Understanding Fundamental Analysis

Fundamental analysis is a way of analysing financial markets. The Forex trader studies economic data and news. It focuses on the general state of the economy. This includes interest rates, employment levels, GDP, international trade and manufacturing. Then you look at the relative impact on the national currency concerned. It’s all about finding out what is happening to the economy in the country whose currency you want to trade. Technical analysis is about studying the charts, observing price action. Fundamental analysis doesn’t need any input from the charts.

Quite often, the price of a currency may differ from its real value. Sometimes, the market may misprice a currency in the short-term. The belief is, regardless of market price, it will always return to the correct price. Fundamental analysis can help you to figure out what the true value of a currency might be. This may be different from the current price on the market.

Many traders rely on technical analysis alone, and that’s fine. But, if you learn how to do fundamental analysis, it’s like cleaning the fog off your glasses. It’s a great tool to use for analysis. Some traders rely on fundamental analysis to predict future price movement. Other traders use it in combination with technical analysis.

How Does Fundamental Analysis Work?

Instead of wondering why a currency pair is moving in a particular direction, you have more of an idea about WHY. This can give you a nice advantage. Technical analysis (which is the subject for the next chapter) only focuses on price. It considers no other factors. Fundamental analysis researches everything but the current price.

Fundamental analysis is rarely a good choice for short-term traders. If you are scalping the market you are unlikely to reap the rewards of a longer-term strategy. Fundamental analysis is often used by traders who play the long game. These are Forex traders holding trades for longer than a day. Some traders hold trades for days, weeks or even months.

Fundamental analysis is a logical form of assessing where price movement may head off to. How you analyse this is what we are going to discuss in this chapter.

One of the defining facts can be a country’s unemployment rates. And that makes total sense, doesn’t it? Unemployment is a reflection of a country’s economy and monetary policies. Unemployment levels always affect the levels of demand for its currency.

It's logical, isn't it? If the future economic outlook is good, the currency should gain strength. If the future economic outlook is not so good, then the currency rate will fall. It's common sense isn’t it?

A strong economy encourages investment from businesses and investors. To invest, buyers have to convert their money into the currency of the country concerned. Buying more of the currency further pushes the demand and price continues to rise.

It sounds simple, doesn’t it? It also sounds like common sense logic. Before you rush off to become a fundamental Forex trader, let's look at some anomalies to factor in.

The truth is, sometimes healthy economies show weakening currencies. Why is that? Well, trading currencies are different from trading the stock of a company. Currencies do not always reflect the health of the economy.

As we mentioned earlier in the course, sometimes it is in the interest of a country to have lower currency rates. So, even if the country has a growing economy, it may seek to push the price down. This is where market makers and central banks may manipulate the price. We discussed this in earlier chapters.

For example, let’s imagine the GBP has been gaining strength. The British economy has been improving and the price reflects buying confidence. As the British economy continues to improve, the UK may need to raise interest rates. This is a way to control growth and inflation. Higher interest rates make the pound more attractive to investors.

As investors buy the pound, price increases further. Demand rises for the currency. The value of the pound will likely increase against other countries with less demand.

Fundamental analysis is about understanding economic, financial and political news. Then working out how it impacts currency rates.

It’s easy to feel intimidated by fundamental analysis. It seems like hard work. But it’s not hard work once you have a grasp of what to do. All you need to know is how to assess probabilities. You can measure this by analysing the strength or weakness of a country’s economic outlook.

How News Affects the Forex Market

News reports can have a significant impact on the Forex market. They can cause substantial moves and fast spikes in price action.

Some news reports are weekly. Others release monthly or quarterly. One essential tool for the fundamental trader is a Forex news calendar. We will be discussing economic calendars in chapter 14. As a Forex trader, you need to know the news schedule, so you can plan for potential trades.

With technical analysis, the Forex trader analyses price data every second. They analyse the current price movement and chart patterns. Fundamental data is less instantaneous. A fundamental trader has to be alert to economic news data. The trader can use the news to assess a probable result on the charts.

With the release of economic data, traders and investors study the charts. They look for signs of strength or weakness in different economies. No matter how we look at it, the Forex markets core driver of price is sentiment. How people feel about what may happen will drive trading activity. Sentiment can cause a bit of volatility before the data release.

The Forex market will always experience volatility if there is uncertainty. It responds to the unexpected. Price can bounce around or take great leaps up or down. This is never a good time for a novice trader to be in the market.

As a novice trader, it is good practice to stay away from trading around news announcements. If you have open trades, take care to ensure you have stop losses in place. Wait until the market has settled after the news before getting into a new trade.

Of course, some news is not anticipated and can send the market into a tailspin.

For instance, when Trump was posting on Twitter this caused significant price changes. Anyone in power making a statement about their country will drive prices. World news creates confusion in the market. As traders try to work out a potential direction for a currency, there may be a tug of war for a while.

During peak Brexit talks from Boris Johnson, the market spiked and spun around for a bit. When lockdown hit the UK in March 2020, the Forex market was volatile. The general sentiment was concern and indecision. No one knew what was going to happen next. With no previous experience of a pandemic in our lifetime, no one knew the short or long-term impact on the economy. Who could foretell how Covid-19 could affect the global economy? Across the world, the market was unstable. These are fundamental changes because of unknown potential outcomes for the economy.

Some Forex traders specialise in trading news events. One such event is the monthly US Non-Farm Payroll. This is the first Friday of the month. The reported data is employment changes, unemployment rates and average hourly earnings. We will cover more on this in chapter 14 when we learn about economic calendars.

Interest Rates

News announcements count in fundamental analysis. But interest rates are a major fundamental Forex analysis indicator. There are many different interest rates to consider. In this chapter, we will look at the nominal or base interest rates which are set by an economy’s central bank.

Central banks create money. As we discussed in other chapters, many of them trade Forex to raise money for clients and their bank. This money is then borrowed by private banks. The percentage that private banks pay the central banks is the base rate or a nominal interest rate. When you hear the term ‘interest rates’ this is what people are referring to.

One of the primary functions of central banks is to manipulate interest rates. It is a big part of the national monetary or fiscal policy. The reason is that interest rates are a great leveller of an economy. Interest rates are a major factor in influencing currency values. They can have a significant impact on inflation, investment, trade, production and unemployment.

Governments set an inflation level they wish to achieve. Central banks will decrease interest rates to align with these levels of inflation. The lowered interest rates stimulate borrowing by individual and private banks. It also stimulates consumption and production. It boosts the economy in general. That said, whilst low-interest rates appear to be a good tactic to grow an economy, it is a poor strategy.

Over the long-term, low-interest rates can over-inflate the economy with cash. This can create economic bubbles. When the bubbles burst, it sends a negative rippling reaction across the economy.

To avoid this issue, central banks may also increase interest rates. This decreases the amount of borrowing. Then there is less money for banks, businesses and private individuals.

The best time to look for trading opportunities is when interest rates are changing. By doing the fundamental analysis, you can stay ahead of probabilities.

Inflation

Every economy has a desired level of ‘healthy inflation’. This is usually in the region of 2%. Over a long period, as the economy grows, the amount of money in circulation should also grow. This is the definition of inflation. Inflation levels are a measure of the fluctuations in the cost of goods over a period.

Governments and central banks have a continual balancing act to meet the set level. If inflation is too high, it tips the balance of supply and demand. Too much supply and the currency depreciates. This happens because there is more supply than demand. During deflation, the value of money increases as goods and services lower in price.

Short term, this may be a positive thing. But, in the long run, it can be negative for an economy. Money fuels the economy. Less money means less currency movement. If deflation continues, it can have a terrible effect on a country. If there isn’t enough money to support the economy the economy can stall. For any country, this can create unpleasant outcomes.

GDP

GDP is an acronym for Gross Domestic Product. This is the measurement of all goods and services produced within an economy within a set period. It may be one of the best indicators of the general health of an economy. Though, on its own, it isn’t that useful. What is helpful is to look at the rate of change in GDP over some time. GDP shows if the economy is growing or shrinking. You can then test the possible strength of a country’s currency. An increase in GDP is likely to have a positive effect on the value of a currency.

Again, this information makes logical sense. But there is always a caveat. The relationship between economic growth and currency value is not straightforward. As you know, it isn’t uncommon for a country with a strong, growing economy to have a weakening currency. Continual high economic growth can lead to an increase in inflation. And as we learned, inflation can harm the value of a currency.

Conclusion

So, in conclusion, the three main economic indicators for Forex fundamental analysis are:

• Interest rates
• Inflation
• GDP

These three indicators can have the biggest impact on the economy. There is a lot of economic data released that has a significant impact on the Forex market. You can't escape the fundamental impact of economic data. It’s unavoidable. If you think about it, every piece of news has some impact on the financial implications for a country. So, it makes sense for a Forex trader to utilise this form of analysis. Understanding the potential behind the news announcements may give you a useful edge.

Next: Understanding Technical Analysis