Forex Fundamental Trading Strategies

Forex fundamental trading strategies use fundamental analysis for swing and position trading. The best approach is to use combination of fundamental and technical analysis. Some of the popular forex fundamental trading strategies are:

Carry Trading
As a forex trader, you should be aware of the role played by the interest rate changes in the general economic and investment climate. You should know that interest rates are an essential part of investment decisions and can drive currency markets as well as the stock and commodities markets in either direction. After the unemployment figures, Federal Open Market Committee (FOMC) rate decisions are the second largest currency market moving release.

The impact of the interest rate changes not only have short term consequences but also have long term impact on the currency markets. One Central Banks decision can affect more than a single currency pair in the interconnected forex markets.

In forex trading, an interest rate differential is the difference between the base currency and the counter currency interest rate. In the pair, EUR/USD, Euro is the base currency and US Dollar is the counter currency. The interest rate differential for the EUR/USD currency pair will be the difference between the Euro and the US Dollar interest rate.

Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable for you when you trade forex. In addition to FEDs overnight fund rate decisions, expected future overnight rates as well the expected timing for the interest rate changes can be crucial to the currency pair movements.

The reason why it is profitable is that international investors like hedge funds, big banks and institutional investors are yield seekers. They actively keep on shifting funds from the low yield assets to high yield assets.

Interest rate differentials are considered to be the leading indicators for currencies. London Inter Bank Offer Rate (LIBOR) and the 10 year government bond yields are usually used as leading indicators of currency appreciation or depreciation. 

Lets use an example to make it clear. Suppose the Australian 10 year government bond yield is 5.25%. The US 10 year government bond yield is 1.75%. The yield spread between AUD and USD would be 350 basis points in favor of the AUD. 

Suppose the Australian government raised its interest rate by 25 basis points. The Australian 10-year government bond yield would also appreciate to 5.50%. Now, the new yield spread is 375 basis points in favor of the Australian Dollar (AUD). The AUD will also be expected to appreciate against USD overtime.

The general rule of thumb used is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currency in the currency pair. This is important information for you as a trader in telling you before hand about the change in currency price. Up to date interest rate data is available on Bloomberg. Keep track of the currencies in the pairs that you trade with that data.

With that said, in forex markets, carry trading is an easy way to take benefit of the basic economic principle that money is constantly flowing in and out of different markets. Markets with a high rate of return will generally attract more capital.

Carry trading is one of the fundamental trading strategies employed by professional forex traders. Leveraged carry trading is one of the favorite strategies employed by hedge fund and investment banks. You as a forex trader can also benefit from carry trading.

What is a carry trade? In nutshell, carry trading means taking advantage of interest rate difference between two currencies in a currency pair. Investors take benefit of the interest rate differential between two currencies by going long/buying the high interest rate currency and going short/selling the low interest rate currency.

Lets use a simple example to make it clearer: lets assume, New Zealand dollar is offering an interest rate of 4.75% whereas the Japanese yen is offering an interest rate of 0.25%. 

In order to carry trade, an investor buys New Zealand dollars (NZD) and sells Japanese Yens (JPY). As long as the exchange rate between the NZD and JPY does not change, the investor will earn a profit of 4.75-0.25=4.5%. Using a leverage of 5:1, this 4.5% return will be leveraged into 22.5%.

If the currency pair NZD/JPY appreciates, the investor can get a capital gain as well as a yield on the investment. When there is a carry trade opportunity, many investors jump on the bandwagon. The more investors carry trade, the more the currency pair appreciates.

However, carry trading depends a lot on the mood of the investors as a group. When investors have low risk aversion, carry trades will be profitable. But suppose the investors as a group suddenly develop high risk aversion and run to take refuge in safe haven currencies. In this scenario, carry trading will become unprofitable. 

However, if the low interest currency appreciates to some extent for different reasons, carry trade will become unprofitable. In such a scenario, the more the low interest currency appreciates, the more unprofitable carry trading that currency pair will become.

So it essential when you determine a currency pair for carry trading, you also identify the current trend of the currency pair to see whether it is moving in the right direction. 

You can use the MACD (moving average convergence divergence) indicator to identify the trend.

Keeping On Top of Global Macroeconomic Events
As a forex trader you should use a combination of trading strategies in developing your forex system. This will hedge your risk and maximize return. Short term forex traders and day traders try to focus only the economic news release of the week and how it will impact their day trading. This works well for many traders. Learn forex nitty gritty, a method based on only 20 minutes trading a day.

You should not lose sight of the big macroeconomic events that may be brewing in the economy or for that matter in world. Large scale macroeconomic events have the potential and ability of moving the currency markets big time for many months or even years.

The impact of big macroeconomic events has the ability and potential to change the fundamental perception about a currency not only for a few days but for a long time. Events such as natural disaster, political uncertainty, wars and international meetings have widespread physical and psychological impact on forex markets.

Therefore, by keeping on top of the global developments, understanding the underlying market sentiments before and after these global events and trying to anticipate them could be very profitable for you. At least it can help prevent significant losses in your currency trading.

You may ask what type of big events affects the currency markets in the long term. Important world summits, major central bank meetings, potential changes to the currency regimes, possible default by large countries, G-8 Finance Minister meetings, Presidential and Parliamentary elections in big countries, possible wars, FED Chairman semiannual testimony to the Congress. These are only a few examples of big events that make the currency markets jittery and may have a long term impact.

Let's illustrate it with an example, 2004 and 2008 US Presidential elections were hotly contested. Different candidates had opposing stances on the growing budget deficit, trade deficit and unemployment. There were differing views on how to deal with the recession engulfing the US economy. This made US Dollar bearish during the election campaigns.

G-8 Finance Ministers meetings also tend to leave a long lasting impact on forex markets. Combined these eight rich countries account for 2/3rd of the world GDP. So whatever decisions that are taken during these G-8 Finance Minister meetings usually leave a short term as well as a long term impact on the global markets for a considerable time.

For example, the US Dollar collapsed after the September 2003, G-8 Finance Minister meeting in which the finance ministers wanted to see more flexibility in the exchange rates of the member countries. This meeting was also important as the US Trade Deficit was ballooning and going out of control at that time. 

EUR/USD pair bore the burnt of dollar depreciation. Japan and China intervened aggressively to stabilize their currencies. US Dollar had already begun to sell off leading up to the meeting. The trend continued for many months after the meeting with the EUR/USD pair. 

In 2005, US dollar moved higher against most major currency pairs. What turned the market around? Some of the events that drove the dollar higher were dictated by monetary policy as the Federal Reserve continued to raise interest rates. Then there were economic, geopolitical, and political developments on the domestic front that influenced the dollar’s value. For starters, the Homeland Investment Act (HIA) was passed. 

The HIA is part of the 2004 American Jobs Creation Act and was intended to entice U.S based multiconglomerate corporations to bring money back into the United States. The window of opportunity for companies to take advantage of the HIA benefits prompted companies to increase the pace at which funds are repatriated to the United States. Since companies had only until the end of 2005, many analysts suspected that companies would rush to repatriate foreign profits by year’s end and that there would then be a high dollar demand to convert foreign currencies. 

Geopolitical issues arose during the summer of 2005 when there were riots in France as a result of less support for the euro currency. That contributed to a very poor market sentiment and a lack of confidence in the euro. This was grounds for foreign investors to make a flight to financial safety, selling their currency to buy U.S. dollars. The tone was essentially dollar positive and euro negative, which is a result of a change in political views and shows how consumer sentiment can have a negative effect on a currency. 

I have said many times on my posts that technical analysis should be your “bread and butter” for profiting in the forex market; but you still need to be aware of fundamental developments, economic reports, and the times when these reports hit the newswires. As you can see, fiscal policy changes can drive markets in new directions. Therefore, the long term impact of these macroeconomic events is much more significant that the short term impact and the event itself have the ability to change the overall market sentiments.