Fundamental analysis is a powerful tool that can effectively indicate currency pair price movements.
Why is it called ‘fundamental?’ Because, instead of looking at the charts, it looks at what’s going on in the world that might change the price of a currency. Nearly all currencies that we trade are linked to a nation state, or a region (like the euro). When times are good in Japan, and the economy is strong, the Japanese yen goes up in price. Bad times mean it goes down in price.
So fundamental analysis looks closely at the factors that are affecting the economy. There is a vast range of factors to be considered, and, in fact, a national economy can be affected by political changes, wars, environmental disasters, health crises, changes in the price of energy, and just overall global economic changes like a slowdown or a recovery.
There are, in particular, certain economic events that tend to drive the price of a currency higher or lower, and fundamental analysis zeroes in on those events.
Interest-rate increases and decreases are one of the most fundamental factors for a given currency: Higher interest rates make it worth more with respect to others and vice-versa for interest-rate reductions.
So, here’s what happens when interest-rate rises are expected:
(Reuters – New York – Feb. 28, 2018) – The dollar rose to five-week highs on Wednesday, bolstered by an upbeat assessment of the U.S. economy from the Federal Reserve’s new chairman, which raised expectations the central bank could aggressively increase interest rates over the next two years.
A fundamental analyst will try to predict this change ahead of time, and then enter a trade at the lowest point possible close to the event.
Economic Data to Watch for
Interest-rate changes are only one of the vast number of economic factors and events that fundamental analysts watch.
Some of the most important include:
- Any major central bank announcement;
- Employment statistics
- Sales of homes and property in the country
- Consumer confidence reports
- Purchasing Manager Indexes (these are surveys of private companies by a researcher called Markit)
- National credit rating (issued by analysts like Fitch or Moody’s)
There are a great many such events, and it is up to the fundamental analyst to choose the one that is significant in a given trading period, research to get ahead of it and predict it, and then take advantage to enter the trade at the right time.
Working with Fundamental Analysis
You may wonder how to sift out the data and events that move the forex market from the ones that can be traded?
Fundamental analysis requires lots of studies. You need to have a deep understanding of the economic factors in play. So, if you wish to trade USD/GBP using fundamental analysis, you will look back over several years, and see how the market reacted to certain announcements, and, most of all, you will learn why it reacted.
Because, sometimes, the market doesn’t react the way you’d expect.
For example, on Dec. 18, 2018, the Fed raised interest rates. You would have expected the dollar to move higher against the pound, but it didn’t. Why? Because the Fed’s announcement that accompanied the rate rise said that there wouldn’t be any more for a long time. Traders took that as a sign to unload the dollar, and it fell.
Of course, you would also want to know, at the time, what the British economy was doing, and whether the pound might fall along with the dollar? These are the kinds of questions to consider in fundamental analysis.
Technical and Fundamental Analysis together
You may have guessed by now that, because of its complexity, fundamental analysts tend to trade longer term than technical analysts, who are just looking at what happened in the recent past on the charts.
But it’s wise to always keep a bit of the fundamental approach on your radar screen as you are trading. Suppose you’re trading the five-minute chart? You won’t expect any economic events to interfere with the orderly patterns you’ve observed and wanted to make use of.
All of sudden, the ministry of finance of the country whose currency you’ve just gone long in releases a devastating economic report about the currency you are trading. According to the ministry, recession is just around the corner!
The currency you are going long in plunges right past your stop-loss.
This is why even a died-in-the-wool technical analyst pays attention to fundamental factors.
Tools for Fundamental Analysis
The most basic tool to use to avoid situations like the one just described is always to read the daily economic calendar published either by your forex broker or by one of the forex websites. There are also economic reports for the day from some forex pubs. These would have indicated that the country’s ministry of finance was to release an economic report on that day, and you would have known to keep away from the national currency ahead of the announcement.
Some other very useful tools are less tied to daily events. Economic reports on nearly every country in the world are published regularly by the International Monetary Fund and the OECD. These can be obtained on the organization’s websites, and they will give you a very accurate idea of what factor matter most for the economy of the country whose currency you wish to trade.
In the same way, it’s useful to read the economic press regularly, with particular attention to the countries you are interested in.
One website, https://tradingeconomics.com/ has an enormous wealth of data about nearly every country in the world and is extremely useful.
Don’t be afraid to try fundamental analysis when you feel confident you know the economic situation behind a currency pair well. Research and knowledge lead to wins with this technique.