If you wanted a great example of how hard it is to trade fundamentals, you could have watched the value of the pound between 12 and 2pm on Wednesday, as George Osborne stood up to deliver the most important budgetary announcement this country has seen since the Second World War.
It barely flinched! Fundamental analysis is dead!
Or is it?
What happened (or, rather, didn’t happen) on Wednesday afternoon was the result of a series of leaks about what would be in the budget review – these leaks meant that the news was already “baked into” the price of Sterling. There were no surprises.
Fundamental analysis – time for a rethink?
Some traders will tell you that fundamental analysis is dead.
Are they right?
For many years, the currency markets were all about fundamental analysis – with traders needing to cram up on political and economic events that may affect forex prices.
To be a fundamental trader, you need to look at economic policy, inflation, growth rates and unemployment rates. And by understanding the historic effects of political and economic events on a country’s currency, you can then hope to predict the effect that current events will have on that currency today.
The fundamental trader’s to-do list
Just like any other market, the forex market is affected by supply and demand, which are themselves influenced by the relative economic strength of the currencies you’re looking at.
Therefore, when the fundamental trader looks at investing in a currency, they’ll be looking at foreign investments, GDP …
… And trade balance … If a country shows a deficit on its balance of trade, it is usually seen as an adverse sign – especially if the deficit is growing – as money is leaving the country to pay for foreign goods.
Next the fundamental trader needs to examine current economic conditions – that means pouring through CPI, retail sales figures, durable goods orders …
A quick look on the Forex Factory economic calendar for next week shows up 75 pieces of data coming out that the forex trader should be aware of.
And that’s on top of political factors.
Fundamental analysis is far from simple and requires currency traders to work with huge quantities of information, that often require extensive analysis.
Suddenly, technical analysis looks incredibly simple!
Just a few lines on a graph – easy-peasy!
Carry on regardless
Before we throw fundamental analysis out with the bathwater, let’s take a look at the meat-and-potatoes of fundamental trades – one that used to be a favourite back in the noughties.
A major indicator that forex traders look at is interest rates – moves in interest rates can weaken and strengthen currencies. High interest rates (which can be detrimental to the equities markets in a country, because of the cost of borrowing) can, conversely make that currency attractive to currency traders.
In 1999, when Japan slashed its interest rates to zero, this was big news for those investment banks using what’s called a “carry trade”.
This is how it works …
The trader borrows money on the currency with the low interest rate, and invests in the currency with the high interest rate. So, you could borrow on a low rate from Japan, at say 0.1%, and put your money on deposit in Australia, at around 5% – and pocket the difference.
Sounds simple – but then there’s all those other economic and political factors that can get in the way. A quick look at a historical chart for AUD/JPY will show you just how tumultuous this trade can be.
Carry trades are not for the meek.
These days, rather than the Australian dollar, carry trades are happening in emerging markets.
With quantitative easing and ultra-low interest rates in Japan, the US and the UK, there’s plenty choice of places for investors to take their money from. With these meager yields in their own countries, great herds of investors are moving their money in search of better returns.
And economies in Asia and Latin America are offering very tempting alternatives (Brazil has an interest rate of 10.75%).
And by investing in foreign stocks, such as Australia’s BHP Billiton, Brazil’s Vale, and Mexico’s America Movil, traders have been able to enjoy booming share prices plus the higher interest rates of those currencies. A bit like renovating houses during a housing boom.
I’m not suggesting here that you change all your money into Bazilian Reals – these trades are often described as “picking up nickels in front of a steamroller”. Carry trades involve a huge level of risk – they are also long-term commitments and require a lot of funds in order to give yourself the relative safety of diversification.
The biggest risk is that the currency exchange rate moves against you, with the higher-interest-rate currency suddenly devaluing.
What I am suggesting is that when you look at a currency chart, you try to think about what the carry traders are doing – are they getting in, or getting out? Where is the market sentiment going?
A foot in both camps
Whether you’re looking at the technicals or the fundamentals – it all boils down to one thing: market sentiment. That’s what we’re trying to gauge.
Personally, I base the majority of my trading decisions on technical analysis. However, we cannot afford to ignore important fundamentals.
As Dennis Gartman put it: “Think like a fundamentalist and trade like a technician.” You need to have an understanding of the fundamentals, but when you look at a chart, you then need to forget what you “think” about the price, and read what you “see” in the technicals without prejudice.
And, while we’re talking about understanding the fundamentals, here are some to watch out for next week …
In the next seven days …
Tuesday will bring us the first estimate for Q3 GDP. This is expected to show growth of around 0.5-0.6 per cent, which represents a dip below trend, but remains above forecasts for the year as a whole.
The Distributive Trades Survey on Thursday is a leading indicator of consumer spending. This is expected to be up, but may be skewed over the coming months due to higher spending ahead of the VAT rise in January.
We can expect to see some strong data out of the Eurozone next week, with industrial orders on Monday, and monetary growth numbers from the European Central Bank on Wednesday.
By contrast, US GDP figures due out on Friday are expected to be below long-term predictions, forecasting a disappointing year for US expansion – expect more Federal purchases not to far down the line.