In the world of Forex, Fundamental Analysis is all about comparing and analysing one country’s economic data and performance with a second one (or a group of countries in case they share a common currency).
The Forex market has currency pairs, which means that the price is always showing the balance and relationship between 2 economic entities. Many factors could, in fact, impact price. Fundamental analysis is about reviewing the economic data and performance of an economic zone to predict future economic development and in some cases also price movements.
Fundamentals In Forex
Whether an economy is experiencing growth or stagnation, it has a tangible effect on the financial market. When the economic performance of one country exceeds that of another, confidence in its currency will result in increased value relative to its competitors.
This expectation can be credited to central banks who adjust interest rates as needed depending upon their respective economies; raising them if progress shines and lowering them when downturns arise- incentivizing activity while avoiding systemic inflationary pressures.
Higher interest rates traditionally increase demand for a currency. The reason is simple: buyers are better rewarded for owning a currency if the interest rate is higher. The interest rate levels of both countries and their comparison vis-à-vis each other are important elements because a trader or investor is always buying one currency and selling a second. A change in interest rate alters this relationship and the price will reflect this change. Most often the currency which increases its rates will see an increase in its price.
Economic Measuring Indicatioins
To judge whether the interest rate levels will increase or decrease in the future, investors and traders monitor other economic data, policy statements, press conferences, speeches and news releases to assess the overall economic situation of each country and economic unit. The central bank of each economic zone; however, is the entity that is responsible for deciding whether to increase or decrease the rate. All parties can compare the economic data and performance to judge what the future development of price could be. Here is a list of economic measuring points:
- Trade balance (export/import)
- Retails sales
- CPI- Consumer Price Index
- Interest Rates
- Monetary Policy
All this data provides smaller and bigger clues of the economic activity and are signals for potential decisions of the central banks.
Driver of each Currency
Although traditionally speaking economists, banks, analysts, policymakers, and traders are analysing the data to understand the direction of the interest rates, a broader scope could show a different side of what causes price movements. In essence, the balance between GDP (Gross Domestic Product = sum of economic activity) and the monetary base (monetary assets available in an economy) could be seen as key. This equation shows “available” money in an economic zone versus the current economic activity.
If the monetary base increases more than the GDP, each unit of currency is worthless and this will hurt the exchange rate of that currency;
If the monetary base decreases more than the GDP, each unit of currency is worth more and this will have a positive impact on the exchange rate of that currency;
If the GDP increases more than the monetary base, each unit of currency is worth more and this will have a positive impact on the exchange rate of that currency;
If the GDP decreases more than the monetary base, each unit of currency is worthless and this will hurt the exchange rate of that currency.
The importance of the above has been noticeable during recent years when the FED (central bank of the USA) and other central banks have introduced the policy of Quantitative Easing (QE), which intends to stimulate the economy. The impact of QE is the increase in the monetary base.
Fundamentals In Trading
Fundamental traders can use fundamental analysis to make trading decisions. Fundamental traders or Traders that use Fundamental Analysis are typically more long-term-oriented position traders than technical traders. In my opinion, this is probably so because the fundamentals do not change that rapidly from day to day. On a daily level, the long-term economic data does not drastically change in most cases. News traders are other types of traders that trade fundamentals. They monitor high-impact data releases to capitalize on the expected volatility that is often connected to these events. When the actual figures are lower or higher than the previously expected figures, then the market will react to this differential and speculators try to capitalize on the opportunity.
Other traders combine fundamental with technical analysis. They could use fundamental analysis for long-term directional guidance but use technical analysis for executing trades with precise time i.e. to know entry, take profit & determine to stop loss level.
Traders using technical analysis can still keep an eye out on the news in various ways. High-impact data releases, news events, press conferences and speeches have the potential of moving prices for a duration of time with a lot of volatility. This means that prices could potentially make spike up and down. The trader needs to take that into account when trading their technical strategy.