In many ways, forex trading is similar to playing a game. You have an opponent (the market). In game of chance the key feature is that everyone faces the same odds and therefore the same level of information. In these games, no player can change the odds.
Playing forex, however, is not a game of odds. Participants in forex trading do not share the same amount of information. In forex, this asymmetry of information results in advantages and disadvantages to trades.
Some players have more information than the others. In forex, information about fundamental aspects of economies does not arrive simultaneously to all participants. The real important question is what kind of knowledge and information can improve trading performance.
The search for an edge starts with a fundamental understanding of the nature of the forex market. Having a foundation of knowledge in fundamentals is a first step in evolving into a winning trader. In getting acquainted with the forex market, most people start by looking only at price charts and price patterns. This is called technical analysis. But the study of what moves those charts is called fundamental analysis.
Why should fundamentals matter if a trade is done off a short-term time interval such as the 5-minute chart? The short answer is that one cannot separate the fundamentals from the technical analysis without exposing oneself to great distortions in understanding the forex market.
Foreign exchange is by its nature both fundamental and technical and reflect the increased globalization of the world economy. It is worthwhile to note the comments of the late, great Milton Friedman in a 2005conversation with Dallas Fed president Richard Fisher:
The really remarkable thing about the world is how people cooperate together. How somebody in China makes a little bit of your television set. Or somebody in Malaysia produces some rubber. And that rubber is used by somebody in the United States to put on the tip of a pencil, or in some other way. What has happened has been an enormous expansion in the opportunities for cooperation. (http://dallasfed.org/research/swe/2006/swe0606e.html)
Consider the following: every transaction in the world settles in a currency. Whether it is a consumer purchase, an imported or exported item, an investment in an equity, or even cash under the mattress, the world’s economic activity is essentially a flow of money.
What makes forex fascinating as a market and as a trading vehicle is the fact that currencies provide an intimate linkage to the world economy. The currency trader by putting on a currency trade becomes a participant the world economy.
The trader is participating as a speculator looking for a very short-term profit. The forex trader is riding on a global wave. Some will surf the waves, jumping on and off; others will stay in much longer and face the volatility.
Forex trading becomes possible because the world is constantly assessing and reassessing the value of one currency against another. The forex currency trader is looking to tap into this stream of changing values.
The challenge is to find the right combination of tools that can assist the trader in finding high-probability profitable trades. In meeting this challenge, the first step is understanding what moves currencies over time. In putting together a recipe for successful forex trading, knowing the fundamental chemistry of forex is highly recommended.
Anyone who doubts this should simply look at daily headlines that evoke names and places that are part of the daily consciousness of a trader. These names should be familiar to all traders: Bernanke, Fukui, Trichet, Xiaochuan.
The words and decisions of these central bankers of the United States, the Bank of Japan, the European Central Bank, and the Bank of China alert the trader to interest rate policy and news that affect sentiment about the direction of the dollar.
Mention the capitals Pyongdong, Baghdad, Tehran, and they evoke emotions of fear and crises. Detect news about retail giant Wal-Mart’s sales, and one starts anticipating a potential reaction in the currency markets.
These and other factors mix together and form the chemistry of forex, which results in shifts of sentiment regarding the U.S. dollar. These shifts in sentiment cause price reactions and shift the balance between buyers and sellers. Let’s look in more detail at these fundamental factors.
Interest rates are the “dough” of the fundamental forex pie. They are one of the most important factors that affect forex prices, as interest rates are the modern tool that central banks use as a throttle on their economies.
The central banks of the world do not hesitate to use this important tool. The European Central Bank raised interest rates eight times from December 6, 2005, to June 13, 2007, to a level of 4.0 percent to guide a booming European economy to slow down and avoid too high inflation. The United States’ central bank—the Federal Reserve—increased interest rates 17 times between June 30, 2004, and August 2006, and then paused when it decided the economy no longer needed the brake of interest rate increases.
Interest rate increases do much more than slow down an economy; they also act as a magnet to attract capital to bonds and other interest-bearing instruments. This has been called an “appetite for yield,” and when applied globally the flow of capital in and out of a country can be substantially affected by the difference in interest rates between one country and another.
The outflow of capital from Japan to New Zealand, Australia, and Great Britain has reflected money chasing more yield and has been a major multibillion-dollar feature called the “carry trade.” The carry trade was driven by the interest rate differential that has existed, for example, between Japan (0.50) and New Zealand (8.0), causing low-cost borrowing in yen to invest in higher-yielding kiwis. There can be no doubt of the critical role interest rates play in forex price movements.
Fundamentally, however, one of the most important categories of economic data around the world, which is sensitive to interest rate changes, is housing data. The housing sector in the United States, as well as other nations, provides a major share of wealth, consumer spending, and job creation.
Closely watched are data releases that relate to housing activity. Some of the main data releases track:
- The level of unsold homes
- Mortgage loan applications
- New and existing home sales
- Single-family housing permits
- Housing prices
Forex traders’ expectations of the future direction of interest rates are significantly affected by housing data because, for example, weak housing leads to expectations of a slowdown on consumption. The economic reasoning is that consumers start seeing a decline in housing values and restrain their consumer spending.
What is important to realize about fundamental analysis of housing sector data is that the trader can identify pending changes in trends and direction of the economy. Of course, it is true that forex prices move all the time in reaction to news and the like, but economies don’t change direction overnight.
By understanding housing data, one can develop a fundamental viewpoint that leads to trading strategies before technical price patterns reflect the change.
For example, in Table 1.1 we see data on U.S. new housing starts. The year 2005 was a year of a high level of housing starts peaking in February at 2.2 million units and then testing that peak in January 2006 (see Figure 1.2). After January 2006, the data showed a decline, and by August 2006, the decline in housing starts reached levels of 2003.
The forex trader may not have picked the start of the slump by looking at this kind of data, but clearly would have seen that right after the start of 2006 new home starts were in a period of weakening. When housing starts reached a peak and then started declining, it was difficult to be pro-dollar. Although housing data showed a slump, the Federal Reserve didn’t stop the increase in rates until August 2006. In this case the new housing start data was a very reliable leading indicator that interest rates would not increase.
Tracking changes in how an economy is growing is clearly an important part of gaining a sense of whether a currency will be strengthening or weakening. The relationship of growth and currencies applies throughout the world. While there are many aspects to economic growth, the forex trader’s main focus should be on interest rates. An increase in interest rates tends to strengthen the currency.
The trader needs to go further than just knowing what the rate levels are. They trader needs to assess whether the economy is strengthening or weakening. Housing data is one of the most important areas that affect the decision to increase rates, keep rates the same, or decrease rates. The forex trader should keep track of housing data when trading a currency.