects for investment in a foreign currency. From a basic point of view, the main market changes occur while expecting a major political or economic event to happen. Let me give you an example.

The European economic downfall caused by the expectations of the Greek economy to go bankrupt. Fear of the upcoming negative events led investors to withdraw funds from European assets and give up using the euro as an investment tool. As a result, EUR/USD quotes were plunging over the long term against the backdrop of growing risks of the European country’s economy going bankrupt.

The Presidential elections may cause economic volatility. Though one doesn’t know for sure who would be the next head of state, investors are a bit afraid of the risk that a protest candidate can win, which will bring a medium-term economic downfall.

The growing protest movements may signal worsening of the economic and political situations. The historical record is peppered with examples of the strikes organized by doctors, taxi drivers, public service drivers, miners, or enterprise workers. They managed to cripple entire cities and even countries, which affected the national currency value.

Said otherwise, an analyst must keep an eye on the soaring trends and foresee how an event may affect the currency exchange rates.

Corporate Sector Analysis

First, we need to figure out what the term “Index” stands for. If you have already visited the brokers’ websites I mention in my list, you could not help but notice that almost all of them offer to trade stock market indices. Before you start trading something, you should study what exactly it is.

The stock market index (the index basket) is a composite indicator, which expresses price changes for an asset group. The most popular stock market indices show how the stock basket price of the national champions from different fields may vary. Let me tell you a bit more about the most popular stock market indices.

• Dow Jones Industrial Average.—The blue-chip companies of the American economy. Deals with the stocks of almost all the fields except for the transport and the utilities branches.
• S&P 500—500 large companies having common stock listed on the NYSE or NASDAQ which capitalization makes up 75% of the whole US stock market.
• NASDAQ—All the companies traded on the American NASDAQ stock exchange.
• S&P/TSX—The large-cap companies traded on the Toronto Stock Exchange (Canada).
• Mex IPC—The large-cap companies traded on the Mexican Stock Exchange.
• BOVESPA—The large-cap companies traded on the B3 Stock Exchange (São Paulo, Brazil).
• Euro Stoxx 50—The European blue-chip companies from 12 Euro-zone countries.
• Euro Stoxx 600—The large-cap, mid-cap and small-cap companies from 18 Euro-zone countries.
• FTSE—The Blue chip companies of the London Stock Exchange.
• CAC 40—The Blue chip companies of the Euronext Paris pan-European Stock Exchange.
• FTSE Eurotop 100—100 most highly capitalized blue-chip companies in Europe.
• FT30—30 largest British companies.
• DAX—The blue-chip companies of the Frankfurt Stock Exchange.
• IBEX 35—The blue-chip companies of Bolsa de Madrid (Madrid Stock Exchange).
• FTSE MIB—The blue-chip companies of Borsa Italiana (Italian Stock Exchange).
• AEX—The blue-chip companies of the Euronext Amsterdam Stock Exchange.
• SMI—20 largest companies traded on the SIX Swiss Exchange.
• ATX—The blue chip companies of the Vienna Stock Exchange (Wiener Börse AG).
• OMX STKH30—The blue-chip companies of the Stockholm Stock Exchange.
• MICEX Index—The blue-chip companies of the Moscow Interbank Currency Exchange. All transactions are calculated in rubles.
• RTSI—Russian stocks traded on the Moscow Exchange, calculated in US dollars.
• Nikkei—225 largest companies of the Tokyo Stock Exchange.
• TOPIX—All the companies traded in the First Section of the Tokyo Stock Exchange.
• Hang Seng—The blue-chip companies of the Hong Kong Stock Exchange.
• S&P/ASX 200—The large-cap companies traded on the Australian Securities Exchange.

Source: Wikipedia

You might have noticed the term blue chips. I think we should clear it up. A blue-chip is stock in the largest and most reliable corporation of the highest stock liquidity. The term itself originates from the blue casino chips, which are of the highest value.

How Can We Use the Stock Indices for Analyzing the Stock Market?

If you trade shares of a separate company, the stock index may be a leading indicator for you. For example, your trading tool is a share of Apple Inc. (the U.S. technology company). To analyze, you should compare the dynamics of the stock change with the dynamics of the S&P500 index. If the share grows faster than the index, it may be too late to open a long-term position. If the index grows faster than the share, you can purchase with no doubts.

 

Which Indices Should a Forex Trader Work With?

A forex trader should pick the indices that match his trading tools the same as one does in the stock market. Let’s have a closer look at the most popular currency pairs, which are EUR/USD, GBP/USD, USD/JPY, USD/CHF and USD/CAD.

Every mentioned currency pair works with the US dollar, which is why we may use the S&P500 and Dow Jones Avg (DJA) indices for analysis.

• We may add the European indices for the EUR/USD currency pair. The French Cac40, the German Dax, the Dutch AEX and the European FTSE Eurotop 100 will be good enough for us to cover the European side.
• We may use the FT30 index for the GBP/USD currency pair. However, as practice shows, a trader tracks the same indices used in the case of the euro.
• We should pay attention to the main European indices and the SMI index (SIX Swiss Exchange) in the case of the USD/CHF currency pair.
• We should analyze the USD/JPY currency pair by examining the Nikkei 225 index dynamics.

How Do Traders Use the Stock Indices?

A trader uses the stock indices as a trading and analytical tool. I think we should consider a few trends that might work in the market economy conditions.

• A trader applies an index as the leading indicator of the upcoming changes in the national currency price.

For example, if the S&P500 index uptrend shifts to a descending trend, we will see the dollar fall against the primary world currencies. Is such a case, the index should be considered the leading indicator for the U.S. currency. A trader may open a short position and keep tracking the changes in the index.

You should never forget that our trading instrument is a currency pair, not a national currency. If the dollar is weakening because of some macroeconomic events and the situation in the eurozone is much worse, with the euro being under great pressure, the EUR/USD currency pair quotation may go up or down unpredictably. It is most likely we will see a wide price range with great volatility. It is unwise to expect a clear up or down trend in these conditions.

• A trader uses a stock index as a trading tool catering to any other asset’s rate.

Suppose you see that the oil is on an uptrend. In addition to buying a derivative (CFD or the oil future), you can also buy the CFD or the index future, which are based on the largest oil companies’ quotation.

Naturally, the first option is the most popular scenario. Many traders keep several index charts indices in the workspace designed to help them to comprehend the actual trends of the national markets. Sometimes the indices react faster than the currencies in case of an unexpected international event. We use the term “correlation” for such a phenomenon.

The term “correlation” stands for the dynamics ratio between two assets. If you see that the Canadian dollar rate repeats the movement of the US dollar rate with high accuracy, you can say that they are correlating and a trader is looking at a positive correlation of the two assets.

Catastrophes, Wars, or Terrorist Attacks

Unfortunately, one cannot imagine the modern world having no emergencies that bring influence to bear on the lives of a large number of people and the economy of the states. If we take a currency chart and analyze it throughout its existence, we will see that the largest price movements were caused by the global accidents that triggered enormous shock in the society.

I can recall a few accidents that deeply shocked international financial markets.

Of course, the first thing we think about is the largest radiological accident at the Fukushima nuclear power plant in Japan caused by the tsunami that followed a powerful earthquake.

An accident at a nuclear power plant is the worst thing that humanity can ever imagine. Such disasters cause irreparable damage to the ecology, economy and health of the nation. Similar to the Chernobyl NPP accident in 1986, thousands of people got irreparable health damage in addition to the tragic death of the people working at the plant when it exploded and collapsed.

Even though no one can accurately evaluate the scale of the accident when the first news from the tragedy finally arrives, it is the time when trading volume rises and the wildcatters start to buy and sell currency. Every minute counts, in this case, so even the slightest delay may cost a trader millions of dollars.

Monetary Reforms by the National Authorities

I can think of two trading sessions that made lots of traders gray with worry.

On January 15, 2015, the foreign exchange market shuddered. The Swiss franc was always a haven for the traders and the hardest currency. That day brought the Swiss national currency rising by 30% (!!!) against the euro and 22% against the dollar.

The incredible growth of the Swiss franc was set in motion by the Swiss National Bank, which decided to abandon the franc’s euro peg that served as a deterrent to further national currency strengthening. Moreover, the negative bank rate was lowered even more from -0.25 to -0.75 rate. I will explain what that means a bit later.

The whole forex market went crazy at that moment. The EUR/USD quotation immediately went 6000 points up, which resulted in slippage that didn’t let the traders close their stop-loss positions. Many brokers got a significant deficit on their balances, which they had to deal with in different ways.

Several brokers closed down after this situation. Other brokerages stated that the risk management systems had managed to protect the funds of the traders and close positions before their accounts went into the negative balance.

After this case, most modern brokers started to provide their clients’ accounts with protection from going into the negative balance and assure that they will make up for the traders’ losses if they fail to do that. You can find more information on the brokers’ websites from my list.

Of course, there were other examples of the monetary reforms which shuddered the foreign exchange market. Some of them happened in Japan. I am talking about the so-called interventions, which means that the national bank of a country starts buying and selling foreign currencies. For instance, if there is a need in supporting the national currency, the national bank can sell a large amount of foreign currency from the national foreign exchange reserves. That is exactly what happened in 2011, resulting in a significant lowering of the USD/JPY quotation price during one trading session.

I should note that such actions are considered radical and called revitalization or artificial respiration of the economy. Intervention is used when the softer means to strengthen the national currency have come up dry.

Remember! A trader should realize that if a national bank uses such emergency means to stimulate the economy, the economic situation might be quite disturbing.

It means that even if the currency rate got a few percent stronger in the small, the value of the currency may soon go back to square one and keep falling. Practically it is very difficult for a trader to make a profit out of such rate interventions (especially in case of the yen traded during the Asian trading session while the European traders sleep) but the following market movement may become a great source for a trader to make a good profit.

It is extremely important to make an analysis and see the cause-and-effect link between the events in such scenarios. A trader creates a price behavior pattern and understands what to do to make a maximum profit during the next rate intervention.

Economic Statistics

Daily economic statistics is the most intelligible fundamental analysis tool for a trader. You can find a daily updated economic calendar on the website of your broker and it looks something like this:

 

A standard economic calendar usually contains five columns:

• Exact local (for your location) time of the news publication;
• the title of the news or the identifier’s name. For example, “Statement by the Bank of France director” or “The inflation rate in the Eurozone;”
• previous indicator value;
• consensus forecasts the result of the expert analysis, which determines the most probable consequences of the news;
• current value. It is the real value, which is filled immediately after the news is released; and
• the news importance level.

Usually you see this indicator is displayed in a clear view (as stars or bars) in the broker’s economic calendar. The lowest value (for instance, marked with one star of three possible) means that the news will probably not affect the foreign exchange market while a three-star news has every chance to cause strong volatility.

I feel quite confident in recommending that you focus on the consensus forecast if you are planning to keep a close watch on the economic statistics. Do a little research and find the important news release dates on the currency pair chart. You will see that the strongest movements occur when the real value turns out to be very different from the predicted one. In other words, the experts made a mistake and their forecasts did not work well.

Remember this trend as it will come in handy in your work.

What is truly difficult about fundamental analysis of the forex trade market is a huge amount of information and a large list of sources that might be wise for you to follow.

This is not only about the newsfeeds. I am also talking about expert publications, analytics and forecasts. As it always has been, the key task of a trader is to identify the essentials, to not waste time and energy. Let’s try to gain insight on the main economic indicators that you will often see in the news feeds, and which have the strongest impact on the currency pairs quotation.

10 Most Important Macroeconomic Indicators

I have looked through the economic calendar over a long period and wrote out the macroeconomic indicators that I found essential to explain to my readers. If you find that some indicator is missing, please, feel free to write about it in the comments. I will add them to the article if necessary. Let’s begin!

Gross Domestic Product (GDP)

Gross domestic product is a macroeconomic indicator reflecting the market value of all the final goods and services (ready for consumption), produced for consumption, export, and accumulation by all the economic fields on the territory of a country within a year, regardless of the national affiliation of the factors of production used.

In other words, GDP displays an evaluation of all the goods and services produced in the country. This is a key indicator of the national economy used by a trader. The GDP news in the economic calendar is usually marked as important.

Key Interest Rate

The key interest rate is the minimum interest rate on which the central bank provides the commercial banks with loans. It plays a critical role in setting the interest rates on the bank loans and exercises an influence on the inflation rate and the funding costs of the banks.

From my perspective, this statistical indicator has the strongest impact on the foreign exchange market, since it is the main monetary policy tool of the central banks.

Durable Goods Orders

Durable Goods Orders (DGO) is the indicator reflecting the order volume of the durable goods that the manufacturers have. Durable goods are the types of goods that can be used for three years or even longer.

The analysts use this indicator for forecasting the GDP level of the country. The greater the demand for durable goods, the better the economic situation of the state is. The slump in demand may indicate the end of an upturn in the economic cycle and the beginning of the recession.

Leading Indicators Index

LEI is a composite indicator used for complex analysis of the national economy and making a three to six months forecast. The index is built upon the following indicators:

• Factory orders level;
• amount of the jobless claims;
• money supply overall indicator M2;
• workweek average duration;
• stock value of the largest enterprises;
• durable goods order level; and
• consumer confidence index

A trader/analyst should track first the index dynamics pattern instead of watching the absolute index value. If you see a downfall in several reports, you can be sure about a slowdown in the economic growth of the country.

Purchase Managers Index

I am talking about the whole group of indices based on the surveys of the professional associations. The specialized institutions survey the managers of various industries and conclude the current state of the industry out of it.

Of course, surveys cannot be considered an accurate indicator and the market rarely reacts strongly when they are published. However, if you work in a specific field, for example, trading shares of pharmaceutical companies, the surveys among the managers of this field may help you to understand the true state of the field.

Consumer PMI

This indicator is very much the same as the previous one and the whole group by its meaning and influence over the market. In the case of the PMI, the analysts survey the workers of a particular field. In this case, we are dealing with the poll conducted among the families to figure out their consumer expectations.

Respondents to the survey can give only the “worse” or “better” responses to several questions:

• The financial situation of the family compared to the previous period;
• expected financial situation of the family during the year;
• evaluation of the economic situation during the year;
• estimation of the expected unemployment and economic downfall; and
• evaluation of the family purchases (clothes, household appliances, etc.).

A trader-analyst may derive benefit from this indicator only in case of estimation of the long-range investments.

Consumer Price Index

CPI is the key indicator reflecting the underlying inflation in the country. It displays a change of the aggregate price in the group of the most important consumer goods that form the so-called consumer basket of goods and services. For clarity’s sake, I must say that the basket includes more than just-food.

There are also minor consumer price indices used for the evaluation of changes in a separate economy sector. CPI Ex Food & Energy is the most popular indicator, which does not include the most volatile fields such as food and energy.

Industrial Production Index

This indicator reflects the change in the factory output volume. I think you understand perfectly well what conclusions can be drawn if the manufacturing output of a country keeps falling. I would like to clarify a couple of things before we talk about the next index.

If you take into account the sectoral indicators, figure out what share of the GDP a given field makes up. In other words, a significant change in the factory output volume would not much affect the economy of a country that gains 95% of its revenue from tourism.

We are talking about the so-called low base effect. I will explain it by giving you an example. Let’s say you have had $10 on your account and you earned $20 extra. You got a 200% profit, which is a fantastic result but I do not think you can say that you have become a lot richer.

Conclusion: take into account the GDP structure of a country before analyzing the sectoral indicators.

Personal Income

The more people earn, the more they spend. If the people cannot afford to spend money, there is no sense for the state and the enterprises to drive up production. Therefore, such indicators as the consumer income and expenditure behavior or the level of unemployment are important for fundamental analysis.

The greater the income and expenditures of the people, the higher the economic growth rate of the country is.

Initial Jobless Claims, Nonfarm Payrolls and Level of Unemployment

This group contains the indicators reflecting the as-is state of the U.S. labor. Three indicators get the statistics simultaneously on the first Friday of each month and it is always a momentous event for each trader. Over the years, the news about the U.S. citizens’ employment have always caused a leap in the exchange market volatility.

I think it’s about time for you to have a break and make an analysis of the main currency pairs charts behavior at the moments of the news release about the unemployment in the US. Take a short-term time frame such as M1 or M5 for visual clarity.

If you are not planning to make fundamental analysis, you need to pay attention to increasing volatility and widening of spreads at the time of the most important macroeconomic statistics released.

Balance of Trade

Balance of trade is a key indicator of a country’s foreign economic activities.  That is the balance between exports and imports, or in other words, the ratio of the value of all the goods exported abroad and the goods imported from other countries.

There are two key points a trader must understand:

1. The indicator is to be analyzed over time, that is, in comparison with the previous periods.
2. The greater the export of the country, the greater the need for its national currency is. Consequently, the trade deficit can reduce the demand for the national currency, which will lead to a decline in the national currency value against foreign currencies.

I think I have given you my list of 10 most important macroeconomic indicators, which you will often see in the newsfeed. Of course, there are many other indicators but after you are through with this lesson, you need to draw the following conclusions:

Conclusion #1

The indicators have different degrees of reliability. The results of the surveys are less reliable than the mathematically calculated indicators.

Conclusion #2

The same indicator may have a varying degree of importance in different countries. You should carefully analyze the importance of a sectoral indicator before building a trade forecast on its basis.

Conclusion #3

The news affects the price in different ways. Some of them just pass unnoticed while others start a tremendous volatility in the market. If you want to have a true and fair view, you need to analyze the quotation changes occurred at the time of the different news releases.

Expert Reports and Researches

The MetaTrader 4 platform will intermittently provide you with notifications on the published researches in addition to the macroeconomic statistics. A title may look like this:

• Report by the German Research Institute;
• OPEC Monthly Oil Market Report (Organization of Petroleum Exporting Countries);
• International Energy Agency Monthly Oil Market Report.

Each of these reports contains a large amount of information, which is most interesting for the analysts working in specific fields. I have never seen the trader who was interested in studying detailed reports but you need to understand that any unpredictable data or unexpected statements can cause a great stir in the market.

The main conclusion you should make is that a trader should keep an economic calendar in plain view and take into consideration the time of the news release marked as important by the news agencies in his trade.

Speeches of the Officials

Speeches of the officials contain a lot of useful information that may come in handy for the analysts and investors. As you might have guessed, sometimes the statements of the officials may influence the market greatly by the rise of volatility. Let us have a look at the few examples from the economic calendar:

• Speeches of the head of the Central Bank or the US Federal Reserve System;
• speeches of the top public officials (e.g. Presidents, Prime-ministers, Chancellors, Kings, etc.); and
• speeches of the parliament members and the members of various sectoral committees.

The substantive content of such speeches may consist of:

1. Report on the indicators over a certain period;
2. judgment and attitude to a problem;
3. answers to the questions of the journalists or professional associations;
4. personal assessment of certain events; and
5. plans and prospects.

As my practice shows, when the top public officials express their opinion about a certain problem or answer a question, you can see the strongest reaction of the market. At the moments of big pressure, they often betray themselves and as we know even a misinterpreted phrase can cause an explosion in the market volatility.

I recommend you to track the currency quotes during the press conference of the ECB or the FR’s heads and make a conclusion about how the market reacts to certain words.

Key Conclusions of the Lesson

I think we should now finish this lesson on fundamental analysis and go directly to the key conclusions.

• The stability of the national currency directly depends on the state of the national economy.

The strongest impact on the market may be caused by:

1. Unexpected events such as catastrophes, terrorist attacks, bankruptcy filings, etc.;
2. macroeconomic data that appeared to be worse or better than the expected one; and
3. speeches by the top public officials of the country.

• You can evaluate the real importance of the news only by putting together the time of the news release with the currency chart. Today, the release of data on any indicator can influence the market a lot while in a year it will not mean anything to the investors.
• The volatility growth is the main thing you need to pay attention to when the news is released. This results in the difficulties that the traders may encounter while opening or closing positions and widening of spreads. Besides, the market becomes less predictable when the news is released.

Adherents of technical analysis may not track the news content, but they have to take into account the time of their release for further trade planning.

• Macroeconomics is a global environment and nobody can fully understand all its aspects. Usually an analyst would pick a specific specialization and become an expert in one or several trading instruments such as oil, gold, bitcoin or the U.S. industrial stocks. When one decides to become a trader, they usually learn the ropes and then develop main patterns of how the currency pairs’ quotes react in one case or another.

Main terms of the lesson

Index | Blue Chips | Correlation | Intervention | Gross Domestic Product | Key interest rate | Durable goods orders | Leader Indicators Index | Purchase Managers Index | Consumer PMI | Consumer Price Index | Industrial Production Index | Personal Income | Initial Jobless Claims | Trade Balance | Low Base Effect

Home assignment

I do understand that this lesson was rather big. Do not forget to share your impressions in the comments, I will be happy to answer the questions and chat with those who are interested in the fundamental analysis of the financial market. The economy is a very interesting thing!

I do not think I can force you to make the home assignment but I do advise you to spend 10 minutes to consolidate the lesson. The home assignment on fundamental analysis will be like this:

1. Recall a natural catastrophe (a hurricane, tsunami, earthquake, etc.), find out the exact date and find it on the chart in MT4. Leave a comment about the event you picked and how it affected the currency pairs’ quotes.
2. Analyze how the U.S. unemployment statistics release (published on the first Friday of each month) affected the EUR/USD currency pair quotations over six months.
3. Look at the economic calendar over the next week (you can find it on a broker’s website from my list) and make a schedule when the most important news will be released.

Leave a comment about how you feel about the lesson and write down answers to the home assignment! I hope we shall meet again in the next article, in which we will return to the technical analysis practice.

Sincerely, Pipbear