|Trading Forex Using Fundamental Analysis|
|Part 1: Exchange Rates and Fundamental Analysis|
|Part 2: Impact of Interest Rates|
|Part 3: Economic Indicators|
Reading time: 8 minutes
Exchange rate movements are often erratic and, according to many academics, unpredictable.
Throughout history, however, economists identified a number of factors to help determine the direction of exchange rates, a practice referred to as fundamental analysis.
FX Trading: Fundamental Analysis Vs. Technical Analysis
To trade Forex, two primary vehicles are used:
- Fundamental analysis involves studying the economic well-being of a country. Those who favour fundamental analysis are often labelled fundamentalists.
- Technical analysis is a methodology in place to examine and predict price movements, based on an asset’s chart history. Traders favouring a technical approach are often branded chartists.
The vast majority of retail Forex traders employ technical analysis and often overlook the importance of fundamental analysis.
Although technical analysis serves well in the short term (while some traders also profess to its use as a long-term methodology as well), fundamental analysis can help support a longer-term view. Despite some market participants favouring one discipline over another, both technical analysis and fundamental analysis have a place in the financial markets.
Technical analysis does a superb job of capturing the psychology of a market, often viewed through support and resistance levels (a backbone to many Forex trading strategies). The euro versus the US dollar, or EUR/USD pair (see figure 1A), is one example. Trading above $1.1500 since mid-2020, and recently rejecting the widely watched $1.2000 level, is notable movement from a technical perspective. Due to the $1.2000 level representing a large psychological (resistance) barrier, technical traders have clearly interpreted this area as an overbought zone to either initiate fresh shorts or liquidate a portion of long positions. Interestingly, Danske Bank, the largest bank in Denmark, had the following to say regarding the euro:
‘We view fair value for EUR/USD to be a 1.08-1.20 range, depending on the model employed. Either way, at current levels, valuation is neutral if not an outright headwind for spot.’
As a result, technical and fundamentals, according to some analysts, are aligned at the moment.
(Figure 1A – Trading View)
Fundamental Analysis: Economic Indicators
Economic conditions are measured by economic indicators.
One economic indicator all fundamental analysts are mindful of is the Big Mac Index, considered a light-hearted method of currency evaluation by comparing the local price of a McDonald’s Big Mac burger.
This index measures Purchasing Power Parity (PPP).
PPP is a theory of exchange rate determination. It asserts (in the most common form) the exchange rate change between a currency pair over any period of time is determined by the change in the two countries’ relative price levels. Like most economic theories, the PPP example has been simplified from a global scenario into a two-country model for easier comprehension using the Big Mac.
This is due to the availability of the Big Mac in almost every country. The Economist magazine, in 1986, took this a step further by creating the Big Mac Index, the measure of the burger’s price in these countries. The way it works is by comparing the prices of Big Macs across countries to get an implied exchange rate. Then simply compare the implied exchange rate to the actual exchange rate and you should see whether a particular currency is overvalued or undervalued (see figure 1B). The Big Mac index is a way of establishing a currency’s long-term forecast and exchange rate evaluation.
(Figure 1B – The Big Mac Index)
Using the CPI in PPP Analysis
From the graph in figure 1B, you can see the EUR and GBP is undervalued against the USD. However, although the Big Mac Index is a great foundation to understand PPP, using the Big Mac index is not accurate if compared to the PPP theory generally agreed upon in academia. It is considered more efficient to use the general price level as the good that is being compared instead of Big Macs. This is because although the general price level is viewed as a single good here, it actually takes into account prices for a number of goods in a particular country. The textbook formula for this is as follows:
For price levels, you have to use core inflation rates, derived from the Consumer Price Index (CPI) for both countries. To illustrate, if country A is the United Kingdom and country B is the United States and you want to find the PPP exchange rate in August 2020, you must know the core inflation rate in August 2020 for both the UK and the US. A quick check will show you the percentage change in the core CPI for both the UK and the US is 0.9 percent and 1.7 percent, respectively. Given the actual exchange rate in August 2020 is approximately 0.7621 (month average), the formula is as follows:
S1 = 0.7621 x 1.009/1.017
From the above, we can calculate the PPP exchange rate is equal to 0.7561. What this means is, according to PPP theory, the exchange rate in August 2020 ought to be 0.7561 instead of 0.7621. Consequently, GBP was undervalued in August 2020 by 0.8 percent.
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