Forecasting Forex Currencies  -The Fundamental Approach

 

There are two main approaches in order to forecast the future exchange rate of any currency pair: The Fundamental Approach which is based on hard economic data and the Technical Approach which is based on technical analysis and price statistics.

 

In this article, we are going to analyze how Forex Traders can forecast the future exchange rate of any currency pair based on hard economic evidence (Fundamental Approach). Fundamental analysis includes factors such as the Monetary Policy, Fiscal Policy, Growth, Inflation, Unemployment, Political Conditions, etc.

The Fundamental Analysis aims to analyze the Long-Term Cause of the Currency Movements while the Technical Analysis aims to analyze the Short-Term Effect.

 

Understanding the Basic Currency Market Mechanisms

 

The exchange rate of any currency pair is determined by a great number of fundamental and non-fundamental factors that are changing dynamically. Generally speaking, the global currency rates fluctuate based on certain fundamental conditions and especially as concerns growth, inflation, interest rates, and political stability.

Forex exchange rates basically reflect:

(i) growth variations between two economies

(ii) inflation variations between the two economies

(iii) interest rate variations between two economies

(iv) general political conditions (stability) between the two economies

 

 

Along with these basic factors, there are a lot of other economic and strategic factors influencing the Forex exchange rates. Note that the impact of important news releases is instantly incorporated in any exchange rate. 

 

Monetary and Fiscal Policies

 

Any changes regarding the monetary and fiscal policy imposed by the Central Government can have a dramatic impact on the level of Forex exchange rates.

Monetary Policy Decisions

The Monetary Policy is applied by the Central Bank. Almost all monetary decisions are based on three economic variables:

(i) The actual and desired level of Growth,

(ii) The actual and desired level of Inflation

(iii) The actual and desired level of Unemployment

The Role of Interest Rates

The level of the domestic Interest Rates is applied by the Central Bank and it works as a balance between Growth, Inflation, and Unemployment. Modifying the level of Interest Rates has a strong impact on the demand and the supply of the domestic currency. Higher Interest Rates attract more Foreign Investors so the Domestic Currency is appreciated against other currencies, and vice versa. There are three main Central Bank’s Policies as described below.

Fiscal Policy Decisions / Taxation

The Fiscal Policy imposed by the domestic government can have also a significant impact on the exchange rate of the domestic currency. Higher taxation means slower economic growth while lower taxation means higher economic growth. Therefore, as taxation affects directly the growth opportunities of any economy it affects the domestic currency rate as well.

Three (3) Major Monetary Policies imposed by Central Banks

 

There are three main monetary policies imposed by Central Banks

(i) Flexible-Currency Monetary Policy

Mission: Central Bank aims to achieve higher Growth and Lower Unemployment

Interest Rates: The level of interest rates usually decreases

Effect: The exchange rate of the domestic currency will depreciate against other currencies in the future

(ii) Hard-Currency Monetary Policy

Mission: Central Bank aims to achieve Economic Stability and Lower Inflation.

Interest Rates: The level of interest rates usually increases

Effect: The exchange rate of the domestic currency will appreciate against other currencies in the future

(iii) Balanced Monetary Policy

Mission: Central Bank aims to achieve a balance between Growth and Inflation

Interest Rates: The interest rates remain unchanged (or minor changes)

Effect: The effect in the domestic currency will be neutral in general

 

Forecasting the Exchange Rates based on what Central Banks are Aiming to Achieve

 

A simple and very effective way to forecast the future exchange rate of two currencies is by analyzing what the two involved Central Banks are trying to achieve in the following months or years. For example, take the Bank of Japan during December 2013. BOJ made it clear back then that it is aiming a flexible Japanese Yen monetary policy. ECB and FED on the other hand imposed a more conservative monetary policy regarding Euro and US Dollar. This was the perfect signal for long-term Forex traders in order to sell the Japanese Yen against the US Dollar and the Euro. Indeed in 2014, the Japanese Yen was strongly devalued against USD and Euro.

Trading Tip: Give extra weight to the comments of Central Bank Executives during monetary policy meetings. When they say something they say it for a good reason.

Forecasting the Exchange Rates using Economic Models

There are a lot of Economic Models aiming to forecast the fair valuation of a Forex Pair based on the fundamental conditions of the two economies involved. Actually, any fundamental change is incorporated instantly in the exchange rate of any Forex pair, therefore, these models tend to follow the market and not exactly forecasting it. Let’s see two popular Fundamental Analysis Forecasting Methods, the PPP Theory, and the Relative Economic Strength Approach. 

 

Two (2) Fundamental Methods for Forecasting Forex Currency Changes

 

Here are two basic methods for forecasting Forex currency rates based on Fundamental Analysis:

(1) Purchasing Power Parity (PPP)

According to the Purchasing Power Parity, identical goods/services in different economies must share identical prices. This is called as the “Law of One Price”. This price should be calculated after we deduct shipping and similar costs. The Big Mac Index is maybe the most popular application of PPP theory.

► Big Mac index from The Economist

In other words and according to that theory the exchange rate between two economies must reflect the level of changing prices (inflation). Therefore if inflation in Eurozone is 2% and inflation in Japan is 1% the exchange rate of these two economies (EURJPY) must devaluate 1% yearly in order for goods and services in both economies to maintain the same prices (Law of One Price).

(2) Relative Economic Strength Approach

The Relative Economic Strength Approach aims to measure the economic strength of two different economies in order to determine the fair exchange rate between their currencies.

This method uses mainly the difference in economic growth. According to the Relative Strength Approach a strong economy attracts more investors from foreign countries (Foreign Investment).  These investments create capital inflows from abroad and have a positive impact on the domestic currency against the currencies of economies with lower rates of growth.

 

 

The Political Factor

Trading the Global Markets without taking into account the Political Factor is the shortest way to lose your funds. The Political Factor is far more important than any Economic Factor. Dramatic changes regarding the political stability of any economy can have devastating effects on the exchange rate of the domestic currency. Furthermore, Political Risk is associated with the overall Systemic Risk of an economy and that means that political instability makes currency investors wanting to sell the domestic currency at any price. Fundamentalists keep always a close eye on the political conditions of any economy and make also political forecasts of at least 1 year ahead. An easy way to get information about the political conditions of any state is the World-Factbook site of the US Central Intelligence Agency.

 

Concentration on a Limited Number of Forex Pairs is more Effective

In order to be able to keep up with all news and fundamental updates, it is better to concentrate on a small number of Forex currencies. In this way, you can concentrate all your efforts on learning and understanding the unique characteristics of each currency pair. Each Forex pair is unique because it is reacting differently to fundamental changes and updates. Usually, fundamental traders select to trade the majors (EURUSD, USDJPY, USDCHF, and GBPUSD) as these pairs offer almost perfect information.

 

◙ George Protonotarios, November, 9th, 2014 {Forecasting Forex Currencies  -The Fundamental Approach}

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