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.
For example, knowing how a currency pair may react to a major central bank decision before it is released, and what the market is expecting to happen by going through a basic forex fundamental analysis process can be very helpful to a currency trader when establishing or liquidating a position.
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 are 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 analyzing 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 historic 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 analyze how a currency might react to a specific economic release after examining its behavior 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 signaling 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 transfers 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 reevaluating 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 demeanor 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 Purchases and Quantitative Easing – the 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.
- 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 favors 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’etat 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.
- Risk Appetite/Aversion – formally 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 favored, 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 surveys – In 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.