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Political and economic conditions may affect currency prices; FOREX traders rely on news reports regarding various economic factors, such as the unemployment rate, the current administration's policies, and inflation or growth rates. Examination of these factors is what is known as “fundamental analysis”.
This type of analysis is primarily used to get the “large picture” view of currency market movement, and to determine the economic conditions that affect a particular currency. It is usually considered supplemental to “technical analysis”, which is relied on for establishing specific points of market entry and exit.
Economic conditions affect supply and demand; these forces in turn affect currency prices on the market. The strength of the current economy and the current interest rates are the two most important factors for examination. The Gross Domestic Product (GDP), our nation's trade balance, and the amount of foreign investment all affect economic strength.
Both government and educational institutions release various “indicators” – generally reliable ways to measure economic vitality – on a weekly or, more often, monthly basis. These are followed by all segments of the market. In the United States, 28 key indicators are used, of which interest rates and international trade balances are two of the most important. Other primary factors include: retail sales numbers, the Purchasing Manager's Index (PMI), Durable Goods Orders, the Producer Price Index (PPI), and, of course, the Consumer Price Index (CPI).
The CPI weighs the cost of living. The PPI measures production costs. The GDP is a means of determining the value of goods and services produced within the country. Also, the total amount of all currency is measured by the M2 Money Supply.
Currencies can be both strengthened and weakened by rising and falling interest rates. High rates can strengthen a local currency by attracting foreign investment; however, investors may sell holdings in reaction to a rise in rates on the theory that a higher cost of borrowing capital will have a negative impact on many corporations, causing a downturn in both the stock market and national economy. Many factors go into determining whether foreign investment increases or local stock market downturns will predominate; however, observers usually come to a shared understanding of the ways in which the economy as a whole. The price of a specific currency in particular, will be affected by a change in interest rates.
A trade deficit (more imports than exports) is generally considered an unfavorable indicator, because the country is spending more money to buy foreign-made goods than it's bringing in through sales of its own products. This may have the effect of devaluing the nation's currency. Market expectations have a say in determining whether or not a particular deficit trade balance will be considered unfavorable – if it's normal for a country to operate with a trade deficit, that's already factored into the currency price.
A trade deficit only affects currency price negatively when it exceeds the normal deficit level expected by the market. It is important for FOREX traders to be aware of the leading indicators in preparation of trading strategies. Thus, many websites and FOREX brokers provide continually updated information to traders as part of the services they offer.