Fundamental analysis is a method of analysing financial markets with the purpose of price forecasting. Forex fundamental analysis focuses on the overall state of the economy and researches various factors including interest rates, employment, GDP, international trade and manufacturing, as well as their relative impact on the value of the national currency they relate to.
The core premise of fundamental analysis in Forex, as well as other financial markets, is that the price of an asset may differ from its value. For this reason, various markets may sometimes misprice an asset, over or underpricing it in the short run. Fundamentalists claim that despite being mispriced in the short-term, the assets will always return to the correct price eventually.
The end goal of performing fundamental analysis is to discover the true value of an asset, compare it to the current price and locate a trading opportunity. This also nicely demonstrates the key difference between fundamental and technical analysis. While technical analysis barely pays attention to anything but the current price, fundamental analysis researches everything but the current price. Whilst it is true that fundamental analysis may not be the best tool for a short-term trader in day-to-day markets, it is the fundamental Forex factors analysis that answers what happens in the long-term.
FX fundamental analysis isn't just about comparing the current data of single economic indicators to it's previous data. There are a great number of economic theories which surround fundamental Forex analysis, attempting to put various pieces of economic data in context to make it comparable.
The most popular economic theories of currency fundamental analysis babysit the notion of parity - a condition of price at which currencies should be exchanged when adjusted according to their local economic factors, such as inflation and interest rates.
You may have noticed that from the very practical standpoint of an average Forex trader, it is news reports that produce movements on the markets. How and why does this happen?
There are economic indicators that financial experts observe because they can provide hints on the health of the economy. These indicators are found in news reports and news outlets. Some are released weekly, most monthly and a few quarterly.
Let's compare technical and fundamental analysis by the frequency of data updates. In the case of currency trading fundamental analysis, new data arrives every second in the form of a price quote, while fundamental indicators are only published once a week at the most.
Capital flows gradually from countries where it accumulates at a potentially slower rate to the countries where it could accumulate at a potentially faster rate. That has everything to do with the strength of an economy. If an economy is forecast to hold strong, it will appear as an attractive place for foreign investment, because it is more likely to produce higher returns in the financial markets. Following that thought, in order to invest, investors will first have to convert their capital into the currency of the country in question. Buying more of that currency will push the demand and force the currency to appreciate.
Unfortunately economics is not that simple, which is why examples of healthy economies showing weakening currencies are not exactly unknown to history. Currencies are not like company stock that directly reflects the health of the economy. Currencies are also tools that can be manipulated by the policy makers - such as central banks and even private traders like George Soros, who definitely learnt his fundamental Forex analysis.
When economic reports are released, traders and investors will look for signs of strengths or weaknesses in different economies. If prior to the news releases, the market sentiment leans in one direction, changing the price before the release is called a 'priced in market'. It causes little commotion upon the actual data release. Conversely, when the market is unsure - or the data results vary from what was anticipated - severe market volatility may occur. That is why Forex rookie traders are generally advised to stay away from trading around the news when practising fundamental analysis.
Economic data, as mentioned above, may hint towards shifts in the economic situation of the respective country.
Interest rates are a major fundamental Forex analysis indicator. There are many kinds of interest rates, but today we will mostly talk about the nominal or base interest rates set by central banks. To those of you who still don't know, central banks create money. That money is then borrowed by private banks. The percentage or the principle that private banks pay central banks for borrowing currencies is called a base or a nominal interest rate. Whenever you hear the phrase 'interest rates', people are usually referring to the aforementioned concept.
Manipulating interest rates - a big part of the national monetary or fiscal policy - is one of the primary functions of the central banks. This is because interest rates are a great leveller of the economy. Interest rates, perhaps stronger than any other factor, influence currency values. They can impact on inflation, investment, trade, production and unemployment. Here is how it works.
The central banks generally wish to boost the economy and reach a government-set inflation level, so they decrease interest rates. This stimulates borrowing by both private banks and individuals, as well as stimulating consumption, production and the economy in general. Low interest rates can be a good tactic but a poor strategy. In the long-term, low interest rates can over-inflate the economy with cash and create economic bubbles, which as we know, sooner or later set a toppling chain reaction across the economy, if not economies. To avoid this, central banks can also increase interest rates, thus cutting borrowing rates and leaving less money for banks, businesses and individuals to play around with.
From a Forex fundamental analysis standpoint, the best place to start looking for trading opportunities is in the changing interest rates.
News releases on inflation report on the fluctuations in the cost of goods over a period of time. Note that every economy has a level of what it considers 'healthy inflation'. Over a long period of time, as the economy grows so should the amount of money in circulation, which is the definition of inflation. The trick is for governments and central banks to balance themselves at that self-set level.
Too much inflation tips the balance of supply and demand in favour of supply, and the currency depreciates because there is simply more of it than demanded. The converse side of the inflation coin is deflation and there is nothing pleasant about it either. During deflation, the value of money increases, whilst goods and services become cheaper. Sounds good, right? Well, for a man in the street in the short run, yes. For the economy in the long run, and the same man on the street, not so much.
Money is fuel for the economy. Less fuel equals less movement. At some point deflation may bleed the country so bad that there will hardly be enough money to keep the engine running, let alone to drive the economy forward.
Gross domestic product is the measurement of all goods and services a country generates within a given period. GDP is believed to be the best overall economic indicator of the health of the economy. This can seem odd, considering GDP is basically a measurement of supply of goods and services, yet it has nothing to do with the demand for these goods and services. The general idea is that it takes a knowledge of both supply and demand to make reasonable estimations. It would be unwise to believe that GDP reflects both sides of the market. Therefore, an increase in GDP without a corresponding increase in gross domestic product demand or affordability, are the very opposite of a healthy economy from a fundamental Forex analysis perspective.
Interest rates, inflation and GDP are the three main economic indicators employed by Forex fundamental analysis. They are unmatched by the amount the of economic impact they can generate compared to other factors such as retail sales, capital flow, traded balance as well as bond prices and numerous additional macroeconomic and geopolitical factors. Moreover, economic indicators are not only measured against each other through time, but some of them also correlate cross-discipline and cross-borders, which is described in more detail in the Best Forex fundamental indicators explained.
It is important to understand that there is a lot of economic data released that has a significant impact on the Forex market. Whether you want to or not, you need to learn how to make Forex fundamental analysis a part of your trading strategy to predict market movements.