Inflation is a sustained increase in the amount of currency in circulation – which in turn increases the price of goods and services. With this in mind, inflation is one of the most important of all Forex fundamental indicators, as it demonstrates how healthy an economy is. It is important to understand that even through the power of central banks, governments can’t really control inflation.

The level of ‘healthy’ inflation’ is defined by each state according to the needs of their economy. Developed economies set their aim at around 2%, while developing economies can go up to 7% without causing any panic among investors. Depending on whether the actual inflation rate is above or below the set target, the country can be in a state of hyperinflation – whereby too much money has been introduced into circulation, or negative inflation – which means that there is too little in circulation.

The state has its own equally damaging ramifications. Any deviation from a set inflation rate can be considered a fundamental indicator. Inflation is difficult to control because there are many sources for money to appear from, and many places that it can disappear. Today, currencies are not backed up by commodity standards, which means that they can be added into circulation by private banks via a fractional reserve system.

Also, because financial assets don’t obey national borders, foreign entities can accumulate and keep large sums of currencies until they see fit, to then discharge them back into the market at a later time. All of this complicates things exponentially for fiscal policy makers. In terms of Forex trading, the higher the rate of inflation, the quicker the currency depreciates, and the less reliable of an asset it is for foreign investors, with both resulting in weakness.

The Interest Rate is the market rate that the buyer (or borrower) has to pay the seller (or lender). Interest rates impact the local currency’s strength against other currencies. Interest rates in each country are determined by its central bank, as part of its monetary policy. The compatibility of interest rates to market conditions helps maintain stability. Central banks raise interest rates in order to decrease inflation if they believe it is too high. In other words, increasing the interest rate will cause inflation to slow down and even stop, which in turn leads to a drop in prices while strengthening the currency! Meaning, it moderates the pace at which the economy grows.

Remember: In a healthy economy the interest rates usually vary between 3% and 5%.

For those who are not quite sure what inflation is – it is growth rate in prices. Inflation is the reason a chocolate bar that cost 5 cents twenty years ago costs 30 times more today. All in all, central banks are interested in market growth, but to control inflation (so it will not go too high), they raise interest from time to time and thereby restrain and control growth.

Inflation higher than 2% is usually not healthy. The same goes for a market with no inflation at all.

Remember: Announcements about interest rates deeply affect currency trading movements. 

Example: In the early 2000s, the interest rate in the U.S. decreased. This move had a huge influence on the US dollar for many years to come, in a process lasting almost a decade (till approximately 2007-2008). Reducing interest rates weakened the dollar against other currencies, thereby changing the face of U.S. real estate throughout the first half of that decade. 

Interest Rate Rises = Lower economic growth + Inflation slows

Interest Rate Cut = Higher economic growth + inflation speeds up

The order of events is supposed to follow the order of the above examples, but it doesn’t always work that way. The purpose of the image above is to simply show how things are supposed to go in a perfect world but we don’t live in a perfect world, and that’s why you must understand the fundamentals.  

The most significant times in a given market are when interest rates are expected to change. If the interest rate has already moved in a certain direction a few times, it must be balanced back. That is what speculators build their trades on. 

Interest Differentials – a trading method based on two currencies’ rates: Many traders choose pairs by comparing the interest rates of two currencies. If the “interest rate differential” (the gap between the two interest rates) gets bigger, it will strengthen the stronger currency of the two (and vice versa). This strategy is called the “Carry Trade Strategy”.

• While one interest rate is supposed to go up and at the same time, the other one will go down, this could cause serious changes in price.

A Central Bank is a state bank whose job it is to manage and run the country’s monetary policy while maintaining the currency’s strength and stability.

The central bank’s monetary policy aims to ensure prices stability and market growth. It also controls inflation, interest, money supply and banks’ reserves.

In solid markets with continuously growing economies, central banks will respond to high inflation by increasing the interest rate. As we have already mentioned, this constant zapping navigates between the need to retain stability and the desire to attract foreign investors. We as traders can respond by trading according to the monetary policy, its targets, and purposes.

Central banks can also print more banknotes in order to expand the supply of the currency. This might change its strength compared to other currencies. It would make the currency weaker because the more currency in the market the cheaper it gets.

Example: During the past few years, Brazil has been a developing market with a fast-growing economy. Commercial banks and corporations from all over the world, and also speculators, commercial firms, and venture capitalists have decided to invest heavily in this track, transferring a high volume of capital into Brazil.

There are several other significant economic events that have a big impact on the Forex market. Imagine that all major economic journals and news sites including CNN, CNBC, and Bloomberg report that a certain well-known, major corporation is in a real danger of bankruptcy. You can imagine what is going to happen to its share price over the following days.

Now, take the corporation out of this story and replace it with a country’s economy instead. You can imagine what is going to happen to its currency. Actually, you do not have to imagine!

It is happening all over the world with the economies of U.S.A, Spain, Italy, Greece, Portugal, and others that are in danger. The effect is similar to stocks and shares. One crucial difference between stocks and Forex is that prior information on stocks is absolutely illegal, while prior information on currencies isn’t, especially if it can help to predict trends.

Now we are going to see some major fundamental events, those influence on currency movements.

The NFP is released on a monthly base, on the first Friday of each month. Presents the change in the number of unemployed over the last month (remember that the number of workers on payrolls changes between different periods, according to holidays, year’s end and vacations). NFP plays a powerful role, indicating the market’s general condition. The more positive the NFP, the better the condition of the market. It needs to be compared with both the previous month and the market’s expectations.

Gross domestic product (GDP) measures the total value of all goods and services produced in a country within a given period. GDP is considered to be one of the best overall fundamental indicators of the economy for Forex. From an economic theory standpoint, it’s all very simple – growth in GDP indicates economic growth. However, the relation of GDP to inflation – and thus to currency – is a matter of debate.

As far as economic logic goes, an increase in GDP (basically an increase in the supply of goods and services) must be followed by an increase in the demand for these goods and services, otherwise it’s just a negative value. To facilitate that demand, an adequate amount of funds should be made available to consumers. Thus, a higher GDP means more money, which means more inflation within a central bank set limit.

Rather than an increase or decrease in GDP, for a Forex trader, it is more important to know if the GDP increase is in line with other economic indicators – such as the consumer price index – and within an anticipated range. If it is, it hints at economic strength and an appreciation of currency. A disparity in the pace of increase would hint at least a minor yet growing economic bubble.

The Consumer Price Index (CPI) measures the weighted average price of a household basket of goods and services (transportation, food, medical care), with 100 being the base value. For example, today it costs X USD to purchase a set of goods and services the CPI will read 100. When in a decade it would cost 25% more, the index will have moved from 100 to 125.

This is an important fundamental Forex indicator, as it helps to measure changes in consumer buying power through the effects of inflation. Large rises in CPI during short periods of time hint towards high inflation, while short-term severe drops in CPI hint at deflation.

The Producer Price Index (PPI) works much like the CPI, only instead of measuring the cost of ready goods, it measures production costs. PPI does not consider volatile items such as energy and food to receive ‘cleaner’ readings. Tracking production costs can assist in evaluating how production level prices may be affected, which in turn can help traders to understand the possible impact on an economy.

A slightly different type of report. It does not measure economic conditions, but rather it publishes banks’, companies’ and venture capital holdings in the market. It is released every Friday at 2:30 pm EST (i.e., New York). It helps us understand how different major forces in the market are going to invest their capital. It also helps us understand the general atmosphere and to predict in which direction the wind is going to blow in the future. This report is a great tool for long-term traders. It is also relevant for ‘swingers’.

Tip: If the COT report includes data on “extreme net long/ short”, you can know that it indicates a change in trend in the next session!

COT can be presented either as a report or a graph (below a currency chart). Unlike most of the technical indicators, COT measures volumes traded.

A report on the percentage of the unemployed seeking jobs, out of total the potential labor force. This is published once a month and helps to get a general market view. A strong, healthy economy is characterized by decreasing numbers of job seekers, and by relatively low unemployment rates. A decline in those numbers leads to a stronger currency, and eventually to a rise in interest rates.

Issued once a month. It expresses consumers’ attitude towards the economy.

If using this report, compare its elements to those in a Consumer Sentiment Report from another economy. It will help you to make a decision on a good trading partner for the U.S. dollar (or any other major currency).

The ratio of capital entering and exiting a market. The data can be either positive or negative. If positive, more investors will enter the market, and bolster its currency, in the same way as the supply/demand ratio. Increasing demand causes a stronger currency.

This report shows the ratio of imports to exports. If exports are higher, the ratio is positive! A positive ratio, especially if it is higher than the previous reports, strengthens a currency, making this currency more “desirable”.

An excellent index of an economy’s strength. Released once a month, around 12th of every month, it shows changes in market trends regarding consumer purchases.

Federal Open Market Committee (FOMC) is a board that determines the future direction of the United States’ monetary policy. The FOMC includes twelve members (reserve bank presidents, the chairman of the Fed, and governors), who meet eight times per year and make decisions regarding money supply, government securities, interest rates and the banking system. FOMC meetings are secret; therefore, they are the subject of market speculations and large movements of currencies, mostly USD.

Established in 1999, the Group of Twenty, more commonly referred to as G20, is a collection of Central Bank Heads and Finance ministers to discuss important global economic issues. Its member countries include: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, Republic of Korea, Turkey, United Kingdom, United States of America and The European Monetary Union, represented by the ECB, is also a member of the G20.

Comprising two-thirds of the world’s population, the G20 countries make up as much as 90% of the world’s gross national product. It also represents more than 80% of global trade.

This says a great deal about recoveries in markets’ growth. Since the 2007-2008 global crisis, this report has played an important role. A rise in times of crises has considerable influence on a currency’s strength. During the last few years, Housing Starts have been under a magnifying glass, affecting the U.S. dollar as well as the American market in general. (Since the 2007 collapse, the American and also global real estate market have typically received pessimistic reports).

This indicator shows the shape of the sectors of the economy which are crucial for any country. Some economies rely more on the service sector while others rely more on the manufacturing and industrial sectors. The US and UK economies are more dependent on the service sector so this economic indicator is more important in these two countries while the manufacturing sector is more important in Germany, China, Japan, France, Italy etc.

The Beige Book is published 8 times a year. This detailed report summarizes a market’s economy and offers an inclusive general point of view on the market. It examines:

• Amount of new manufacturing orders for consumer goods
• Speed of delivery of new merchandise from suppliers to vendors
• Average number of initial applications for unemployment insurance
• Average weekly hours of work in the manufacturing sector
• Amount of new orders for capital goods (excluding defense)
• New building permits for residential buildings
• Consumer sentiment
• Inflation-adjusted monetary supply
• S&P 500 stock index
• Spread between short and long interest rates

The ISM report measures the flow of new orders, thus predicting the production activity in the economy. It’s expressed as an index of 50. A reading below 50 means that there has been a decrease in production orders compared with the previous period. As supply follows the demand, an increased ISM indicates that the demand for goods and services has increased, which is a good sign for an economy. 

IPI indicates the monthly change in production for major industrial sectors – such as mining, manufacturing, and public utilities. This index is considered to be a good indicator of employment, average earnings, and overall income levels in those industries. An increase in the index points towards a healthier economy.

The Commodity Price Index tracks the average change in price for commodities like oil, minerals, and metals. This one is particularly important for ‘commodity dollars’ – which includes currencies of the commodity exporter countries like Canada and Australia. An increase in the index would constitute an increase in prices, and therefore, higher returns from exports. Note that a decrease in CPI would be good news for the currencies of those countries that import those commodities.

Trade balance reports the difference between total imports and total exports. If more goods are exported, then that represents a positive trade balance. It is an important Forex trading fundamental indicator if we are to measure the dynamic of change. Even if the trade balance is negative, an increase in exports would mean a higher demand for the currency.

Trade flow is much like trade balance, only that it weighs up the total inflow of foreign investment against the outflow of total investment. The more investors there are that are interested in a country’s business, the more international trade occurs at a condition of a positive trade balance, and the more positive the trade flow reading will be. But there’s a caution to this tale.

If there is too much slow positive trade for a prolonged period of time, this can create a bubble. Goods and services can’t disappear, but money can, and the bubble can burst – (search for the China stock market crash from July 2015 for an example of this). Typically, a positive trade flow means that there is more money coming in, compared with money coming out, and it is a sign of a healthy economy, and an increased demand for currency.

Bond price, bond yields, and bond yield spread can also be added to the list of fundamental Forex indicators. Here is how it works: A bond is a debt obligation. A government bond is a government debt obligation. When people, businesses, or banks purchase government bonds, they aren’t really buying anything. Rather, they are lending their money to the government, and in exchange they receive a note that states that the government owes them.

Governments are not the only bond issuers. Companies can do that as well – only they call their kind of bonds ‘stock’ and trade with them on the stock market. When things start getting shaky in the economy, investors tend to protect their capital by moving it from the less credible debtors to the more credible ones. Who could possibly be more credible than the government?

Thus, investors start buying government bonds. The more government bonds there are being bought, the more they cost, and by the virtue of their inverse relationship, the less they yield. The other type of government debt investors tends to seek safe haven in is national currency. So, for example, when looking at the 10-year treasury notes auction, an increase in price may indicate the strength for the currency.

What is a bond spread?

Bond spread is the difference between the bond yields of two different countries, and is a Forex trading fundamental indicator that explains that a currency with a higher bond yield will appreciate higher compared to its counter currency. Remember, always try pairing up the stronger currency with the weaker one.

Before moving onto the second part of our article on the best Forex fundamental indicators explained, here is some food for thought. With GDP, as well as with inflation rates, and other fundamental indicators, it is not how much they differ from the previous releases that is important, but rather, how much they vary from what was expected. A deviation from the forecast could indicate a lack of insight in analytical circles, and this creates a trading opportunity for a smart fundamental Forex analyst.

Purchasing Power Parity (PPP) is one of the best fundamental indicators for Forex. It’s used as an economic theory component and a technique that helps to determine the ‘true’ value of currencies. The idea is based on the law of one price, where if we assume that there are no transaction costs or official trade barriers, similar goods will have the same price around the world.

PPP allows traders to evaluate the exchange rates that would be appropriate to be able to buy the same set of goods in those countries. In addition to this, since PPP can be used to track the change in the price of goods, it provides us with a reading on ‘actual’ inflation rates, and will be equal to the percentage of the currencies’ appreciation or depreciation.

PPP can be used to compare countries economically. When looking at year-long time periods, exchange rates do tend to move in line with the PPP expected rate. This indicator may be further used as an adjuster for economic data like GDP and income, helping to smooth out currency rate differences, and to get a clearer picture of the economic situation.

Interest Rate Parity is conceptually similar to PPP, only instead we are researching the purchase of financial assets. Theoretically, they should yield the same return in all countries after currency rate adjustment. If they are not the same, a currency rate has to be adjusted. This differential is one of the most useful Forex trading fundamental indicators available to a long-term trader.

IRP assumes that:

• Capital is mobile, and that investors can easily exchange domestic or foreign assets.
• Assets can be substituted through risks and liquidity.

Given these points, investors would quite logically, hold assets that generate higher yields. As we know, investors hold assets from various countries, so if their yields do not match, there will be a disparity in the currency rates. Ideally, a Dollar return on a Dollar investment should equal a Dollar return on a Euro investment.

The International Fisher Effect is an economic theory which states that a change in the currency exchange rate between countries is approximately equal to the difference in their nominal interest rates at the time.

When explained as a fundamental Forex indicator, the IFE works like this: if higher interest rates mean higher inflation rates, then a currency in a country with a lower interest rate will appreciate against a currency with a higher interest rate. Please note that while the IFE uses reasonable logic, it fails to evaluate the impact of other factors on currency exchange rates.

Balance of Payments (also known as the balance of international payments) is a record of all payments and monetary transactions between countries for a given period of time. It involves the exchange of goods, services, income, gifts, financial claims, and liabilities to the rest of the world.

BOP consists of three accounts. First, the current account is a sum of the balance of trade (exports minus imports), factor income (earnings on foreign investment minus payment to foreign investors) and cash transfers. Second, the capital account records the net change in the ownership of foreign assets. Third, the balancing items account is for any statistical errors – and to ensure that the current plus capital accounts equal zero – it is essentially the balance sheet.

The BOP deserves a lot credit as a fundamental indicator in Forex, as it enables economists to quantify certain economic policies targeted at very specific economic objectives. For instance, a country may artificially keep its currency exchange rate low in order to stimulate exports, or conversely, to adopt policies that will attract more foreign investment.

Ultimately, both trade account deficit and account surplus may help us to get an idea of exchange-rate directions. If a country operates at a deficit, its currency will tend to depreciate to compensate the imbalance. Likewise, if a county operates at a surplus, this will lead its home currency to appreciating, longing for the same balance.