Focus on Forex Fundamentals by Abe Cofnas

Focus on Forex Fundamentals by Abe Cofnas

 

What are fundamentals?  Often in the world of trading a person encounters the reference between the fundamentalist and the technical analyst. The fundamental trader looks to economics and factors that cause price movements. In contrast, the technical analyst views the chart as providing the necessary information for trading.
We take the view here that both are needed and that particularly for forex trading, an understanding of what moves forex prices will provide an important base of knowledge to the new trader.

What are fundamentals?  Often in the world of trading a person encounters the reference between the fundamentalist and the technical analyst. The fundamental trader looks to economics and factors that cause price movements. In contrast, the technical analyst views the chart as providing the necessary information for trading.
We take the view here that both are needed and that particularly for forex trading, an understanding of what moves forex prices will provide an important base of knowledge to the new trader.
FOREX AND THE GLOBAL ECONOMY
KEY CONCEPT – FOREX REFLECTS AN INTERCONNECTED GLOBAL ECONOMYYou do not need a PhD in Economics to get a useful sense of the global economy. Before you start trading forex, one needs to understand the “big picture.” New traders often want to skip any review and tend to look at where a price is at the moment. This is a mistake because important clues as to trading opportunities are embedded in gaining a larger perspective. The knowledge base necessary for trading is not all in the charts.
 
Let’s start with the fact that every transaction in the world is ultimately expressed in a currency. The price you paid may be in U.S. dollars, Euros, Yen, the Aussie, the Loony, or the Canadian dollar, etc., but inevitably, in this age of globalization, the cup of coffee you purchase, the television you’re watching, the computer you’re using, the automobile you’re driving, the shoes you’re wearing, involve a chain of money exchanging hands around the world.   For producers to make a product, they have to locate the suppliers, pay the manufacturers and shippers, before the consumer gets to buy it in local economy. Today globalization affects the profitability of every major international firm and as a result a shift in the value of the dollar can expose a major firm to significant reduction in income. Firms such as Toyota, Mercedes-Benz, Nissan, all have located manufacturing plants in the United States, not only to improve their market share, but to minimize currency exposure. The earnings and net profits of  almost all multinational companies are directly affected by the U.S. dollar. A recent example is Coke. Its earnings surged because of the U.S. dollar decline. Knowing about U.S. dollar trends can be an advantage for managing equity portfolios! When the dollar is trending weaker, stocks that export will tend to have greater earnings.When the U.S. dollar is strong, tourism and industries related to imports will face rewards.
The Forex Era Began in 1971
But before we go into the world of currencies, let’s gain some perspective from history. Currency trading is not new. It began thousands of years ago when coins were issued to represent an exchange medium instead of barter. The image of Caesar on a coin increased confidence in the currency and transformed the efficiency of trading. During this period the credibility of the money was based on it being backed by  precious metals. The value of currencies reflected a set value of a percentage of the metal that the money could be converted into.  In fact the term dollar arose out of the historical circumstance that  silver coins were minted in the town of Joachimstaler (Czech Republic). They became known as talers The word talers pronounced in Dutch and German sounds like the modern word dollar.   Gold became the accepted standard for calibrating the value of currencies. In the U.S. from 1900 to 1930 the convertibility of the dollar to gold was based on 1/20th of an ounce of gold.  During the Roosevelt administration the ratio was changed to 1/35 of an ounce of gold and private ownership of gold in the U.S. was banned in the Roosevelt administration and in 1946 the Breton Woods System setting gold to a fixed rate of $35 an ounce occurred.   But the U.S. dollar was still legally convertible to gold and that promise was important.  On August 15, 1971 U.S. President Richard Nixon altered the world of money by taking the U.S. off the gold standard and eliminating the convertibility of gold. This created the era of Fiat Money. By 1973 gold went to $140 an ounce.  It was a huge historical moment that few people now understand or remember. It is worth studying and gaining an understanding of why the U.S. decided to leave the gold standard. At that time Europeans held over 1 trillion U.S. dollars . The U.S. government feared the risk that at any time a substantial amount of those dollars could be convered into Gold causing severe disruption to the U.S. economy. It was politically and economically a huge risk.  As a result of Nixon’s decision, the world entered a floating rate exchange system and the modern era of currency trading really began at this time. Many people have called for a return to a gold standard since that time. In fact, Alan Greenspan, who was Chairman of the Council of Economic Advisors from 1974 to 1977, wrote a famous article regarding a return to the gold standard. It appeared in the Wall Street Journal on September 1, 1981. It is worth reading. (http://www.gold-eagle.com/greenspan011098.html)    If the world ever returned to a gold standard, effectively currency trading would end.   In recent years, there were attempts to try to link currencies to gold. The Islamic diner had emerged, which provides the ability of trading using gold backed diner currency. Digital currencies are now emerging. They allow for internet transactions in a digital gold format. (i.e. E-gold). It is an exciting time to be involved in the world of currency trading.
Until the arrival of the internet, currency trading was the domain of banks and  large investors and corporations. The online trading revolution changed all that and today, currency trading is no longer an exotic form of investment. Rather it affects everyone in the world and currencies can be traded by almost anyone with a computer.  It’s important to have a sense of the global economy as you consider what currencies to trade.  Globalization has truly arrived and with the power of the internet, the person interested in Forex trading is really riding the world economy. Understanding the status of the world economy and knowing which countries and regions are growing, in recession, facing increase interest rates, or inflation is important in shaping how you trade currencies.
The Global Economy
How healthy is the world economy? How does a currency trader find out the answers? How do we measure global economic performance and health?   Why is maintaining knowledge about the global economy important for your forex trading? The answer is that when the world economy and its regions are in periods of economic growth, economic stagnation, inflation or deflation, these conditions impact greatly on the direction of the currency reflecting that region or country.   Let’s see how.
 
A currency is in many ways a play on the actual direction of an economy and the expected direction. If there is a global sense that a country’s economy is growing, it will attract capital for investment in that country. If there is pessimism about the economic prospects of a country or region capital will flow away from that country or region toward areas that offer a better return. Ultimately, the demand for a currency increases when the demand for the goods and services that is purchased with that currency increases. In a real sense a currency is a commodity subject to the laws of supply and demand.   A summary of key economic fundamentals and forex is listed below.
 
Key Fundamental Concepts and Forex  
 
1. A country with a large population will demand more currency from a country with a small population and vice versa.
2. People will demand more currency from another nation when they find its products to be more appealing.
3. Countries with high and rising incomes will demand more foreign currency than countries with low incomes or those that are in recession.
4. Relatively high domestic inflation in a country will curtail the demand for its currency.
5. If importers expect prices in the exporting country to rise in the future, they will demand more of that currency in the present to beat the price increases.
6. People will demand more of a foreign currency if they can get a higher rate of return on financial investments in that country.
7. On the other hand, if foreign investors expect inflation will undermine the real return on their investments in a country, then they will get rid of that currency and move their money to another country.
8. If people expect a currency to appreciate in the future, they will demand more of that currency in the present.
9. Central banks will demand more of a foreign currency if they wish to depreciate their own.
Note: Please see Abe’s book “Understanding Forex: Trading to Win” for the remainder of the chapter. Copies can be obtained from the Freebie section of forexhound.com
Other topics covered in this chapter include:
  • Global Economic Indicators – How to Track the Health of the Global Economy
  • The Impact of Interest Rates and Forex Movements
  • The Interest Rate Expectation Game
  • The Purchasing Power Parity Concept – PPP
  • The BIG MAC Index
  • Growth, Recession, the Trade Deficit, and Forex
  • Trade deficits