Fundamental analysis

Fundamental analysis is simply the ability to understand why the market is moving in a certain direction. For some, who see fundamental analysis as irrelevant, it is worth reflecting why nearly every single institutional trading firm invests large sums of money to get economic releases and analysis delivered to their trading desks within seconds.

The Bloomberg terminal, for example, costs around $2000 per month. If technical analysis alone was sufficient for profitable trading, then these serious trading firms would not invest so heavily in useless tools. Fundamental analysis is a beneficial pursuit for the serious trader. When the Bank of Japan issued a quantitative easing (QE) program in April 2013, it pumped a huge amount of money into Japan’s economic system, devaluing the JPY.

Fundamental analysts’ expectations of the effect of the Bank of Japan’s QE program was that the price on the USD/JPY chart would reach 110. It took over 14 months for the price to reach that level. So, that was more than enough time for traders to get on board and take advantage of that price move. This example alone shows not only the impact of monetary policy on a currency but also that it can take some time before a central bank’s monetary policy is fully priced into the market. That time allows traders opportunities to earn from these moves.

Fundamental analysis involves studying Central Banks’ monetary policy

All developed nations have a central bank. The central bank has a mandate to ensure both their country’s economic and price stability. The monetary policy set by the central banks directly influences the currency of their own nation. Central banks set the money supply for their nation, the interest rate targets, the required reserves, and also implement various currency measures. Fundamental analysis can seem impenetrable and too complicated to grasp unless you have a finance degree, especially at first. However, all we need to do is focus on the core indicators that the central bank has identified

Central bank tools to ensure price stability

Interest rates

Interest rates are generally used by banks to control inflation. If inflation is increasing above the central bank’s target rate, they will raise interest rates to control it. This will encourage people to start saving and stop spending their money which reduces the rate that inflation goes up. In contrast, if inflation is low the bank will cut its interest rates which will encourage people to spend their money and not save. It will also incentivize other people to borrow money which they can then invest. This investment is then injected into the economy and results in a pick-up in growth. Interest rates affect the country’s currency causing it to appreciate.

Four core indicators the Central Bank focuses on

The banks have a core set of 4 economic indicators which they focus on. The four areas focus on production (manufacturing data/housing/services/construction etc.), employment (how many people are earning/wages etc.), growth (GDP/measure of total production), and inflation. Inflation and growth are two of the most important indicators while inflation is the single most important area.

Inflation considers how much the cost of goods and services goes up over time. Nearly all central banks have either a specific or general inflation level they are trying to achieve. For example, the Bank of England currently has a specific inflation target of 2% while the Royal Bank of Australia has an inflation target in the range of 2-3%. We will now consider the tools that the central banks have to make sure they control inflation and maintain price stability.

Central bank tools to ensure price stability

Interest rates

Interest rates are generally used by banks to control inflation. If inflation is increasing above the central bank’s target rate, they will raise interest rates to control it. This will encourage people to start saving and stop spending their money which reduces the rate that inflation goes up. In contrast, if inflation is low the bank will cut its interest rates which will encourage people to spend their money and not save. It will also incentivize other people to borrow money which they can then invest. This investment is then injected into the economy and results in a pick-up in growth. Interest rates affect the country’s currency causing it to appreciate.

An example can be seen in the chart below when the Bank of Canada surprised markets on the 12th of July in 2017 by raising interest rates (CAD positive). The pair below is USD/CAD and it fell heavily (CAD being bought) with the surprise hike. Over the next 10 or so trading days price moved over 300 points with very little retracement. This would be an excellent scenario to use leverage to maximize your gains, as traders could have the highest conviction that the trade will move in their direction.

Price control

Price control is when the bank communicates that it would like the currency to be at a certain price. A good example is when the EUR/CHF had a floor at the 1.2000 level. If the price dropped towards that area the Swiss National Bank defended that floor by buying the EUR/CHF pair to defend the area. This was a great opportunity to buy the EUR/CHF between 2012 and 2015. Every time the price went towards the 1.2000 level the bank defended the level. However, this opportunity was not without risk, since the SNB did eventually stop defending the level causing the EUR/CHF pair to depreciate by over 40% in just a few minutes.

Central bank language

The banks make statements about where they want the price to be and they can issue threats if the price is not where they want it to be. Of course, a central bank is only listened to if the market sees it as credible. However, sometimes a slight shift in emphasis, a removal or addition of a key phrase is enough to signal shifts in a central bank’s focus.

Quantitative Easing

Quantitative easing or ‘QE’ is the process by which the central bank prints money and puts it into the nation’s financial system. It stimulates growth and investment in the economy. It also devalues a country’s currency and supports growth as the country’s exporters become more competitive. It is a very effective tool and is paid a lot of attention to by the markets.

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