What Are Economic Fundamentals And Long-Term Currency Movements?

Technical analysts often project short-term currency movements based on indications of changes in supply and demand. However, fundamental analysts frequently look for longer-term trends based on alterations in fundamental economic and political indicators that can influence the direction of currency flows.

Behind Supply And Demand: Macroeconomic Indicators

Forex market analysts keep their eyes trained on a series of indicators to determine the long-term direction of currencies. These are known generally as macroeconomic indicators. As a whole, they describe the movements of money within economies that determine the perceived value of their currencies. Analysts can further compare the indicators of differing economies to determine whether their currencies are likely to strengthen or weaken against one another.^[1]

Balance Of Payments: A Roadmap To Forex Flows

The balance of payments is a country's regular documentation of currency transactions across national borders. Balance of payments data is usually published on a monthly or quarterly basis by a country's central bank or other top governmental economic authority. The data is customarily divided into two main components: the current account, and the capital and financial account.^[2]

The Current Account

The current account balance basically registers international commercial transactions of goods and services in addition to net foreign investment earnings and net international transfers of cash during a specified period. Within the current account, analysts can find the national foreign trade balance showing total imports and exports, and the net exchange of cross-border services. These services can include items like travel, tourism, royalty payments, cross-border insurance payments and payments for international shipments and transportation.

The importance of the trade balance can vary from one country to the next depending on its openness to foreign trade. However, in a general manner, the flow of foreign trade is considered a key component of the current account balance. If a country is importing more than it exports from month-to-month and its foreign trade balance is registering a widening deficit, then it is likely to trend toward posting a current account deficit over time.

The trend toward a current account deficit is considered an indication that foreign money is flowing out of a country and that a currency will likely weaken over time.^[3]

The Capital Account

The other major component of the balance of payments, the capital account, is basically a register of investment flowing in and out of a country. Among the types of investments registered in the capital account balance include direct investments and portfolio investments.

Direct investments are investments made in physical capital, such as real estate, production facilities like factories, and machines and equipment. Portfolio investment includes investment in financial assets, such as shares of stock and government and corporate debt. Investment registered in the capital account is understood to offset and cover for any shortfalls seen in the current account balance. Investment found in the capital account, however, falls into categories of short- and long-term investment.

Some categories of short-term investment, known informally as "hot-money," are considered to be more volatile, and can enter and leave a country rapidly in search of higher returns. Long-term investments identified in the capital account are considered to be more reliable capital for offsetting current account shortfalls. In particular, foreign direct investment (FDI) is highly valued capital. It's viewed as capital that will remain in the country for a long period of time and that will generate future production and income locally.^[4]

Currency Inflows And Outflows

Another important indicator that can be published within official balance of payments data are net foreign currency inflows and outflows into an economy during a given month. These may not be discriminated by type of investment but rather as simple totals of all types of flows.

This data is considered to be an important indicator of day-to-day sentiment about all types of investment in a country. Also, it can serve as a signal foreshadowing longer-term trends about flows of money in and out of the local economy. When foreign currency is flowing out of an economy, the local currency generally shows weakening against its peers and when foreign currency enters, it strengthens.

Foreign Reserves

Foreign reserves are a balance of foreign money that has accumulated within a country because of goods and services transactions that have been made with individuals and entities abroad. Foreign reserves are accumulated insofar there is a positive sum of the current account and capital account balances. These reserves are generally invested in instruments that are considered safe, including debt securities of major economies such as the U.S. and Europe.

The accumulation of reserves is relevant for currencies for several reasons. Countries that are accumulating reserves are normally receiving incoming foreign money, and their currencies are often on a strengthening trend. Foreign reserves, however, are also considered a cushion and defense during times of economic turbulence. Central banks use their reserves to defend against volatility and speculative attacks against their currencies by selling portions of the reserves, or derivatives backed by them, into the market.

Countries with smaller quantities of reserves are often considered more vulnerable to attacks and volatility; and countries with large quantities of reserves can command more respect and caution from the market, facing fewer attacks and less volatility. Countries are recommended by international lending authorities to maintain reserves on hand equivalent to at least three months of their imports, or 100% of short-term debt, to guarantee payment of overseas obligations during possible balance of payments shortfalls.^[6]

Other Important Indicators For Forecasting Currency Movements

Inflation

Inflation is technically defined as an increase in the price of goods and services in an economy. High domestic inflation is generally considered to be a factor that prompts a weakening of currency over time against its peers. This is because of the economic principle of purchasing power parity, which states that adjustments in an exchange rate should be equal to the relative international purchasing power of a currency.

Thus, currencies in countries with elevated inflation rates are considered to be good candidates to depreciate. Inflation in most developed economies that are considered "stable" is generally between 1 and 3%.^[7]

Interest Rates

Interest rates are a key policy variable over which countries have some control. They're also generally the indicator that most immediately influences currency trends.

Among the various instruments available in capital markets, investments in government and corporate debt securities, whose returns are determined by interest rates that are set by national monetary authorities, are considered to be safer investments that can attract money from both locally and abroad.

Thus, when central banks raise interest rates, typically they attract incoming foreign money from investors who are seeking higher returns, and this brings pressure for strengthening of the local currency. Conversely, when central banks lower interest rates, money may flow out of their economies and currencies may undergo weakening. Central banks typically adjust their interest rates to curb elevated inflation or to help stimulate economic growth.^[8]
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Government Accounts

Government accounts can have a significant influence on any economy, representing up to 30% or more of a country's total gross domestic product. Because of this, what the government does within its budget often has a significant influence on other economic indicators and ultimately also on its currency.

Within government accounts, traders will want to monitor several items including tax and other revenue collection, whether the government is posting a deficit or surplus, and the amount of public debt that has been accumulated. Two of the main indicators influenced by government accounts are inflation and interest rates.

As the government plays a large part in any economy, inflation can be influenced by the pace of government spending. If the government spends more relative to the pace of spending by other agents in the economy, it can bring pressure for more elevated inflation. Heavy government spending that goes beyond the pace of revenue collection can also elevate a country's debt.

If debt rises to a level that is considered less sustainable, the country may begin to be considered a risky investment by credit ratings agencies. Investors may then demand a higher interest rate in order for them to send money to the country for investment in government and private debt securities. Through either of these channels, then, the management of spending and government accounts can help determine whether a currency strengthens or weakens against other currencies.^[9]

Economic Activity And GDP Growth

While government actions are important, the dynamism of an individual economy is ultimately determined by the productivity of a country's private sector. To track economic activity and what it may mean for currency strength, traders monitor a series of data releases. Growth of a country's GDP is the broadest indicator of the level of economic activity in an economy. A growing economy attracts investment and thus is a sign of potential currency strength. However, the correlation may not always be exact.

The pace of growth can sometimes be most intense when a currency is weak, because a weaker currency helps promote exports and local production. As a result, it may be interesting to pay attention to where a country is on a longer term business cycle. If it has been growing a lot over time, there may be a chance that its economy could soon see a downturn. Similarly, if it has been in a slump and its asset prices are believed to be cheap, it may soon experience an increase in economic activity and growth. GDP data is usually released on a quarterly basis.

Some of the other top indicators related to economic activity include monthly data on industrial production, consumer demand and employment. When these are improving, it's a sign that economic activity is heating and that an economy is likely to be growing and attracting outside investment. Another indicator that is often published by governments is a monthly economic activity index, which serves as a proxy for the GDP and a forecast of a country's quarterly growth report.^[10]

Adding Them Up

There is no magic number for when a currency trend will begin or end, but the preponderant weight of all these factors together can generally show the path a currency will take over the coming period of weeks or months. The data noted above are constantly under review by analysts at large banks and other financial institutions that can enter the market—and influence trends—by buying or selling a particular currency in accordance with their understanding of what the data means for that currency's strength.

Conditions Can Change

It is important for traders to recognise that overall economic conditions can change on a day-to-day or week-to-week basis, and that currency trends will respond to these changes almost immediately. Because of this, it can be useful for traders to use a combination of both fundamental analysis of indicators and technical analysis of market trends.

Intangibles

There are often other factors outside of pure economic indicators that can weigh on the future prospects for a currency. Generally, these are factors that will sooner or later have an impact on economic indicators, such as domestic political events, foreign conflicts, civil unrest, trade disputes, supply shortages, global growth and the global interest rate environment.^[11]

Summary

There are a number of factors that go into analysis of the fundamental health of economies and the implications for currency movements. However, once traders are aware of what these factors are, they can begin to monitor them in order to compile the relevant data and draw conclusions about where a currency may be moving next against its peers.

While pure technical analysis may be used for identifying short-term trends, traders will benefit from an awareness of the factors involved in fundamental analysis to understand market psychology and the real-world motivations behind longer-term currency movements.

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