For a trader to be consistently profitable in the Forex market, they require an understanding of technical, fundamental, and sentimental indicators. New traders usually prefer using technical analysis as an approach to gauging the demand and supply of the market, although, using technical analysis in isolation is a flawed approach to tackling the market because sometimes the markets will be moved by fundamental and sentimental forces. Most beginners find it difficult to understand fundamental indicators and how they are priced in the market. Success in trading belongs to those who always seek to stay ahead of the game, and understanding fundamentals give traders just that. This article will be an introduction to understanding basic economic indicators. Indicators that will be explored, are interest rates, GDP, rate of inflation, government budget deficits, and unemployment rates. Changes in these fundamental indicators will affect the market in a big way, especially when the changes are unexpected.
Movements in the currency price will have a direct impact on the real economy. For example, a decline in the price of a currency will course the price of imports to be more expensive, there will be higher inflation and hiking of interest rates which will reduce the economic activity of a country. The Gross domestic product reflects the output of all final goods that have a market value. There are two types of GDP, which are nominal GDP and real GDP. Nominal GDP is expressed at current prices and the real GDP is adjusted for changes in inflation. GDP reports give traders a view into the economic activity at an aggregate level. When an economy is expanding, traders can expect growth in GDP. The GDP won't be constantly increasing, sometimes an economy will experience a recession. A recession is defined as two consecutive quarters of negative GDP, which will result in the Central Bank or government implementing or modifying policies.
If the monetary bodies fail to manage the recession properly, it can lead to depression. Depression is a more severe form of a recession. Interest rates are the rate of compensation agreed to between creditors and debtors. The central banks are responsible for setting interest rates, reserve requirements, and open market operations. Commercial banks play a crucial role in assisting central banks to meet their monetary objectives. The reserve requirement is the percentage of cash held by commercial banks to buffer against withdrawals of depositors, and it's the Central Bank that determines the reserve requirement. When the reserve requirement is high, it will be more costly for people to acquire loans, thereby, reducing consumption. Traders must always know whether interest rates are expected to increase or decrease, and how will the currency of the country be impacted.
Lower rates are usually associated with an expanding economy and a weaker currency, and vice versa. Inflation can be defined as the rise in prices of goods and services in a country or a decrease in the purchasing power of money. Inflation can be calculated in terms of the producer's price index or the consumer's price index. Although, in some cases, market participants are more focused on the core CPI. Core CPI excludes prices of goods and energy, this allows traders to discount factors that might be temporary in their forecasting. Inflation will always have adverse effects on the economy because unexpected inflationary pressures will increase the risk in the market. A budget deficit occurs when the government spends more than it gets from tax revenues. This will result in the government having to borrow funds to finance the deficit. If the supply of funds is inadequate to meet the demand, interest rates might need to go up. Alternatively, the government might borrow funds from the world bank or the international monetary fund to finance the deficit.
The currency of a country is hardly affected by the budget deficit in the near term. When the government is running a budget surplus, it can resort to reducing taxes, which will be seen as supportive of economic activity. When an economy is growing, the currency will be strong. Traders must always know when the budget deficit is expected to contract or expand, and how will the outcome influence the markets. Before trading a currency pair, a trader needs to know whether they are trading a fixed or floating currency pair. A fixed exchange rate is set at the fixed rate. For example, the Namibian dollar can be fixed to the price of the South African Rand. The price of a floating exchange rate is determined by the supply and demand model. Trade plays a crucial role in the demand and supply of a currency. For example, when Argentina purchases goods from Congo, they will be required to sell their domestic currency and buy the currency of Congo. This will result in higher demand for the currency of Congo.
Any change that alters the number of imports relative to exports will be responsible for the price changes in the pricing of the currency. A country that is having income growth rate that is lower relative to the income of its trading partners will experience higher currency prices. A country that is having an income growth rate that is rapidly growing will experience a weakening of its currency. A country that has higher inflation than that of its trading partner should experience a depreciation of its currency and a country that has low inflation than that of its trading partner will result in an appreciation of its currency.
If a trader wants to trade the Interest rates report, they would have to know which percentage of interest rates is already priced into the markets. Some traders will attempt to trade the statement release of a central bank meeting. For that, having a strong understanding of what is priced in markets is important. An understanding of the best, or most sensitive market to trade in is very advantageous. For example, I would often see USD/GBP as the cleanest play on the FOMC statement release, as it’s the most correlated to short-term interest rate changes. Professional traders tend to wait for the market to calm down before executing trades.