Fundamental analysis examines economic, political and social indicators to predict the economic
health of a nation. Currencies can be viewed as the international representative of national
economies; it follows, therefore, that economic health is an important component in currency
valuation. The fundamental analyst constructs forecast models based on a myriad of different
indicators to predict future currency movement.
This section outlines a number of theories and indicators—as well as political dimensions and
monetary considerations—that are important in constructing Forex forecast models.
Fundamental Theories
Purchasing power parity: The absolute purchasing power parity (PPP) theory is based on the “law
of one price”, which states that identical goods will have the same price in two countries when the
exchange rate is at equilibrium. Price disparities between two identical commodities can be
exploited by international arbitrageurs, who capitalize on the imbalance for profit, and in so doing
push the market towards equilibrium. In practice, it is difficult to find two countries in which there are
competitive markets for an identical product of identical quality, without the added cost of trade
barriers, tariffs or transportation costs.
Relative PPP: Relative PPP predicts national inflation rates to determine if particular currencies are
over/undervalued. For instance, if the inflation rate is higher in the US vis-à-vis Switzerland, the
market will adjust the currency values to reflect the reality. This is, again, an opportunity for
arbitrageurs who analyze inflationary indicators in search of profit potential.
Fundamental Indicators
Economic Indicators
The gross domestic product: The gross domestic product (GDP) is the total value of all the goods
produced within national borders during a certain time period. The GDP determines the pace at
which a national economy is growing or recessing. The equation to determine GDP is:
consumption+investment+government spending+ (exports-imports). Consumption is by far the
largest component, totaling approximately 2/3 of GDP. Quarterly GDP reports are broken into three
announcements—advance, preliminary and final. After the final revision, GDP is not revised again
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until the July annual benchmark revisions. These revisions can be quite large, and affect the
previous five years of data.
Personal income and personal consumption expenditures report: The personal consumption
expenditures report (PCE) is the largest component of GDP. It indicates the change in the market
value of all goods and services purchased by consumers.
Personal income is the total value of income received from all sources including workforce
compensation, proprietors’ income, income from rents, dividends and interest and transfer
payments (Social Security, unemployment and welfare). The difference between consumption and
income is called the savings rate.
The personal income and consumption report, released at 8:30 EST on the first business day of the
month, has become a significant economic indicator. While personal income and savings are not in
and of themselves extremely important to financial markets, trends in personal income growth and
the size of the savings rate can indicate future consumer spending patterns, which directly affect
the GDP.
Trade balance: The balance of trade is the difference between national imports and exports over a
certain timeframe. A quarterly trade report provides early clues into net export performance, which
is indicative of strengthening competitive positioning, an indicator of coming economic growth.
Import reports can help to measure domestic demand and consumer spending patterns, but the lag
of this report relative to other consumption indicators renders it somewhat unimportant.
Leading indicators: The leading indicators report is a compendium of previously announced
economic indicators: new orders, job claims, money supply, average workweek, building permits
and stock prices. Therefore, the report is extremely predictable and of little interest o the market.
Industrial Sector
Industrial production: The index of industrial production gauges the change in the nation’s industrial
output and measures capacity utilization (an estimate of the percentage of factory capacity being
used). The 85% capacity mark is perceived as a key barrier over which inflationary pressures are
generated.
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Durable goods orders: The durable goods order report measures new orders placed with domestic
manufacturers for immediate and future delivery of factory hard goods: products which last for an
extended period of time (at least three years). Durable goods data offers insight into demand and
business investment, and the durable goods orders report is considered a leading indicator of
manufacturing activity, the largest component of industrial production.
Business inventories: The business inventories report includes sales and inventory statistics from
all three stages of the manufacturing process (manufacturing, wholesale, and retail). But by the time
it is released all three of its sales components and two of its inventory components have already
been reported. Because retail inventory is the only new piece of information it contains, the market
usually ignores the business inventories report. However, sometimes retail inventories swing
enough to change the aggregate inventory profile. This may affect the GDP outlook. When it does,
the report can elicit a small market reaction. The aggregate sales figures are dated and they say
little about personal consumption. They are actually a good coincident indicator, but the market is
far more interested in forward-looking statistics. The inventory-to-sales (I/S) ratio measures the
number of months it would take to deplete existing inventory at current sales rates. A relatively low
(high) I/S ratio may mean that manufacturers will have to build up (draw down) inventory levels.
Depending on the strength of final demand and the degree to which recent inventory changes have
been intended or unintended, this can have an effect on the industrial production outlook. Note, that
this information is much more useful to market economists than it is to other market participants.
Institute for supply management (ISM): The ISM releases a monthly index of manufacturing
conditions compiled from numerous industry reports and surveys. Financial markets are extremely
sensitive to unexpected ISM changes, because the index is a good predictor of inflationary
pressures; indeed, the Federal Reserve keeps a close watch on the index to help determine interest
rate policy.
Construction Data
Housing Starts: Housing starts measure the number of residential units for which construction has
begun in the previous month. The housing sector is very interest rate sensitive, and a sudden jump
in housing starts usually indicates that interest rates have reached a peak.
Single family home sales: The single family home sales report is a demand side indicator of
housing sales. Sales are highly dependent on mortgage rates, and tend to react with a few months
lag to rate changes. Sales will usually be highest after a recession, as pent up demand is released.
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Inflation Indicators
Producer price index: The producer price index (PPI) measures price changes in the manufacturing
sector. There are three broad subcategories within the PPI which are generally used for economic
analysis: crude intermediate and finished. The market tracks the finished goods index most closely,
as it represents prices of goods ready for sale to the end user. The market places emphasis on the
‘core rate’ basket, excluding food and electricity, which are quite volatile and might obscure
inflationary trends.
Consumer price index: The consumer price index (CPI) measures the average price paid by
consumers for a specific basket of goods. The CPI is calculated by averaging the price changes of
all the components of the basket in order to determine inflationary trends. It is the benchmark
inflation index.
Employment Indicators
The employment report: The employment report is comprised of the household and establishment
surveys. The surveys produce non-farm payrolls, average workweek, and average hourly figures.
Together, these two surveys make up the employment report, the most timely and broadest
indicator of economic activity released each month.
The household survey is primarily used to indicate the unemployment rate. The rate is calculated by
dividing the number of unemployed by the number of people in the workforce. The unemployment
figure is quite volatile due, in part, to the small sample size of the survey—roughly 60,000
households. It is useful to crosscheck the household survey results with the labor and employment
figures to determine whether changes are truly representative.
The establishment survey measures productivity of the workforce. The most important component
of the survey—and indeed, in the entire employment report—is non-farm payrolls. Non-farm
payrolls measure the number of non-agricultural workers in the national workforce. The monthly
changes in payrolls can be extremely volatile from one month to the next. However, aside from
large swings and the possibility of rather substantial revisions to previous data, non-farm payrolls
offers the most comprehensive and extensive snapshot of the economy.
