Similarly to how technical analysts draws conclusions from price action data, scholars of fundamental analysis research various economic indicators, comparing them against the time and against each other.
In part I of this article we shall present the fundamental indicators, while Part II will concentrate on theoretical models that tie them together. So without further ado, here are the best Forex fundamental indicators.
Inflation is a sustained increase in the amount of currency in circulation - which in turn increases the price of goods and services. With this in mind, inflation is one of the most important of all Forex fundamental indicators, as it demonstrates how healthy an economy is.
It is important to understand that even through the power of central banks, governments can't really control inflation. The level of 'healthy' inflation' is defined by each state according to the needs of their economy. Developed economies set their aim at around 2%, while developing economies can go up to 7% without causing any panic among investors. Depending on whether the actual inflation rate is above or below the set target, the country can be in a state of hyperinflation - too much money being introduced to circulation, or negative inflation - which means there is too little. Either state has its own equally damaging ramifications. Any deviation from a set inflation rate can be considered a fundamental indicator.
Inflation is difficult to control because there are many sources for money to appear from and many places it can disappear. Today, currencies are not backed up by commodity standards, which means they can be added into circulation by private banks via a fractional reserve system. Also, because financial assets don't obey national borders, foreign entities can accumulate and keep large sums of currencies until they see fit to discharge them back into the market. All of this complicates things exponentially for fiscal policy makers.
In terms of Forex trading, the higher the rate of inflation, the quicker the currency depreciates and the less reliable of an asset it is for foreign investors, both resulting in weakness.
Interest rates are simply the value charged by central banks for lending money to private banks. They are a primary tool used to regulate inflation. Interest rates are set by central banks, usually notifying the public beforehand during press conferences to avoid unnecessary market turmoil.
Commercial lending rates walk hand in hand with central bank interest rates, since private banks can't lend cheaper than they borrow. It is this very connection that makes interest rates a power leveller of the economy and thus a major Forex fundamental analysis indicator.
In a well regulated, well balanced economy, central banks may raise interest rates to cut the pace of money lending to 'cool down' an economy by decreasing inflation. This cuts consumer spending, helping bring growth to a more manageable level. Conversely, if there isn't enough money in circulation and the government is eager to spur the economy, they cut interest rates, making it easier and cheaper for businesses and individuals to borrow money.
For a Forex trader, interest rates are the best multipurpose fundamental indicator, since an increase in interest rates generally forces a currency to appreciate, since there is a cut in supply. Conversely, when interest rates are lowered, the rate for borrowing increases and the currency depreciates.
There are a few things to note here. First of all, learn to distinguish nominal or base interest rates and what are called the real interest rates. The real interest rates are nominal interest rates minus the expected inflation. For example, at the beginning of 2015 The Bank of Russia set interest rate for the ruble at 17%, in response to panic on the market. The ruble plummeted 200% against the US dollar within minutes. The newly introduced level of inflation was approximately 16%.
Secondly, central banks only regulate the supply of currency, while a demand for it originates through political and economical stability, along with the willingness of investors to use the currency as a predictable and reliable financial asset. High interest rates in a stable economy attract investors, while high interest rates accompanied by hyperinflation attract only speculators.
Gross domestic product (GDP) measures the total value of all goods and services produced in a country within a given period. GDP is considered to be one of the best overall fundamental indicators of the economy for Forex. From an economic theory standpoint it's all very simple - a growth in GDP indicates economic growth. However, the relation of GDP to inflation - and thus to currency - is a matter of debate.
As far as the economic logic goes, an increase in GDP (basically an increase in supply of goods and service) must be followed by an increase in a demand for these goods and services, otherwise it's just a negative value. To facilitate that demand an adequate amount of funds should be available to consumers. Thus, a higher GDP means more money, which means more inflation within a central bank set limit. Rather than an increase or decrease in GDP, for a Forex trader it is more important to know if the GDP increase is in line with other economic indicators - such as the consumer price index - and within an anticipated range. If it is, it hints at economic strength and an appreciation of currency. A disparity in the pace of increase would hint at least a minor yet growing economic bubble.
So, what is consumer price index?(CPI)
Consumer price index (CPI) measures the weighted average price of a household basket of goods and services (transportation, food, medical care), with 100 being the base value. For example, if today it costs X USD to buy set of goods and services the CPI will read 100. When in a decade it would cost 25% more, the index will have moved from 100 to 125.
This is an important fundamental Forex indicator, as it helps measure changes in the consumer buying power through the effects of inflation. Large rises in CPI during short periods of time hint towards high inflation, while short-term severe drops in CPI hint at deflation.
Producer price index (PPI)
Producer price index (PPI) works much like the CPI, only instead of measuring the cost of ready goods, it measures production costs. PPI does not consider volatile items such as energy and food to get 'cleaner' readings. Tracking production costs can assist in evaluating how production level prices may be affected, which in turn can help traders understand the possible impact on an economy.
The percentage of unemployed population has a direct effect on the spending patterns - and by extension on the economy as a whole. An increase in unemployment has a negative effect, as less people are getting paid regular wages. Unemployment can't drop below a certain level called aggregate unemployment - and for every state it is different, usually from 2% to 6%. Examples for the reasons behind increased unemployment are companies downshifting gears, or adjusting their business models due to decreasing demand.
Institute of Supply Management (ISM)
The ISM report measures the flow of new orders, thus predicting the production activity in the economy. It's expressed as an index of 50. A reading below 50 means that there has been a decrease in production orders since the previous period. As supply follows the demand, an increased ISM indicates that the demand for goods and services has increased, which is a good sign for an economy.
Retail sales report
Retail sales reports directly track consumer spending patterns, excluding items such as health and education. The population's confidence in the economy is directly reflected in their spending patterns.
Industrial production index (IPI)
IPI shows the monthly change in production for major industrial sectors - such as mining, manufacturing and public utilities. This index is considered to be a good indicator of employment, average earnings and overall income levels in those industries. An increase in the index points towards a healthier economy.
Commodity price index
Commodity price index tracks the average change in price for commodities like oil, minerals and metals. This one is particularly important for 'commodity dollars' - currencies of the commodity exporter countries like Canada and Australia. An increase in the index would constitute an increase in prices, thus higher returns from exports.
Note that a decrease in CPI would be a good news for currencies of those countries that import those commodities.
Trade flow and trade balance
Trade balance reports the difference between total imports and total exports. If more goods are exported, then that's a positive trade balance. It is an important Forex trading fundamental indicator if we are to measure the dynamic of change. Even if the trade balance is negative, an increase in exports would mean a higher demand for the currency.
Trade flow is much like trade balance, only it weighs up the total inflow of foreign investment against the outflow of total investment. The more investors there are interesting in a country's business, the more international trade occurs at a condition of a positive trade balance, the more positive the trade flow reading. There's a caution to this tale. Too much positive trade slow for a prolonged period of time can create a bubble. Goods and services can't disappear, but money can and the bubble can burst - see the China Stock Market crash from July 2015.
Typically, a positive trade flow means more money coming in than coming out, and it is a sign of a healthy economy and an increased demand for currency.
Bond price, bond yields and bond yield spread can also be added to the list of fundamental Forex indicators.
Here is how it works. A bond is a debt obligation. A government bond is a government debt obligation. When people, businesses or banks, purchase government bonds, they aren't really buying anything. Rather, they are lending their money to the government and in exchange they get a note with watermarks that says the government owes them.
Governments are not the only bond issuers. Companies can do that aswell - only they call their kind of bonds 'stock' and trade them on the stock market. When things start getting shaky in the economy, investors tend protect their capital by moving it from the less credible debtors to the more credible ones. Who could possibly be more credible than the government? Thus, investors start buying government bonds. The more government bonds there are being bought, the more they cost and by the virtue of their inverse relationship, the less they yield. The other type of government debt investors tend to seek safe haven in is a national currency. So, for example, when looking at the 10-year treasury notes auction, an increase in price may indicate the strength for the currency.
Bond spread is the difference between bond yields of two different countries, and is a Forex trading fundamental indicator explaining that a currency with a higher bond yield will appreciate higher compared to its counter currency. Remember, always try pairing up the stronger currency with the weaker.
Before moving on to Best Forex fundamental indicators explained, Part II here is some food for thought. With GDP as well as with inflation rates and other fundamental indicators, it is not how much they differ from the previous releases but rather how much they vary from what was expected. A deviation from the forecast could indicate a lack of insight in analytical circles and creates a trading opportunity for a smart fundamental Forex analyst, working on his own.