JBManagement
course 3 of 4

Fundamental analysis on the currency market is the valuation of a currency through the state of a country's economy and the monetary policy of its central bank. The core principle: capital moves to where real returns are higher at an acceptable level of risk. It is expectations about future interest rates that shape long-term trends on the currency market.

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lesson 3.1

The central bank's policy rate determines the return on assets denominated in the national currency. All else being equal, a rate rise makes the currency more attractive: capital flows in search of yield.

A critically important point. The market reacts not to the decision itself but to the deviation from expectations. If a 0.25 per cent rate rise was already fully priced in, the currency may fail to rise at the announcement, or even fall. Trading on the principle "rate raised, so I buy the currency" without analysing what is already priced in loses money systematically.

Major central banks and how often they meet.

BankCurrencyFrequency
US Federal ReserveDollar8 times a year
European Central BankEuro8 times a year
Bank of EnglandPound sterling8 times a year
Bank of JapanYen8 times a year
Swiss National BankFrancQuarterly
Bank of CanadaCanadian dollar8 times a year

What to read beyond the rate decision: the accompanying statement, the inflation and growth projections, the governor's press conference and, for the Fed, the dot plot showing committee members' expectations for the future rate path. The market move is often triggered by the wording rather than the number.

lesson 3.2

Inflation determines real returns and directly affects rate decisions.

Consumer price index

The main indicator, published monthly. Core inflation is tracked separately: it excludes food and energy prices as the most volatile components. Central banks focus primarily on the core measure.

Producer price index

A leading indicator: rising producer costs feed through into consumer prices over time.

Personal consumption expenditures index

The Federal Reserve's preferred measure of inflation in the United States.

inflation target in most developed economies

The logic of the link. Inflation above target means the market expects policy tightening, and the currency strengthens. Inflation sharply below target means easing is expected, and the currency weakens. The inflation target in most developed economies is around two per cent.

lesson 3.3

Non-Farm Payrolls is the change in the number of people employed in the US non-farm sector. It is published on the first Friday of the month at 14:30 CET. It is one of the most volatile releases of the month: EUR/USD can move fifty to one hundred pips in the first minutes.

The unemployment rate and the change in average hourly earnings are released alongside it. The latter is often more important than the headline jobs number: wage growth creates inflationary pressure and influences Fed decisions.

CET — Non-Farm Payrolls release on the first Friday of the month

pips — EUR/USD move in the first minutes after the release

minutes after the release — a pause for beginner traders

A practical warning. Trading at the moment of the release comes with spreads widening several times over, slippage and sharp moves in both directions. Beginner traders are well advised to close positions before the data comes out, or not to open new ones for fifteen to thirty minutes after the release.

lesson 3.4

Gross domestic product is the summary indicator. It is published quarterly in three releases: advance, second and final. The advance estimate causes the biggest market move.

Purchasing managers' indices are leading indicators, published monthly ahead of the official statistics. A reading above fifty points to expansion in the sector, below fifty to contraction. Separate indices are calculated for manufacturing and services. These indices are especially valuable because they are among the first to come out and often set the market mood for the whole month.

Retail sales are an indicator of consumer demand, which in developed economies accounts for the bulk of gross domestic product.

lesson 3.5

Beyond economic data, exchange rates are driven by participants' overall attitude to risk.

Risk-on mode

Investors are willing to take risk; equities and the currencies of commodity economies rise — the Australian, New Zealand and Canadian dollars — while safe-haven assets weaken.

Risk-off mode

Emerges against a backdrop of crisis, geopolitical tension or a stock market slump. Safe-haven assets strengthen: the US dollar, the yen, the franc and gold.

Understanding the prevailing mode explains situations where a currency strengthens despite weak statistics: in a risk-off phase the dollar rises as a safe haven regardless of the US economy's own data.

lesson 3.6

A strategy in which capital is borrowed in a low-rate currency and placed in a high-rate currency. The return comes from the rate differential.

The strategy's risk Carry trade explains persistent multi-month trends in pairs with a large rate differential. The significant risk: when sentiment turns, positions are unwound en masse and quickly, causing sharp moves against the direction of the strategy.

lesson 3.7

The economic calendar lists the release time, the country, the name of the indicator, its importance level, the previous value, the forecast and the actual value.

Working procedure

  • Filter events by the currencies of your instruments.
  • Keep only high-importance events.
  • Compare the forecast with the previous value: this shows what the market expects.
  • After the release, assess the deviation of the actual figure from the forecast, not from the previous value.
  • Take revisions of past data into account: a large revision is sometimes more important than the current figure.

Three events that deserve maximum attention Three events require maximum attention: interest rate decisions, inflation releases and US employment data.

lesson 3.8

The situations that most often cause confusion.

Data beat the forecast, but the currency fell

The most common reason is that market expectations were above the official consensus forecast. The second is a simultaneous downward revision of the previous data.

The rate was raised, but the currency weakened

The rise was fully priced in, and the accompanying statement signalled the end of the tightening cycle. The market trades the future, not the present.

A strong move with no news

Possible causes include large stop orders being triggered, portfolio rebalancing by institutional investors, month- or quarter-end, or low liquidity over a holiday period.

The main takeaway of the course: fundamental analysis explains the direction and the cause of medium-term moves, but it is poor at pinpointing the moment of entry. The practical approach is to use fundamentals to choose the direction, and technical analysis to determine the entry point and the stop level.

self-check

Answered 0 of 80%

1.Why might the market not respond with a rise in the currency after an interest rate increase?

Incorrect. The correct answer is B

2.Which inflation measure is the main one for assessing consumer price dynamics?

Incorrect. The correct answer is B

3.Why are average hourly earnings data important for the market?

Incorrect. The correct answer is C

4.Which purchasing managers' index reading usually indicates expansion in the sector?

Incorrect. The correct answer is B

5.Which assets usually strengthen in risk-off mode?

Incorrect. The correct answer is C

6.What does the Carry Trade strategy involve?

Incorrect. The correct answer is B

7.What should be compared after economic data are released?

Incorrect. The correct answer is C

8.Why might a currency fall after the release of strong economic data?

Incorrect. The correct answer is B

F & Q

Expectations about the central bank's future interest rates. These, in turn, are shaped by inflation, employment, economic growth and market participants' overall attitude to risk.

Most often because the market expected even stronger data, or because past figures were revised at the same time, or because a general risk-off mode is dominating.

The change in the number of people employed in the US non-farm sector. It is published on the first Friday of the month at 14:30 CET and is one of the most volatile releases: EUR/USD can move fifty to one hundred pips in the first minutes.

Fundamental analysis explains the direction and the cause of medium-term moves, but it is poor at pinpointing the moment of entry. The practical approach is to use fundamentals to choose the direction, and technical analysis for the entry point and the stop level.

Beginner traders are well advised to close positions before the data comes out, or not to open new ones for fifteen to thirty minutes after the release: at that moment the spread widens, and slippage and sharp moves in both directions are possible.

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