Continuing the study of the Best Forex fundamental indicators, Part I, part II concentrates on the economic theories applied by long-term currency traders.
Market related macroeconomic theories revolve around the concept of parity. In Forex fundamental indicators, parity stands for equality in readings of the same economic indicators in two different countries. If there is no parity, currency rates will adjust to compensate for the disparity, but they will do so gradually. For the time of that adjustment, a trading opportunity will exist, so the direction of disparity may serve as a Forex fundamental analysis indicator in itself.
Purchasing power parity (PPP)
Purchasing power parity (PPP) is one of the best fundamental indicators for Forex. It's used as an economic theory component and a technique that helps determine the 'true' value of currencies.
The idea is based on the law of one price, where if we assume there are no transaction costs and official trade barriers, similar goods will have the same price around the world. PPP allows traders to evaluate the exchange rates that would be appropriate to be able to buy the same set of goods in those countries. Further to this, since PPP can be used to track the change in price of goods, it gives us a reading on 'actual' inflation rates and will be equal to the percentage of the currencies appreciation or depreciation.
PPP can be used to compare countries economically. When looking at year-long time periods, exchange rates do tend to move in line with the PPP expected rate.
This indicator may be further used as an adjuster for economic data like GDP and income, helping to smooth out currency rate differences and get a clearer picture of the economic situation.
Interest rate parity (IRP)
Interest rate parity is conceptually similar to PPP, only instead we are researching the purchase of financial assets. Theoretically, they should yield the same return in all countries after currency rate adjustment. If they are not the same, a currency rate has to be adjusted. This differential is one of the most useful Forex trading fundamental indicators to a long term trader.
IRP assumes that (a) capital is mobile and investors can easily exchange assets, domestic or foreign, and (b) assets can be substituted through risks and liquidity. Given points (a) and (b), investors would, quite logically, hold assets that generate higher yields. As we know, investors hold assets from various countries, so if their yields do not match there will be a disparity in the currency rates. Ideally, a dollar return on a dollar investment should equal a dollar return on a euro investment.
International Fisher effect (IFE)
The international Fisher effect is an economic theory which states that a change in the currency exchange rate between countries is approximately equal to the difference in their nominal exchange rates at the time.
When explained as a fundamental Forex indicator, the IFE works like this: if higher interest rates mean higher inflation rates, then a currency in a country with a lower interest rate will appreciate against a currency with a higher interest rate. Do note that although the IFE uses reasonable logic, it fails to evaluate the impact of other factors on currency exchange rates.
Balance of payments theory (BOP)
Balance of payments, also known as a balance of international payments, is a record of all payments and monetary transactions between countries for a given period of time. It involves the exchange of goods, services, income, gifts, financial claims and liabilities to the rest of the world.
BOP consists of three accounts. First, the current account is a sum of the balance of trade (exports minus imports), factor income (earnings on foreign investment minus payment to foreign investors) and cash transfers. Second, the capital account records the net change in ownership of foreign assets. Third, the balancing items account is for any statistical errors - and to ensure that the current plus capital accounts equal zero - it is essentially the balance sheet.
BOP deserves a lot credit as a fundamental indicator in Forex, as it enables economists to quantify certain economic policies targeted at very specific economic objectives. For instance, a country may artificially keep its currency exchange rate low to stimulate exports or, conversely, adopt policies that will attract more foreign investment.
Ultimately, both trade account deficit and account surplus may help get an idea of exchange-rate directions. If a country operates at a deficit, its currency will tend to depreciate to compensate the imbalance. Likewise, if a county operates at a surplus, this will lead its home currency appreciating, longing for the same balance.
Asset market model
The asset market model focuses on the money flow element of BOP. It states that currency is dependant on the flow of capital into the country, with the purpose of purchasing stocks or bonds.
The asset market model deserves to be reviewed as a stand alone fundamental Forex trading indicator, due to a relatively recent explosion of growth in financial assets. More money is flowing in and out of countries in the form of financial assets today, rather than in the form of goods and services, making the capital account of the BOP much larger than the current account.
Should a country see an increase in capital flow from investments, it should also see an increase in demand for its currency, which in turn should lead to its appreciation. Additionally, asset prices and the asset market model are dependant not only on current purchases and holdings of financial assets, but also the projected behaviour of investors in the future.
As mentioned in the Best Forex fundamental indicators, Part I, today large quantities of financial assets are held worldwide. As changes occur in economical conditions relevant to asset holders, large amounts of capital in the form of various financial assets may get redistributed, upsetting the currency exchange rate of both the country they were held at and the one they were moved to. This serves as reminder that interest rates are the most influential factor in Forex.
Real interest rate differential model
Real interest rates are equal to nominal interest rates, minus expected inflation. The real interest rate differential model simply suggests that investors, attracted by higher yields on their investments, will move assets accordingly, provided that the investment risks are at an acceptable level.
From the Forex fundamental indicator perspective, a higher real interest rate, whether achieved through a high nominal exchange rate or low inflation, is a welcoming sign for foreign investment, which calls for an increased demand in local currency.
Monetary model argues that currency value is dependant on monetary supply, income levels, interest rates and inflation rates. It is a hybrid of the quantity theory of money (an increase in money supply leads to a proportional increase in the price level) and purchasing power parity (an increase in price level leads to an increase in interest rates), both following the rule of proportionality.
A currency appreciates when there is a stable monetary policy. This means that the supply of money, interest rates and inflation are within set limits and income levels are increasing. A currency decreases in value if the monetary policy is unstable and policy makers' decisions are inconsistent.
There are two variations of the monetary model: flexible and sticky. The flexible model suggests that the PPP is continuous and momentary, so as soon as money supply, income, inflation or interest rates change, prices for goods and services will follow at once. That being said, empirical data suggests that, while money supply, income, inflation or interest rates may change quickly, businesses will still follow their business cycles, so need time to readjust their prices which creates a lag in the market. This is where the sticky model comes in, stating that prices of goods and services are sticky in the short term and only gradually adjust to fundamental changes.
The biggest criticism of the monetary model comes from the model's ignorance towards the inflow and outflow of capital for investment purposes, much like with the Fisher effect. As we know, the amount of investment often outweighs changes in the price of goods and services caused by the impact on the currency. Nonetheless, monetary theory is an important fundamental Forex indicator that can be used to evaluate currencies of the economies that are less influenced by foreign investment due to restricting national policies.
Economics is an empirical science - there are no controlled experiments. New data is produced every day as a result of a global economic environment that is constantly increasing in complexity. It's natural to want to find and identify patterns and devise theories based on these changes to make sense of what's happening. But it's important to remember, as a Forex trader, that just because a theory or pattern worked today, it doesn't mean it will work again in the future. New data and correlations will emerge which will require their own explanations. The Forex market is constantly changing, so it's important to be able to apply these Forex market and fundamental indicators in order to understand the changes as they happen.