The Basics

As opposed to technical analysts – which are primarily concerned with price data – fundamental analysts are primarily concerned with economic data. To re-summarize what I explained earlier (in the section entitled “What Makes Currencies Move”), a currency that is backed by high economic growth, high interest rates, and low inflation, will generally outperform a currency with low GDP growth, low interest rates, and high inflation, all else being equal. Why is this the case? Because these three factors make it attractive for individuals and institutions to invest/lend money, and the movement of capital into such an economy will exert upward pressure on its currency.

Interest Rates Predominate

Most fundamental analysts practice some variation of the carry trade, which involves borrowing in one currency and lending/investing in another. For that reason, fundamental analysts pay special attention to real interest rate differentials, or the difference in interest rates between two countries, after adjusting for inflation. If one can borrow USD at 3%, exchange them for Brazilian Real and earn 7%, then the 4% is pure profit, as long as the exchange rate remains constant. Of course, exchange rates rarely remain constant, which means the main risk involved in a carry trade strategy is that the exchange rate will move against you, such that any interest earnings will be offset by currency depreciation. This risk is known as volatility, and explains why the carry trade is only popular/viable during periods of low uncertainty. For example, when the 2008 credit crisis struck, investors became suddenly risk-averse and the carry trade collapsed. It wasn’t because interest rate differentials narrowed, but simply because they were no longer wide enough to compensate investors for the (suddenly high) risk of currency depreciation.

Moreover, it’s not enough to be aware of current interest rate differentials; one must also try to predict where they are going. Most Central Banks set interest rates with regard to inflation and economic growth, the two of which are usually closely correlated. Some Central Banks have a specific inflation targets, and they will raise/lower rates when the actual rate of inflation is outside of this target. Other Central Banks, such as the US Federal Reserve Bank (aka the Fed), are charged both with regulating inflation and employment, and lack specific targets. Either way, when a given economy is expanding, prices usually rise at a faster rate, and the Central Bank will raise interest rates. When an economy enters a recession and/or the rate of price inflation slows, the Central Bank will lower rates. Rate changes typically go into effect when they are announced, and currencies will react quickly as the new rates are priced in. However, many, if not most changes in rates are signaled by Central banks ahead of time (so as not to shock the markets), and every press release will be parsed for any such indications.

Not only is inflation relevant insofar as it bears on interest rates, but it is also relevant in and of itself. For example, if it rises faster than interest rates, it could possibly inhibit the viability of the carry trade. I say possibly and not definitely because carry traders technically don’t care about price levels, since they are investors/lenders and not consumers. Still, insofar as inflation erodes the value of the currency, it could affect the real return of the carry trade and must be heeded. There are a variety of price indexes that attempt to gauge inflation. In the US, the two most famous are the Consumer Price Index (CPI), and the Producer Price Index (PPI), both of which are calculated on a monthly basis.

It’s the Economy Stupid

Fundamental Analysts also pay attention to economic growth. The most important figure is Gross Domestic Product (GDP), which takes into account (growth in) the value of goods and services produced within a given country’s borders. It is calculated on a quarterly basis. Basically, there are four components of GDP: consumption, investment, government spending, and the difference between imports and exports. Investors will often try to gauge GDP by analyzing a handful of economic indicators, which are variously connected to one of the four components of GDP. For example, the Retail Sales Index and Consumer Sentiment are proxies for (US) consumption, while Construction Spending and the Institute for Supply Management Index (ISM) can be used to predict investment. Government spending is usually budgeted for, and may be influenced by tax cuts and stimulus programs. The difference between exports and imports is known as the balance of trade, and is calculated on a monthly basis. There are literally dozens of other economic indicators, and it’s impossible to say definitively which are important. Just remember that they do not represent “endpoints” for currencies, but are useful primarily as snapshots of the current health of a particular economy.

Balance of Trade, Balance of Capital

The balance of trade is not only important as a component of GDP, but also insofar as it affects the demand for a particular currency. If an economy’s imports exceeds its exports, then it’s currency should theoretically decline because it means that in terms of the flow of goods and services, more money is going out then is coming in. However, it’s important to recognize that any imbalance of trade (in this case a deficit) must be offset by a corresponding imbalance in the capital account (in this case a surplus). To make this idea more concrete, consider that the US balance of trade has been negative for several decades, but that the complete collapse of the Dollar has yet to materialize. What this signifies is that foreigners remain willing to fund the deficit. They may demand a discount (in the form of a more favorable exchange rate), but the willingness is still there. Thus, as long a country’s capital markets remain deep, liquid, and attractive, it can run larger trade deficits than would otherwise be favorable.

On the other side of the equation are economies that run persistent trade surpluses. With the exception of a handful of countries in Asia, the majority of these economies derive the bulk of their export revenues from the sale of commodities. You might here of correlations between the price of gold and the Australian Dollar, oil and the Canadian Dollar, etc. This is an indirect way of saying that these economies benefit (and demand for their respective currencies) from price increases in select natural resources. Fundamental analysis for certain currencies, then, involves little more than monitoring the prices of commodities on which their economies depend on to drive growth.

As I alluded to above, it’s not enough to pay attention to patterns in international trade; one must also be aware of cross-border capital flows. Ebbs and flows in global risk aversion fit into this category. When a crisis strikes, for example, the US Dollar, Japanese Yen, and Swiss Franc typically benefit, because they are perceived as “Safe Haven” currencies. When the global economy is expanding, on the other hand, many investors will shift their capital to emerging markets, causing such currencies to appreciate.

Debt and More Debt

Fundamental analysis also involves an accounting of debt. Generally, the higher a country’s debt (relative to GDP), greater is the chance of default, and greater is the risk of holding that country’s currency. This is especially true because some countries (especially emerging market economies) will be forced to print money and/or deflate their currencies directly in order to make their debt loads more manageable. However, it should be pointed out that just like a trade deficit, debt is only a problem insofar as it cannot be financed. While the US national debt is enormous, for example, lending to the US is still perceived as extremely safe, and there exists no shortage of institutions willing to do so. Japan, meanwhile, finances the majority of its debt domestically, which means that its large national debt doesn’t necessarily affect the Yen.

Central Banks

Central Banks primarily impact exchange rates by adjusting interest rates. However, they can also influence exchange rates directly by altering the supply and demand for currency. For example, they can print money and use it to increase liquidity in financial markets and/or stimulate the economy. This directly increases the supply of currency in circulation, and unless it is met by a proportional increase demand or is later withdrawn from the economy, it will cause inflation and erode the value of the currency. Central Banks have also been known to intervene directly in currency markets to devalue their currencies (usually to help their exporters), and this is accomplished by selling one’s own currency against other currencies. Central Banks will almost always reveal their intentions to intervene before actually doing so, and it’s up to you to determine whether they are bluffing or telling the truth.

And Everything Else…

Of course, there are a handful of other (fundamental) factors that weigh on currencies, but most of these are only important insofar as they connect to the above, and frankly, I will only confuse you by mentioning them here.

In short, as an aspiring fundamental analyst, you should be aware of interest rates, inflation rates, GDP growth rates, capital and trade flows, and the words and actions of Central Banks, for all of the currencies that you are interested in trading. According to financial theory, however, by the time you have come to know this information, it has already been priced into all exchange rates. If you want to beat the markets using a fundamental strategy, it’s not enough for you to where these rates/figures currently stand, but you instead have to be able to predict where they are going…

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