■ Fundamental Analysis

Fundamental analysis focuses on the economic, social, and political forces that drive supply and demand. Those using fundamental analysis as a trading tool look at various macroeconomic indicators such as growth rates, interest rates, inflation, and unemployment. Fundamental analysts will combine all of this information to assess current and future performance. This requires a lot of work and thorough analysis, as there is no single set of beliefs that guides fundamental analysis. Traders employing fundamental analysis need to continually keep abreast of news and announcements, as they can indicate potential changes to the economic, social, and political environment. All traders should be aware of the broad economic conditions before placing trades.

1. 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, on the other hand, indicates that capital is leaving the economy at a more rapid rate than it is entering, and hence, it 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.
2. Capital Flows – 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. There are generally two types of capital flows—physical flows and portfolio flows (which are further segmented into equity markets and fixed-income markets)
3. Physical Flows – Physical flows encompass actual foreign direct investments by corporations such as investments in real estate, manufacturing, and local acquisitions. All of these require that a foreign corporation sell its local currency and buy the foreign currency, which leads to movements in the FX market. This is particularly important for global mergers and corporate acquisitions that involve more cash than stock. Physical flows are important to watch, as they represent the underlying changes in actual physical investment activity. These flows shift in response to changes in each country’s financial health and growth opportunities. Changes in local laws that encourage foreign investment also serve to promote physical flows.
4. Portfolio Flows in 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 location. 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 equity markets could prompt domestic investors to sell their shares of local publicly traded firms to take advantage of investment opportunities abroad.
5. Portfolio Flows in Fixed-Income Markets – Just as the equity market is correlated to exchange 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.