38 DAY TRADING AND SWING TRADING THE CURRENCY MARKET
FUNDAMENTAL ANALYSIS
Fundamental analysis focuses on the economic, social, and political forces
that drive supply and demand. Those using fundamental analysis as a trad-
ing tool look at various macroeconomic indicators such as growth rates,
interest rates, inflation, and unemployment. We list the most important eco-
nomic releases in Chapter 12 as well as the most market-moving pieces of
data for the U.S. dollar in Chapter 4. Fundamental analysts will combine
all of this information to assess current and future performance. This re-
quires a great deal of work and thorough analysis, as there is no single set
of beliefs that guides fundamental analysis. Traders employing fundamen-
tal analysis need to continually keep abreast of news and announcements
that can indicate potential changes to the economic, social, and political
environment. All traders should have some awareness of the broad eco-
nomic conditions before placing trades. This is especially important for day
traders who are trying to make trading decisions based on news events be-
cause even though Federal Reserve monetary policy decisions are always
important, if the rate move is already completely priced into the market,
then the actual reaction in the EUR/USD, say, could be nominal.
Taking a step back, currency prices move primarily based on supply
and demand. That is, on the most fundamental level, a currency rallies be-
cause there is demand for that currency. Regardless of whether the de-
mand is for hedging, speculative, or conversion purposes, true movements
are based on the need for the currency. Currency values decrease when
there is excess supply. Supply and demand should be the real determinants
for predicting future movements. However, how to predict supply and de-
mand is not as simple as many would think. There are many factors that
contribute to the net supply and demand for a currency, such as capital
flows, trade flows, speculative needs, and hedging needs.
For example, the U.S. dollar was very strong (against the euro) from
1999 to the end of 2001, a situation primarily driven by the U.S. Internet
and equity market boom and the desire for foreign investors to participate
in these elevated returns. This demand for U.S. assets required foreign in-
vestors to sell their local currencies and purchase U.S. dollars. Since the
end of 2001, when geopolitical uncertainty rose, the United States started
cutting interest rates and foreign investors began to sell U.S. assets in
search of higher yields elsewhere. This required foreign investors to sell
U.S. dollars, increasing supply and lowering the dollar’s value against other
major currencies. The availability of funding or interest in buying a cur-
rency is a major factor that can impact the direction that a currency trades.
It has been a primary determinant for the U.S. dollar between 2002 and
2005. Foreign official purchases of U.S. assets (also known as the Treasury
What Moves the Currency Market in the Long Term? 39
international capital flow or TIC data) have become one of the most impor-
tant economic indicators anticipated by the markets.
Capital and Trade Flows
Capital flows and trade flows constitute a country’s balance of payments,
which quantifies the amount of demand for a currency over a given period
of time. Theoretically, a balance of payments equal to zero is required for a
currency to maintain its current valuation. A negative balance of payments
number indicates that capital is leaving the economy at a more rapid rate
than it is entering, and hence theoretically the currency should fall in value.
This is particularly important in current conditions (at the time of
this book’s publication) where the United States is running a consistently
large trade deficit without sufficient foreign inflow to fund that deficit. The
Japanese yen is another good example. As one of the world’s largest ex-
porters, Japan runs a very high trade surplus. Therefore, despite a zero
interest rate policy that prevents capital flows from increasing, the yen has
a natural tendency to trade higher based on trade flows, which is the other
side of the equation. To be more specific, here is a detailed explanation of
what capital and trade flows encompass.
Capital Flows: Measuring Currency Bought
and Sold
Capital flows measure the net amount of a currency that is being purchased
or sold due to capital investments. A positive capital flow balance implies
that foreign inflows of physical or portfolio investments into a country
exceed outflows. A negative capital flow balance indicates that there are
more physical or portfolio investments bought by domestic investors than
foreign investors. Let’s look at these two types of capital flows—physical
flows and portfolio flows.
Physical Flows Physical flows encompass actual foreign direct invest-
ments by corporations such as investments in real estate, manufacturing,
and local acquisitions. All of these require that a foreign corporation sell
the local currency and buy the foreign currency, which leads to movements
in the FX market. This is particularly important for global corporate acqui-
sitions that involve more cash than stock.
Physical flows are important to watch, as they represent the under-
lying changes in actual physical investment activity. These flows shift in
response to changes in each country’s financial health and growth opportu-
nities. Changes in local laws that encourage foreign investment also serve
to promote physical flows. For example, due to China’s entry into the World
40 DAY TRADING AND SWING TRADING THE CURRENCY MARKET
Trade Organization (WTO), its foreign investment laws have been relaxed.
As a result of its cheap labor and attractive revenue opportunities (popu-
lation of over 1 billion), corporations globally have flooded China with in-
vestments. From an FX perspective, in order to fund investments in China,
foreign corporations need to sell their local currency and buy Chinese ren-
minbi (RMB).
Portfolio Flows Portfolio flows involve measuring capital inflows and
outflows in equity markets and fixed income markets.
Equity Markets As technology has enabled greater ease with respect
to transportation of capital, investing in global equity markets has become
far more feasible. Accordingly, a rallying stock market in any part of the
world serves as an ideal opportunity for all, regardless of geographic loca-
tion. The result of this has become a strong correlation between a country’s
equity markets and its currency: if the equity market is rising, investment
dollars generally come in to seize the opportunity. Alternatively, falling eq-
uity markets could prompt domestic investors to sell their shares of local
publicly traded firms to capture investment opportunities abroad.
The attraction of equity markets compared to fixed income markets
has increased across the years. Since the early 1990s, the ratio of foreign
transactions in U.S. government bonds over U.S. equities has declined from
10 to 1 to 2 to 1. As indicated in Figure 3.1, it is evident that the Dow Jones
Industrial Average had a high correlation (of approximately 81 percent)
Dow Jones Industrial Average and USD/EUR
12500 1.15
11500 1.10
1.05
10500
1.00
9500
0.95
8500
0.90
7500
0.85
6500
0.80
5500
0.75
4500 0.70
INDU Index Px Last USD/EUR Currency
3500 0.65
1/31/94 6/30/94 11/30/94 4/28/95 9/29/95 2/29/96 7/31/96 12/31/96 5/30/97 10/31/97 3/31/98 8/31/98 1/29/99 6/30/99 11/30/99
FIGURE 3.1 Dow Jones Industrial Average and USD/EUR
What Moves the Currency Market in the Long Term? 41
with the U.S. dollar (against the deutsche mark) between 1994 and 1999.
In addition, from 1991 to 1999 the Dow increased 300 percent, while
the U.S. dollar index appreciated nearly 30 percent for the same time
period. As a result, currency traders closely followed the global equity
markets in an effort to predict short-term and intermediate-term equity-
based capital flows. However, this relationship has shifted since the tech
bubble burst in the United States, as foreign investors remained relatively
risk-averse, causing a lower correlation between the performance of the
U.S. equity market and the U.S. dollar. Nevertheless, a relationship does
still exist, making it important for all traders to keep an eye on global
market performances in search of intermarket opportunities.
Fixed Income Markets Just as the equity market is correlated to ex-
change rate movement, so too is the fixed income market. In times of global
uncertainty, fixed income investments can become particularly appealing,
due to the inherent safety they possess. As a result, economies boasting
the most valuable fixed income opportunities will be capable of attracting
foreign investment—which will naturally first require the purchasing of the
country’s respective currency.
A good gauge of fixed income capital flows are the short- and long-
term yields of international government bonds. It is useful to monitor the
spread differentials between the yield on the 10-year U.S. Treasury note
and the yields on foreign bonds. The reason is that international investors
tend to place their funds in countries with the highest-yielding assets. If
U.S. assets have one of the highest yields, this would encourage more in-
vestments in U.S. financial instruments, hence benefiting the U.S. dollar.
Investors can also use short-term yields such as the spreads on two-year
government notes to gauge short-term flow of international funds. Aside
from government bond yields, federal funds futures can also be used to es-
timate movement of U.S. funds, as they price in the expectation of future
Fed interest rate policy. Euribor futures, or futures on the Euro Interbank
Offered Rate, are a barometer for the euro region’s expected future interest
rates and can give an indication of euro region future policy movements.
We cover using fixed income products to trade FX further in Chapter 10.
Trade Flows: Measuring Exports versus Imports
Trade flows are the basis of all international transactions. Just as the in-
vestment environment of a given economy is a prime determinant of its
currency valuation, trade flows represent a country’s net trade balance.
Countries that are net exporters—meaning they export more to interna-
tional clients than they import from international producers—will experi-
ence a net trade surplus. Countries that are net exporters are more likely
42 DAY TRADING AND SWING TRADING THE CURRENCY MARKET
to have their currency rise in value, since from the perspective of interna-
tional trade, their currency is being bought more than it is sold: interna-
tional clients interested in buying the exported product/service must first
buy the appropriate currency, thus creating demand for the currency of the
exporter.
Countries that are net importers—meaning they make more interna-
tional purchases than international sales—experience what is known as a
trade deficit, which in turn has the potential to drive the value of the cur-
rency down. In order to engage in international purchases, importers must
sell their currency to purchase that of the retailer of the good or service; ac-
cordingly, on a large scale this could have the effect of driving the currency
down. This concept is important because it is a primary reason why many
economists say that the dollar needs to continue to fall over the next few
years to stop the United States from repeatedly hitting record high trade
deficits.
To clarify this further, suppose, for example, that the U.K. economy is
booming, and that its stock market is rallying as well. Meanwhile, in the
United States, a lackluster economy is creating a shortage of investment
opportunities. In such a scenario, the natural result would be for U.S. resi-
dents to sell their dollars and buy British pounds to take advantage of the
rallying U.K. economy. This would result in capital outflow from the United
States and capital inflow for the United Kingdom. From an exchange rate
perspective, this would induce a fall in the USD coupled with a rise in the
GBP as demand for USD declines and demand for GBP increases; in other
words, the GBP/USD would rise.
For day and swing traders, a tip for keeping on top of the broader eco-
nomic picture is to figure out how economic data for a particular country
stacks up.
Trading Tip: Charting Economic Surprises
A good tip for traders is to stack up economic data surprises against price
action to help explain and forecast the future movement in currencies.
Figure 3.2 presents a sample of what can be done. The bar graph shows
the percentages of surprise that economic indicators have compared to
consensus forecasts, while the dark line traces price action for the period
during which the data was released; the white line is a simple price regres-
sion line. This charting can be done for all of the major currency pairs,
providing a visual guide to understanding whether price action has been in
line with economic fundamentals and helping to forecast future price ac-
tion. This data is provided on a monthly basis on www.dailyfx.com, listed
under Charting Economic Fundamentals.
What Moves the Currency Market in the Long Term? 43
FIGURE 3.2 Charting Economic Surprises
According to the chart in Figure 3.2, in November 2004, there were 12
out of 15 positive economic surprises and yet the dollar sold off against the
euro during the month of December, which was the month during which
the economic data was released. Although this methodology is inexact, the
analysis is simple and past charts have yielded some extremely useful clues
to future price action. Figure 3.3 shows how the EUR/USD moved in the fol-
lowing month. As you can see, the EUR/USD quickly corrected itself during
the month of January, indicating that the fundamental divergence of price
action that occurred in December proved to be quite useful to dollar longs,
who harvested almost 600 pips as the euro quickly retracted a large part of
its gains in January. This method of analysis, called “variant perception,”
was invented by the legendary hedge fund manager Michael Steinhardt,
who produced 24 percent average rates of return for 30 consecutive years.
While these charts rarely offer such clear-cut signals, their analytical
value may also lie in spotting and interpreting the outlier data. Very large
positive and negative surprises of particular economic statistics can often
yield clues to future price action. If you go back and look at the EUR/USD
charts, you will see that the dollar plunged between October and Decem-
ber. This was triggered by a widening of the current account deficit to a
44 DAY TRADING AND SWING TRADING THE CURRENCY MARKET
FIGURE 3.3 EUR/USD Chart
(Source: www.eSignal.com)
record high in October 2004. Economic fundamentals matter perhaps more
in the foreign exchange market than in any other market, and charts such
as these could provide valuable clues to price direction. Generally, the
15 most important economic indicators are chosen for each region and
then a price regression line is superimposed over the past 20 days of
price data.
TECHNICAL ANALYSIS
Prior to the mid-1980s, the FX market was primarily dominated by funda-
mental traders. However, with the rising popularity of technical analysis
and the advent of new technologies, the influence of technical trading on
the FX market has increased significantly. The availability of high lever-
age has led to an increased number of momentum or model funds, which
have become important participants in the FX market with the ability to
influence currency prices.
Technical analysis focuses on the study of price movements. Techni-
cal analysts use historical currency data to forecast the direction of future
prices. The premise of technical analysis is that all current market informa-
tion is already reflected in the price of each currency; therefore, studying
