Forex is mainly used with graphic analysis (chart patterns), but some users trade with fundamental analysis. It means their investment scales is longer cause fundamental repercutions take time to be involve in prices (Some are already included in prices).
The goal of fundamental analysis is to evaluate with accurancy the theoretical value of one currency against another based on economic conditions within the countries concerned. In the short term, the fundamental analyst will therefore consider the various economic indicators, but not only. It also take into account the quality of management, government policy, the measures implemented or planned and the structure of its economic activity (Components of supply and demand for products and services). Once the analysis is complete, the analyst will tell if the currency in question is undervalued or overvalued against another currency.
Here below are the main elements for the evaluation of a currency. You will find a presentation of all ecnonomic indicators here: Learn about economic indicators
Gross Domestic Product (GDP)
GDP is the sum of value added by all firms located on the national territory. They may be French or foreigners. This is not to be confused with the GNP. GDP adds all production activities of the territory. Although GDP was calculated from this definition, some production would be counted twice. Indeed, many products are produced from intermediate products. A computer for example, requires the transformation of a multitude of informatics components to achieve the final product, the computer. GDP takes into account only the production of finished goods and intermediate products are excluded. The actual level of activity on the territory is therefore not distorted. GDP is one of the benchmarks for a country. It is often expressed as a percentage change compared to the GDP of the previous year. Easy comparisons can be made between different countries. But beware, compare countries with similar levels of development. It cannot compare for example China with a GDP growth of about 10% and France with a GDP of 2%. We speak of economic growth. Indeed, China is a developing country while France is a country already developed. It cannot achieve a similar level of development.
GDP is also used by states to build their budget, the budget is prepared on the basis of GDP growth forecast. You can also get reference points. The member countries of the European Union for example are limited to a budget deficit of 3% of GDP.
In practice:
– If the GDP produced by a country is higher than the previous year, there is creation of wealth and the country’s currency will appreciate. The effect is positive.
– If the GDP produced by a country is lower than the previous year, there is destruction of wealth and the country’s currency will depreciate. The effect is therefore negative.
Inflation
Inflation is the general price increase and therefore lead to the depreciation of the currency. The currency depreciation is the fact that a currency to lose value relative to goods and services it provides. It is necessary to have more money to acquire the same good or service. That means a loss of purchasing power. This phenomenon is a consequence of inflation. Indeed, inflation is due to strong money creation which makes losing value to the currency. This happens when the country is in a growing stage, interest rates are low, allowing a significant injection of currency into the economy. The currency depreciation is due to the increase in the number of units outstanding. However, inflation is normally offset by higher wages, which has offset the loss of purchasing power due to the currency depreciation. Finally, it is important to distinguish internal depreciation, due to inflation within the country and the external devaluation which is due to the below par rating of the currency against other currencies. This reflects a loss of confidence of foreign investors for national currency. It is the policy of the countries that enter into consideration. The country may want such a weak currency to boost exports.
In practice:
– When inflation is too high, the purchasing power of the country in question depreciates in the long term.
– On the CT, inflation or rather what provoke it has several effects. If the rate of a country declines, the price of the currency in question will drop too. In contrast, if the rate rises, the price will rise. This is a simple way explanation, if interest rates rise, it is to fight against inflation and is therefore it is viewed positively by the market.
– Inflation is measured by the index of consumer prices (CPI). Its publication has a significant impact on the various parities of the currency concerned.
Deflation
Deflation is an economic period during which there is a price decrease. Therefore, there is an increase of the purchasing power. However, this decline must not be punctual, but you must have a real downward trend in prices to get in deflation. Deflation is now a very rare phenomenon. Even if we are in an economic slowdown, deflation does not often appear. This requires a strong policy commitment to put a country into deflation, as in France in the 20’s. This scenario is very rare. Indeed, governments and companies are constantly under pressure from employees to see their wages increase. However, wage growth creates inflation as there is more money in circulation. In case of growth, lower prices are impossible. Central banks like the European Central Bank, have priority anyway for the fight against inflation. They seek to control inflation but did not attempt to stop it. Inflation, if it is not excessive is considered as an element of growth. However, if the economy goes bad, there is what is called disinflation, that is to say a decrease in inflation rate and so a slowdown in inflation. The general price level increases more slowly. This is done naturally, but over a period which can sometimes be lengthy. For a deflation to take place, it would require that companies decrease their selling prices. The problem is that they cannot reduce costs as rapidly as the decrease of the activity takes place. This decrease in activity is due to the low consumption. But in order that the company adapts to the decrease of activity, it takes time. It must review its production chain, reduce rates, find new suppliers, cheaper one or renegotiate certain contracts. All these factors mean that the process is long. Today, this scenario cannot be excluded. Indeed, there with the current crisis a decrease in prices on certain products. This is particularly true in the car’s sector. However, this is not the case for all products and at the moment it only lead to disinflation. Deflation is therefore difficult to achieve because more governments are not necessarily ready to accept that there is deflation. They also try to revive the business by various means, such as lower interest rates for example. But, a crisis could eventually lead to deflation like it was the case in Japan in 1998.
In practice:
– The deflation can only occur in conjunction with very low interest rates, it will have a negative effect on the currency on the CT. The currency will indeed undergo the phenomenon of carry trades, as investors will borrow money, that is to say to sell it to buy another one more profitable.
– On the LT, the currency will normally appreciate because her purchasing power parity is greater. The currency with the lowest interest rate should normally appreciate on the LT.