Fundamental Analysis

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What is Fundamental Analysis?

Fundamental Analysis is the study of the economic and political forces that determine currency exchange rates. An exchange rate is the price of one currency in terms of another currency. Like any other price, it’s set by supply and demand. By forecasting how these forces will change and develop over the medium term, we hope to forecast how exchange rates will move.

Supply & Demand

Example 1:

Imagine we all want the new BMW model, but it’s a limited edition. Only 500 have been made globally.

– Is the price of that car likely to be high or low?

– The price of that car is likely to be very high, because lots of people will be chasing after a limited amount of cars.

– But what happens to the price if BMW suddenly announces they will produce another 50,000 of the specific model?

– Its price will probably decline, as more cars are available to people.

Example 2:

A farmer in a small village produces potatoes. He is the only one producing potatoes there and the village is relatively isolated from civilization. In 2016, the weather was excellent. He managed to produce 1000kg, more than enough to feed the whole village. He sold every kilo of potatoes for 1 euro in that year. However, in 2017 the weather was rather bad. He only produced 200kg.

– What is likely to happen to the price of every kilo?

– Prices will probably go up. Everyone will want potatoes to eat, but there may not be enough of them to go around. So each person would be willing to pay a higher price for potatoes.

Example 3:

Apple has just released its brand new iPhone.

What will probably happen to the price of the previous model?

– Most likely, it will go down.

– Is that price change going to be due to supply or demand factors?

– Demand factors. Apple’s cost of making an iPhone 6 did not change dramatically overnight. But the fact that people now want the iPhone 7 suggests there is less demand for the previous version.

Factors that affect exchange rates

Growth Rates

Countries that grow faster are often good places to invest.

– More opportunities for expansion
– Rising incomes create demand

Overseas companies want to set up operations in these countries.

Buying companies, building factories, setting up stores.

Foreign investors want to buy stocks of companies operating in these countries.

These factors (normally) boost demand for the currency and cause it to appreciate.

Trade Balance

Trade balance = Exports – Imports

It is the amount a country receives for the export of goods and services minus the amount it pays for its import of goods and services.

Broadly speaking, countries that run persistent trade surpluses tend to have strong currencies.

Conversely, nations with consistent trade deficits tend to have weaker currencies.

Why? If Japan exports more goods to the US, than the US exports to Japan, then the demand for Japanese yens from the US increases, and therefore the yen may strengthen against the dollar (USD/JPY down).

Natural Resources

Countries with natural resources earn foreign exchange by exporting them.
When the price of the natural resource that they export goes up, the value of their exports goes up and their currency may appreciate.

When the price of the resource they export goes down, the currency depreciates.

Examples: Canadian dollar & oil, Australian dollar & iron ore, New Zealand dollar & dairy products.

Monetary & Fiscal Policies

Besides all the aforementioned factors, changes in a nation’s monetary and fiscal policies can have a significant impact on the economy and thereby, exchange rates.

Monetary Policy

Actions taken by a country’s monetary authority (usually central bank)

Fiscal Policy

Actions taken by a country’s government to affect the economy (usually to improve unemployment rates and boost economic growth).