Why is Fundamental analysis important for Forex trading?

By Ekzaga Staff

15 January 2018 12:25 pm


INTRO

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).
Basically, the Forex market has currency pairs, which means that price is always showing the balance and relationship of 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

When one country or economic block has stronger economic data and performance compared to another, then an increase in value of the stronger one is expected; When one country or economic block has weaker economic data and performance compared to another, then an increase in value of the stronger one is expected.

The reason for this particular cause and effect relationship is due to the expectation that central banks could increase or decrease interest rates depending on the performance of the economy.

Central banks will increase the interest rates if the economy is improving as to avoid higher levels of inflation; Central banks will increase the interest rates if the economy is in recession or stagnating as to spur economic growth.

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 of an 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.

 

ECONMOIC MEASRING INDICATORS

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 actually responsible for making the decision 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:

 

 

  • Employment
  • Trade balance (export/import)
  • GDP
  • Retails sales
  • CPI- Consumer Price Index
  • Interest Rates
  • Housing
  • Manufacturing
  • PMI
  • 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, policy makers, 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. Basically, 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 have a negative impact on 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 have a negative impact on 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 of the monetary base.

 

FUNDAMENTALS IN TRADING

Fundamental traders can use fundamental analysis to make trading decisions. Fundamental traders 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 stop loss level.

For traders using technical analysis, they 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 price for duration of time with a lot of volatility. This means that price could potentially make spikes up and down. The trader needs to take that into account when trading their technical strategy.

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