Best Forex Fundamental Indicators Explained
Reading time: 19 minutes
Similar to how technical analysts draw conclusions from price action data, scholars of fundamental analysis research various economic indicators, comparing them against the time and against each other. The first part of this article will present the best fundamental indicators for Forex trading, while the second part will concentrate on the theoretical models that tie them together.
The Best Forex Fundamental Indicators
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.
Either state has its own equally damaging ramifications. Any deviation from a set inflation rate can be considered a fundamental indicator. Inflation is difficult to control because there are many sources for money to appear from, and many places that it can disappear. Today, currencies are not backed up by commodity standards, which means that they can be added into circulation by private banks via a fractional reserve system.
Also, because financial assets don't obey national borders, foreign entities can accumulate and keep large sums of currencies until they see fit, to then discharge them back into the market at a later time. All of this complicates things exponentially for fiscal policy makers. 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.
Conversely, if there isn't enough money in circulation, and the government is eager to spur the economy, they cut interest rates, making it easier and cheaper for businesses and individuals to borrow money.
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. First of all, it is important to learn to distinguish between nominal or base interest rates and what are called the 'real interest rates'.
The real interest rates are nominal interest rates minus the expected inflation. For example, at the beginning of 2015, the Bank of Russia set an interest rate for the Ruble at 17%, in response to panic on the market. The Ruble consequently plummeted 200% against the US Dollar within mere minutes. The newly introduced level of inflation was approximately 16%.
Secondly, central banks only regulate the supply of currency, while a demand for it originates through political and economic stability, along with the willingness of investors to use the currency as a predictable and reliable financial asset. High interest rates in a stable economy attracts investors, while high interest rates accompanied by hyperinflation attracts only speculators.
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.
Institute of Supply Management (ISM)
The ISM report measures the flow of new orders, thus predicting the production activity in the economy. It's expressed as an index of 50. A reading below 50 means that there has been a decrease in production orders compared with the previous period. As supply follows the demand, an increased ISM indicates that the demand for goods and services has increased, which is a good sign for an economy.
Retail Sales Report
Retail sales reports directly track consumer spending patterns, excluding items such as health and education. The population's confidence in the economy is directly reflected in their spending patterns.
Industrial Production Index (IPI)
IPI indicates the monthly change in production for major industrial sectors - such as mining, manufacturing, and public utilities. This index is considered to be a good indicator of employment, average earnings, and overall income levels in those industries. An increase in the index points towards a healthier economy.
Commodity Price Index
The Commodity Price Index tracks the average change in price for commodities like oil, minerals, and metals. This one is particularly important for 'commodity dollars' - which includes currencies of the commodity exporter countries like Canada and Australia. An increase in the index would constitute an increase in prices, and therefore, higher returns from exports. Note that a decrease in CPI would be good news for the currencies of those countries that import those commodities.
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.
Trade flow is much like trade balance, only that it weighs up the total inflow of foreign investment against the outflow of total investment. The more investors there are that are interested in a country's business, the more international trade occurs at a condition of a positive trade balance, and the more positive the trade flow reading will be. But there's a caution to this tale.
If there is too much slow positive trade for a prolonged period of time, this can create a bubble. Goods and services can't disappear, but money can, and the bubble can burst - (search for the China stock market crash from July 2015 for an example of this). 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.
Bond price, bond yields, and bond yield spread can also be added to the list of fundamental Forex indicators. Here is how it works: A bond is a debt obligation. A government bond is a government debt obligation. When people, businesses, or banks purchase government bonds, they aren't really buying anything. Rather, they are lending their money to the government, and in exchange they receive a note that states that the government owes them.
Governments are not the only bond issuers. Companies can do that as well - only they call their kind of bonds 'stock' and trade with them on the stock market. When things start getting shaky in the economy, investors tend to protect their capital by moving it from the less credible debtors to the more credible ones. Who could possibly be more credible than the government?
Thus, investors start buying government bonds. The more government bonds there are being bought, the more they cost, and by the virtue of their inverse relationship, the less they yield. The other type of government debt investors tend to seek safe haven in is national currency. So, for example, when looking at the 10-year treasury notes auction, an increase in price may indicate the strength for the currency.
What is a bond spread?
Bond spread is the difference between the bond yields of two different countries, and is a Forex trading fundamental indicator that explains that a currency with a higher bond yield will appreciate higher compared to its counter currency. Remember, always try pairing up the stronger currency with the weaker one.
Before moving onto the second part of our article on the best Forex fundamental indicators explained, here is some food for thought. With GDP, as well as with inflation rates, and other fundamental indicators, it is not how much they differ from the previous releases that is important, but rather, how much they vary from what was expected. A deviation from the forecast could indicate a lack of insight in analytical circles, and this creates a trading opportunity for a smart fundamental Forex analyst.
Theoretical Methods That Tie Forex Fundamental Indicators Together
Continuing the study of the best Forex fundamental indicators, this part of the article concentrates on the economic theories applied by long-term currency traders. Market related macroeconomic theories revolve around the concept of parity. With Forex fundamental indicators, parity stands for the equality in readings of the same economic indicators within two different countries.
If there is no parity, currency rates will adjust to compensate for the disparity, but they will do so gradually. For the time of that adjustment, a trading opportunity will exist, so the direction of disparity may serve as a Forex fundamental analysis indicator in itself.
Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is one of the best fundamental indicators for Forex. It's used as an economic theory component and a technique that helps to determine the 'true' value of currencies.The idea is based on the law of one price, where if we assume that there are no transaction costs or official trade barriers, similar goods will have the same price around the world.
PPP allows traders to evaluate the exchange rates that would be appropriate to be able to buy the same set of goods in those countries. In addition to this, since PPP can be used to track the change in the price of goods, it provides us with a reading on 'actual' inflation rates, and will be equal to the percentage of the currencies' appreciation or depreciation.
PPP can be used to compare countries economically. When looking at year-long time periods, exchange rates do tend to move in line with the PPP expected rate. This indicator may be further used as an adjuster for economic data like GDP and income, helping to smooth out currency rate differences, and to get a clearer picture of the economic situation.
Interest Rate Parity (IRP)
Interest Rate Parity is conceptually similar to PPP, only instead we are researching the purchase of financial assets. Theoretically, they should yield the same return in all countries after currency rate adjustment. If they are not the same, a currency rate has to be adjusted. This differential is one of the most useful Forex trading fundamental indicators available to a long term trader.
IRP assumes that:
- Capital is mobile, and that investors can easily exchange assets, domestic or foreign.
- Assets can be substituted through risks and liquidity.
Given these points, investors would, quite logically, hold assets that generate higher yields. As we know, investors hold assets from various countries, so if their yields do not match, there will be a disparity in the currency rates. Ideally, a Dollar return on a Dollar investment should equal a Dollar return on a Euro investment.
International Fisher Effect (IFE)
The International Fisher Effect is an economic theory which states that a change in the currency exchange rate between countries is approximately equal to the difference in their nominal exchange rates at the time.
When explained as a fundamental Forex indicator, the IFE works like this: if higher interest rates mean higher inflation rates, then a currency in a country with a lower interest rate will appreciate against a currency with a higher interest rate. Please note that while the IFE uses reasonable logic, it fails to evaluate the impact of other factors on currency exchange rates.
Balance of Payments Theory (BOP)
Balance of Payments (also known as the balance of international payments) is a record of all payments and monetary transactions between countries for a given period of time. It involves the exchange of goods, services, income, gifts, financial claims, and liabilities to the rest of the world.
BOP consists of three accounts. First, the current account is a sum of the balance of trade (exports minus imports), factor income (earnings on foreign investment minus payment to foreign investors) and cash transfers. Second, the capital account records the net change in the ownership of foreign assets. Third, the balancing items account is for any statistical errors - and to ensure that the current plus capital accounts equal zero - it is essentially the balance sheet.
The BOP deserves a lot credit as a fundamental indicator in Forex, as it enables economists to quantify certain economic policies targeted at very specific economic objectives. For instance, a country may artificially keep its currency exchange rate low in order to stimulate exports, or conversely, to adopt policies that will attract more foreign investment.
Ultimately, both trade account deficit and account surplus may help us to get an idea of exchange-rate directions. If a country operates at a deficit, its currency will tend to depreciate to compensate the imbalance. Likewise, if a county operates at a surplus, this will lead its home currency to appreciating, longing for the same balance.
Asset Market Model
The Asset Market Model focuses on the money flow element of BOP. It states that currency is dependant on the flow of capital into the country, with the purpose of purchasing stocks or bonds. The asset market model deserves to be reviewed as a stand alone fundamental Forex trading indicator, due to a relatively recent explosion of growth in financial assets.
More money is flowing in and out of countries in the form of financial assets today, rather than in the form of goods and services, making the capital account of the BOP much larger than the current account. Should a country see an increase in capital flow from investments, it should also see an increase in the demand for its currency, which in turn should lead to its appreciation.
Additionally, asset prices and the asset market model are dependant not only on current purchases and holdings of financial assets, but also on the projected behaviour of investors in the future. Today large quantities of financial assets are held worldwide. As changes occur in economical conditions relevant to asset holders, large amounts of capital in the form of various financial assets may get redistributed, upsetting the currency exchange rate of both the country they were held at, and the one they were moved to. This serves as a reminder that interest rates are the most influential factor in Forex.
Real Interest Rate Differential Model
Real Interest Rates are equal to nominal interest rates, minus expected inflation. The real interest rate differential model simply suggests that investors, attracted by higher yields on their investments, will move assets accordingly, provided that the investment risks are at an acceptable level. From the Forex fundamental indicator perspective, a higher real interest rate, whether achieved through a high nominal exchange rate or low inflation, is a welcoming sign for foreign investment, which calls for an increased demand in local currency.
The Monetary Model argues that currency value is dependant on monetary supply, income levels, interest rates and inflation rates. It is a hybrid of the quantity theory of money (an increase in money supply leads to a proportional increase in the price level) and purchasing power parity (an increase in price level leads to an increase in interest rates), both following the rule of proportionality. A currency appreciates when there is a stable monetary policy.
This means that the supply of money, interest rates, and inflation are within set limits, and that income levels are increasing. A currency decreases in value if the monetary policy is unstable, and if policy makers' decisions are inconsistent. There are two variations of the monetary model: flexible and sticky. The flexible model suggests that PPP is continuous and momentary, so as soon as money supply, income, inflation, or interest rates change, prices for goods and services will follow at once.
That being said, empirical data suggests that, while money supply, income, inflation, or interest rates may change quickly, businesses will still follow their business cycles, and they need time to readjust their prices, which creates a lag in the market. This is where the sticky model comes in, stating that the prices of goods and services are sticky in the short term, and only gradually adjust to fundamental changes.
The biggest criticism of the monetary model comes from the model's ignorance towards the inflow and outflow of capital for investment purposes, much like with the Fisher effect. As we know, the amount of investment often outweighs changes in the price of goods and services caused by the impact on the currency.
Nevertheless, monetary theory is an important fundamental Forex indicator that can be used to evaluate currencies of the economies that are less influenced by foreign investment, due to restricting national policies.
Economics is an empirical science - there are no controlled experiments. New data is produced every day as a result of a global economic environment that is constantly increasing in complexity. It's natural to want to locate and identify patterns, and to then devise theories based on these changes, to make sense of what's happening.
But it's important to remember that as a Forex trader, just because a theory or pattern worked today, it doesn't mean that it will work again in the future. New data and correlations will emerge which will require their own explanations. The Forex market is constantly changing, so it's important to be able to apply these Forex market and fundamental indicators in order to understand the changes as they happen.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.