What Is Fundamental Analysis And How To Use It

Let's start with explanation on what actually is that fundamental analysis.


Trading in financial markets has become more widespread than ever thanks to the availability of the Internet and online trading platforms. The technological advances have increased the number of market participants and the available pool of investment money as a result. 


Nevertheless, enhancing one’s bottom line continues to be the primary goal in this age old game of trading, Analyzing the market fundamentals, whether the underlying asset is a stock, bond, commodity or forex currency pair remains a cornerstone of how trading decisions are made for many professional and retail operators.



For those who are not purely technical, performing sound fundamental market analysis before initiating a trade can make a significant difference in the overall success of a trading position. And this is especially true for longer term position traders.


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, overprice, or under-price 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, to compare it to the current price, and to 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 and how they are analysed that answer what happens in the long-term.

Methodology

FX fundamental analysis isn't just about comparing the current data of single economic indicators to 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.

Good News - Bad News

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 several 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 are released monthly, and a few quarterly. You can track such announcements and developments through Forex calendar.


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, compared 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.


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 known as a 'priced in market'. It often causes a 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.


Major Economic Indicators

Economic data may hint towards shifts in the economic situation of a respective country.


Interest rates


Interest rates are a major fundamental Forex analysis indicator. There are many kinds of interest rates, but here we will focus on the nominal or base interest rates set by central banks. Central banks create money, that private banks then borrow money. 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 that concept.


Manipulating interest rates - a big part of the national monetary or fiscal policy - is one of the primary functions of central banks. This is because interest rates are a great leveller of the economy. Interest rates are perhaps stronger than any other factor, and they influence currency values. They can have an 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 accordingly. 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 can create economic bubbles, which as we know, sooner or later will set a toppling chain reaction across the economy, if not entire 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.


Inflation


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. During deflation, the value of money increases, whilst goods and services become cheaper.


In the short run it may be a positive thing, but for the economy in the long run, it can be a negative thing. Money is fuel for the economy. Less fuel equals less movement. At some point deflation may have a drastic impact on a country, to the extent that there will hardly be enough money to keep the economy going, let alone to drive the economy forward.


GDP


Gross domestic product (GDP) 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 an economy. This can seem odd; especially considering GDP is basically a measurement of the 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 great deal of knowledge of both supply and demand to make reasonable, accurate 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, is 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 of the economic impact that 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.


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.


Key Models in Fundamental Analysis for Forex Traders


Again - what is Fundamental Analysis?


Fundamental analysis is one of two main methodologies for evaluating and forecasting movements in currency exchange rates, as well as for the prices of securities, commodities or any other publicly traded asset or financial derivative.


The other primary method used by traders is known as technical analysis, which focuses on market observables like the exchange rate or the price of an asset, the volume traded and open interest.


The basic skill involved in fundamental analysis in forex trading requires an analyst to determine how a currency will react to macro-economic events, central bank monetary policy shifts, and political and social news from the currency’s nation of origin when compared to the other currency in a currency pair. In the case of a common regional currency, such as the Euro, the analysis of each member state in addition to the entire regional economy as a whole is required to make an accurate fundamental evaluation of the currency.


Basically, currency pairs tend to react sharply to the release of economic data and current geopolitical and local news events, especially when the results differ significantly from what was originally expected by a consensus of market participants. This makes performing a fundamental market analysis of economic releases and events and their effect on currencies valuable when determining the direction of the market and the level of future exchange rates.

Fundamental Analysis versus Technical Analysis

Fundamental and technical analysis is the primary ways traders review economic and market conditions to determine future direction.


While the focus of fundamental analysis generally remains on news, sentiment and the release of economic indicators, technical analysis relies on the price and price movements of the underlying asset or the exchange rate of a forex currency pair.


In addition to looking for patterns on charts of the exchange rate itself, technical analysts also compute and use a number of other related technical indicators to determine directional trends and momentum in exchange rates. These include oscillators, moving averages, volume indicators and open interest in the case of futures to name just a few.


Technical analysis differs considerably from fundamental analysis and may point to a different directional view for a currency pair, but the fact remains that technical analysis provides one of the best objective tools available to the forex trader for quickly assessing a market and trading profitably in the short term.


Nevertheless, technical methods have their drawbacks, including the fact that pretty much every other trader in the world is looking at the same exchange rate data. This can produce a herd like effect when a classic chart pattern starts to develop that can exacerbate stop loss driven movements when the pattern fails.


Fundamental analysis has traditionally been better suited for traders who operate on a longer time frame. The method involves analysing a nation’s overall economic strength, its interest rates, central bank monetary policy, money supply, trade and current account balances, as well as the country’s overall political stability.


Nevertheless, some fundamental traders use short-term news trading strategies that generally operate right after the release of a major economic number, central bank rate decision or news of a major geopolitical event, such as a war or natural disaster.


Regardless of which analysis methodology best fits a trader’s trading plan, research remains a key element in successful fundamental or technical forex trading, and most traders find a working knowledge of both analytical methods beneficial.


While research and analysis is just one key element of forex trading, money management aimed at preservation of capital can be just as important to a trader’s long-term success.

Fundamental Analysis Tools

The most useful tools for fundamental analysis consist of the economic calendar, the financial news media, and historical fundamental data. The economic calendar informs the trader on the scheduled time and date of the release of major and minor economic data that can have an effect on the nation’s currency.


Trading news broadcasts from the financial news media keeps the market informed of any major economic or geopolitical developments that could directly or indirectly affect the market.


Historical fundamental data can be useful to determine trends in fundamental indicators, as well as to analyse how a currency might react to a specific economic release after examining its behaviour in the wake of a previous release or central bank rate decision, for example.

Fundamental Analysis Indicators

Some of major fundamental analysis indicators used by currency traders to determine the overall strength of a country’s economy and potential exchange rate forecast include the Gross Domestic Product or GDP, employment data, trade balance, retail sales, and inflation numbers like the Consumer Price Index or CPI. Some of them may also give traders an idea of what a future release could look like, such as preliminary GDP or survey numbers.


Furthermore, some economic indicators often lead other indicators in signalling when an economy is turning up or down. The leading fundamental economic indicators include purchasing manager surveys, Producer Price Index or PPI data, and durable goods orders numbers.


Let’s take a look at some of the key fundamental economic indicators used by forex traders:


  • Employment Reports – including the unemployment rate, the number of claimants or jobless individuals applying for services, payroll levels, and other job related data.

  • Trade Balance – the difference between a country’s imports and exports which has a direct effect on the demand for that nation’s currency. A deficit would mean the country is importing more than exporting, while a surplus would indicate more exports than imports.

  • Current Account – one of two components of a nation’s balance of payments, the current account is the balance of trade and net cash transfer for a country. A surplus would indicate the value of a country’s foreign assets were higher than its debt, while a deficit would indicate the reverse.

  • GDP – changes in a nation’s Gross Domestic Product can have notable effects on that country’s currency. A sharp increase in GDP indicates strength in the economy that could stimulate appreciation in its currency, especially if the market anticipates a possible interest rate hike.

  • CPI – the Consumer Price Index shows the level of prices of products on a consumer level and is a key inflation indicator. Controlling inflation is one of the first mandates of most major central banks so CPI changes can directly influence monetary policy. An increase in inflation could indicate an interest rate rise, while lower consumer prices would indicate lower benchmark interest rates.

  • PPI – the Producer Price Index gauges what manufacturers are paying for their material before making a finished product. This number affects a nation’s currency because a higher PPI number suggests higher future consumer inflation, while a lower number indicates the opposite.

  • PMI – The Purchasing Managers’ Index surveys the activity of purchasing managers and can be a leading economic indicator. Purchasing managers generally are the first to know of increases or decreases in future production that can indicate strength or weakness in the manufacturing sector.

  • Commodity Prices –the price of commodities can have a significant effect on the currencies of both producing and consuming nations and are directly related to inflationary and disinflationary cycles. Lower prices on commodities such as crude oil directly affect the transport and hence cost of goods, thereby lowering inflation numbers, while higher oil prices typically lead to increased transportation costs and higher inflation.

  • National Credit Quality Other reasons for re-evaluating a nation’s currency would be if the nation’s credit quality improved or deteriorated according to a major ratings agency or if it announced an intention to repay or default on its loans.

Central Bank Monetary Policy

Each major economy has a central bank that typically manages its currency, benchmark interest rates and money supply. Central bank activities and speeches by central bank officials are closely watched by fundamental traders for clues about future monetary policy shifts.

  • Interest Rate Decisions – the amount of interest charged by a central bank is extremely important to the valuation of a nation’s currency. If a country’s central bank sets a high interest rate — barring other factors, such as political instability for example — that nation’s currency tends to attract foreign assets from countries with a lower interest rate.

  • Central Bank Rate Statements – Most central banks issue a statement after a rate release describing their monetary policy committee’s voting and the reasons the rate was changed or left unchanged. The statement could affect the market if the policymakers voting was unexpected or if the central bank has a more hawkish or dovish demeanour for future rate decisions.

  • Policymaker and Central Bank Official’s Speeches – the content of a speech by the president, governor or other official of a major central bank can sometimes give indications of the bank’s future monetary policy, which will often affect that country’s currency. Other key policymakers include the voting members of the central bank’s monetary policy committee, and while their speeches may not carry the weight of a central bank governor, they could also have an effect on the country’s currency depending on the content of the speech.

  • Asset Purchase and Quantitative Easingthe amount of money a central bank uses to purchase debt securities and other assets to support a weak economy. Increases or decreases in the amount of stimulus measures can have a significant effect on a nation’s currency because changes in asset purchases can indicate a change in the interest rate and money supply.

Geopolitical Events
  • Wars – the breakout of a war or a ceasefire significantly affects the valuation of currencies issued by the nations at war and sometimes, depending on what countries are involved, the forex market in general. Wars can also significantly affect commodity prices and other assets produced in the nations involved, thereby affecting the currencies of other countries that produce similar assets.

  • Elections – a change of regime or political majority can significantly affect the value of a nation’s currency. If the incoming government favours capital incentives and lower interest rates, the value of the currency could be negatively affected. Other types of popular votes can also significantly affect the valuation of a currency. For example, a referendum on a country’s exit from the Eurozone might substantially impact the value of the Euro.

  • Power Changes – A nation that has had a change of power such as a coup d’état or a forcible regime change could experience a complete revaluation or devaluation of their currency.

  • Natural Disasters – When a country is hit with a substantial natural disaster, that nation’s currency typically appreciates in the short term due to the need to repatriate money for disaster relief. Nevertheless, in the long term, the currency could be adversely affected if the natural disaster has a considerable negative impact on that country’s economy.

Market Sentiment
  • Risk Appetite/Aversionformally called a flight to quality until quality became something of a misnomer, risk appetite and aversion are the latest market terms used to refer to investor preferences for higher yielding and higher risk currencies versus safe haven currencies. For example, in a risk averse market environment, economic and political stability is favoured, so the Japanese Yen and U.S. Dollar generally appreciate over the European majors and commodity currencies like the Australian, New Zealand and Canadian Dollars. If risk appetite is high, then the higher yielding commodity currencies and other riskier minor currencies typically rally.

  • Financial surveysIn addition to risk appetite and aversion sentiments that affect the entire market, every major economy releases market sentiment indicators in the form of surveys and indexes, generally on a monthly basis. Consumer confidence and purchasing manager index surveys count among these.

  • Sentiment Indicators Examples of commonly used sentiment indicators include the Commitment of Traders or COT report that shows the futures positioning of various types of market participants; the CBOE Volatility Index or VIX which indicates investor fear levels; and the CBOE Equity Put/Call ratio that shows whether option investors prefer bullish calls over bearish puts or vice versa.

Trading on the News

Some fundamental traders use economic news and data releases to initiate and liquidate short-term trades based on the results of the release. While it may sound simple to trade fundamental news, often the market will not react as expected, or in many cases it will move in a completely opposite direction to what traders would intuitively expect.


Furthermore, volatility strategies involving the purchase and sale of options can be useful for opening a market neutral position that will appreciate with a significant move in either direction. Another way to take advantage of extreme news related volatility when trading with fundamentals is to establish both a long and short position in the same currency pair and then trade out of each side — preferably for a profit — once the news or the economic report is released.


Most professional traders try to avoid having a large position immediately prior to a significant economic release, simply because the volatility immediately after a major release could trigger stop positions on either side of the market. Despite the volatility, having a position coming into a number can allow a trader to take advantage of the volatility. The trader can unload their position at a profit and possibly reverse the position to take advantage of a “rubber band” effect that generally occurs after significant releases.


Trading fundamental analysis gives a forex trader a deeper understanding of how the market reacts to a variety of events. Nevertheless, having knowledge of technical analysis along with fundamentals can give the trader a significant edge over a trader that only uses one methodology.


Fundamental trading involving taking shorter-term forex positions can also make sense with a trading plan that allows for wide swings in the market. Some traders might buy option combinations like straddles or strangles with both calls and puts to capitalize on the brief volatility often seen immediately after the release of a number.


Long-term forex position traders evaluate a country’s economic releases over a more extended period of time. This helps give the forex trader a more accurate evaluation of the nation’s economic health, socio-political environment and monetary policy in order to establish a long-term position in the market.


So regardless, of whether you are a short term or long term trader, applying sound fundamental analysis can help guide you in your overall trade decision process.


So, How Much Do You Really Know Now About Fundamental Analysis?


Dominik Stone


Disclaimer:


This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.