Geo-Political Factors

There are two necessary methods in forecasting the currency market; fundamental analysis and technical analysis.

As the technical analysis focuses on the study of price movements, fundamental analysis focuses on the economic, social and political forces that drive supply and demand. Fundamental analysts look at various macroeconomic indicators such as economic growth rates, interest rates, inflation, and unemployment. However, there is no single set of beliefs that guide fundamental analysis. There are several theories as to how currencies should be valued.

Here we will discuss Geo-Political Factors and leading Economic Indicators of the major countries.

Financial Factors

Financial factors are vital to fundamental analysis. Changes in a government's monetary or fiscal policies are bound to generate changes in the economy, and these will be reflected in the exchange rates. Financial factors should be triggered only by economic factors. When governments focus on different aspects of the economy or have additional international responsibilities, financial factors may have priority over economic factors. This was painfully true in the case of the European Monetary System (EMS) in the early 1990s. The realities of the marketplace revealed the underlying artificiality of this approach.

Political Crises Influence

A political crisis is commonly dangerous for Forex because it may trigger a sharp decrease in trade volumes. Prices under critical conditions dry out quickly, and sometimes the spreads between bid and offer jump from 5 pips to 100 pips. Unlike predictable political events (parliament elections, interstate agreements conclusion, etc.), which generally take place in an exact time and give the market the opportunity to adapt, political crises come and strike suddenly. Currency traders have a knack for responding to crises. The traders should react as fast as possible with risk management to avoid big losses. They do not have much time to make decisions, often they have only seconds. Return on the market after a crisis is often problematic.

The Role of Interest Rates

Using the interest rates independently from the real economic environment translates into a very expensive strategy. Because foreign exchange, by definition, consists of simultaneous transactions in two currencies; it follows that the market must focus on two respective interest rates as well.

This is the interest rate differential, a basic factor in the markets. Forex traders react when the interest rate differential changes, not simply when the interest rates themselves change. For example, if all of the G-5 countries decided to simultaneously lower their interest rates by 0.5 percent, the move would be neutral for foreign exchange, because the interest rate differential would also be neutral. Of course, most of the time the discount rates are cut unilaterally, a move that generates changes in both the interest rate differential and the exchange rate. Forex traders approach the interest rates like any other factor, trading on expectations and facts. For example, if rumour says that a discount rate will be cut, the respective currency will be sold before the fact. Once the cut occurs, it is quite possible that the currency will be bought back, or the other way around. An unexpected change in interest rates is likely to trigger a sharp currency move. Other factors affecting the trading decision are: the time lag between the rumour and the fact, the reasons behind the interest rate change, and the perceived importance of the change. The market generally prices in a discount rate change that was delayed. Since it is a fait accompli, it is neutral to the market. If the discount rate was changed for political rather than economic reasons (a common practice in the European Monetary System), the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones. This happened in both September of 1992 and the summer of 1993, when the European central banks lost unprecedented amounts of money trying to prop up their currencies, despite having high interest rates. The market perceived those interest rates as artificially high and therefore aggressively sold the respective currencies. Forex traders deal on the perceived importance of a change in the interest rate differential.

Monetary Operations by Central Banks

All central banks, including the US Federal Reserve System (FRS), affect the foreign exchange markets’ changing discount rates and perform the monetary operations (such as interventions and currency purchases).

For the foreign exchange operations, most significant are repurchase agreements to sell the same security back at the same price at a predetermined date in the future (usually within 15 days), and at a specific rate of interest. This arrangement amounts to a temporary injection of reserves into the banking system. The impact on the foreign exchange market is that the national currency should weaken. The repurchase agreements may be either customer repos or system repos.

Matched sale-purchase agreements are just the opposite of repurchase agreements. When executing a matched sale-purchase agreement, a bank or the FRS sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a predetermined time in the future (generally within 7 days). This arrangement amounts to a temporary drain of reserves. The impact on the foreign exchange market is that the national currency should strengthen.

Monetary operations include payments among central banks or to international agencies. In addition, the FRS has entered into a series of currency swap arrangements with other central banks since 1962. Also, payments to the World Bank or the United Nations are executed through central banks.

Intervention in the United States foreign exchange markets by the US Treasury and the FRS is geared toward restoring orderly conditions in the market or influencing the exchange rates. It is not geared toward affecting the reserves. There are two types of foreign exchange interventions: naked intervention and sterilized intervention.

Naked intervention, or unsterilized intervention, refers to the sole foreign exchange activity. All that takes place is the intervention itself, in which the Federal Reserve either buys or sells US dollars against a foreign currency. In addition to the impact on the foreign exchange market, there is also a monetary effect on the money supply. If the money supply is impacted, then consequent adjustments must be made in interest rates, in prices, and at all levels of the economy. Therefore, a naked foreign exchange intervention has a long-term effect.

Sterilized intervention neutralizes its impact on the money supply. As there are rather few central banks that want the impact of their intervention in the foreign exchange markets to affect all corners of their economy, sterilized interventions have been the tool of choice. This holds true for the FRS as well. The sterilized intervention involves an additional step to the original currency transaction. This step consists of a sale of government securities that offsets the reserve addition that occurs due to the intervention. It may be easier to visualize if you think of it as the central bank financing the sale of a currency through the sale of a number of government securities. Because a sterilized intervention only generates an impact on the supply and demand of a certain currency, its impact will tend to have a short to medium-term effect.

Board of Governors of the Federal Reserve System

• Bank of England
• European Central Bank
• Bank of Japan
• Reserve Bank of Australia
• Swiss National Bank

Economic Indicators

An economic indicator (or business indicator) is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance.

Economic indicators can be leading, lagging, or coincident; which indicates the timing of their changes relative to how the economy as a whole changes.

1. Leading:Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines, and they improve before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors, as they help predict what the economy will be like in the future.
2. Lagged:A lagged economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagged economic indicator, as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.
3. Coincident:A coincident economic indicator is one that simply moves at the same time as the economy does. The Gross Domestic Product is a coincident indicator.

Please find more about regional economic indicators in our economic calendar: Economic Calendar