Forex Fundamental Analysis

Fundamental analysis is a method of evaluating the market that uses multiple data sources to find the fair value of an asset. Unlike technical analysis, which focuses purely on price action, it reflects a holistic picture of Forex strengths and weaknesses. You'll often hear fundamental analysis used as a way to find stocks to buy. But in reality, it is used by traders across many different asset classes. In Forex trading, fundamental traders examine any data that could have a significant impact on the price of a currency pair, such as economic data, political factors or even the impact of natural disasters. However, fundamental traders don't just randomly look at data. They try to assess a market's fair value so they can see if it's currently underpriced or overpriced.

How to Perform Fundamental Analysis?

Forex fundamental analysis is more than just comparing current data on a single economic indicator with previous data. There is a wealth of economic theory surrounding basic Forex analysis that attempts to put various economic data into context and make it comparable. The most popular economic theory of monetary fundamental analysis employs the concept of parity: a price condition in which currency exchange rates adjust based on local economic factors such as inflation and interest rates.

From a very practical perspective of the average Forex trader, it is news reports that create moves in the market. Financial experts observe several economic indicators because they can provide guidance on the overall health of the economy. These indicators can be found in news reports and news media. Some publish weekly, most publish monthly, and a few publish quarterly. The best way to track such news events is to use the Forex Calendar, an essential tool of fundamental analysis that provides a daily schedule of planned economic announcements.

In Forex technical analysis, new data appears in the form of quotes every second, while fundamental indicators are released only once a week at most. Capital gradually flows out of countries where accumulation is likely to be slower compared to countries where capital accumulation is likely to be faster. This is closely related to economic strength. If an economy is expected to remain strong, it will become an attractive place for foreign investment because it is more likely to generate higher returns in financial markets.

According to this idea, in order to invest, investors first have to convert their capital into the currency of the country in question. Buying more of the currency will drive demand and force the currency to appreciate.

Unfortunately, economics is not always that simple, which is why examples of healthy economies showing currency weakness are not unknown. Currencies, unlike company stocks, do not directly reflect the health of the economy.

Currency is also a tool that can be manipulated by policymakers, such as central banks, or even private traders like George Soros. When economic reports are released, traders and investors will look for signs of strength or weakness in different economies. If, before the news is released, market sentiment is leaning in one direction, changing the price before the release is called "market pricing." It usually causes some commotion when the actual data is released.

On the contrary, when the market is uncertain or the data results are not in line with expectations, severe market fluctuations may occur. This is why beginner Forex traders are often advised to stay away from trading around the news when doing fundamental analysis.

Key Factors Affecting Fundamental Analysis

Interest Rate

Interest rates are the main indicator for fundamental analysis of Forex. There are many types of interest rates, but here we will focus on the nominal or base rate set by the central bank of an economy. Central banks create money and then private banks borrow that money. The percentage or principle that private banks pay the central bank for borrowed money is called the base or nominal interest rate. Whenever you hear the term "interest rate," that's what people are usually referring to.

Manipulating interest rates is an important part of a country's monetary or fiscal policy and one of the main functions of the central bank. This is because interest rates are an important equalizer for the economy. Interest rates, perhaps more than any other factor, affect the value of money. They have an impact on inflation, investment, trade, production and unemployment.

Central banks typically want to boost the economy and reach inflation levels set by the government, so they lower interest rates accordingly. This stimulates lending by private banks and individuals and stimulates consumption, production and the overall economy. Low interest rates may be a good strategy, but they are a bad strategy. In the long run, low interest rates over-inflate the economy with cash and can create economic bubbles that, as we know, will sooner or later cause ripple effects throughout the economy, if not the entire economy. To avoid this, central banks can also raise interest rates, thereby reducing the amount of borrowing and making less money available to banks, businesses and individuals. From a Forex fundamental analysis perspective, the best place to start looking for trading opportunities is with changing interest rates.

Inflation

News releases about inflation levels report fluctuations in the cost of goods over a period of time. Note that every economy has what it considers a “healthy” level of inflation (usually around 2%). As an economy grows over a long period of time, the amount of money in circulation increases, which is the definition of inflation. The trick is for governments and central banks to balance themselves at levels they set.

Excessive inflation tilts the balance of supply and demand in favor of supply, and currency depreciation occurs because the supply of money exceeds demand. The flip side of the inflation coin is deflation. During deflation, the value of money increases and goods and services become cheaper. In the short term, this could be a good thing, but in the long term, it could be a negative thing for the economy. Money is the fuel of the economy. Less fuel equals less movement. At some point, deflation can have such an impact on a country that there is barely enough money left to keep the economy going, let alone fuel it.

Gross Domestic Product

Gross domestic product (GDP) measures all goods and services produced by an economy during a given period and is considered the best indicator of the overall health of an economy. GDP itself isn't a particularly useful indicator, but the rate at which GDP changes over time can tell you a lot about the health of an economy, such as whether it's growing or shrinking. This in turn can give you an idea of the strength of a country's currency, with GDP growth likely to have a positive impact on currency values.

However, the relationship between economic growth, or lack thereof, and the value of money is not that simple. As we mentioned earlier in the article, for a country with a strong, growing economy, currency depreciation is not unknown. Sustained high economic growth can lead to increased inflation, which, as we have seen, has a negative impact on currency values.