What is fundamental analysis?
Fundamental analysis is the study of economic, social and political data, reports and news to gain some insight into the past, present and future direction of exchange rates. From a fundamental perspective there are many different ways to analyse currencies, we will focus on the interest rate differential model.
The future direction of an exchange rate will ultimately be determined by the underlying demand and supply for that particular currency. Using some key economic indicators, we can apply readily available data to our interest rate differential model, predicting with some accuracy present and future demand and supply and thus the direction of exchange rates.
What is the Interest rate differential model?
The interest rate differential model is based on the idea that currencies with higher interest rates appreciate as market participants move their funds to countries with a higher yield. While the average investor may not deem it suitable to send the funds overseas, savvy investors, funds and institutions have long been taking advantage of this opportunity, earning interest and capital appreciation on leveraged positions to get big returns. As a retail trader we want to be focused on taking advantage of these trends, taking positions in the spot forex market where we can also earn interest, assuming the interest rate differential is in our favour.
Most economic data and reports carry significance because of the implications they have on the future direction of interest rates. The below points look at the key components of the interest rate differential model; data and reports, which when released have an impact on the market because of their assumed affect on the future direction of interest rates. Strong data or data that beats the market’s expectations will usually mean an appreciation of a currency, while weak data or data that misses expectations will usually mean a depreciation of a currency. This is an extremely important point! Understanding that market participants will act based on their perceived outlook for a currency.
Key components of the model:
Interest rates are the key driver of this model but they are a part of a number of contributing factors which will move exchange rates. Interest rates are a tool used by central banks to meet a number of their monetary policy objectives, these are:
- Keep Inflation between a target band of 2-3%. They do this by either tightening (raising rates) or loosening (lowering rates)
- Strong and sustainable growth.
Interest rates are able to achieve the above goals as they affect the demand in an economy. When interest rates rise the cost to borrow money increases causing the amount of spending in an economy to decrease. The opposite is true when they want to stimulate demand.
Understanding how and why interest rates are used will further your understanding of the macroeconomic themes present in the Forex market. This means that when you read information from your news feed or dissect a bank report you will be able to think about the cause and effect of most economic variables being talked about.
Now that we understand what interest rates do and how they affect our model we can look at data that will help us to make trading decisions. The data or news releases that you will want to be looking at can be found on www.forexfactory.com, they will have both an immediate and long term effect on the currency.
- Interest rate announcements
- Central bank minutes
- Central bank speeches
All of the above releases can either be traded once released or incorporated into your model to decide whether the currency will rise or fall based on the future direction of interest rates. Arguably the most important of these announcements is the central bank minutes. This is because is because the central bank members have effectively done the thinking for you, outlining in veiled language their outlook for that particular economy, its trading partners, the global economy and the affect this is likely to have on their decision making process in the future.