How does fundamental analysis work in forex trading?
Those who trade in the foreign exchange (forex) market rely on the same two basic forms of analysis used in the stock market: fundamental analysis and technical analysis. The use of technical analysis in forex is much the same: the price is assumed to reflect all the news, and the charts are subject to analysis. But unlike companies, countries don’t have balance sheets, so how can fundamental analysis be done on a currency?
Fundamental analysis is a way of looking at the foreign exchange market by analyzing economic, social and political forces that can affect currency prices.
If you think about it, this makes a lot of sense! Just like in your Economics 101 class, it is supply and demand that determines the price, or in our case, the exchange rate. Using supply and demand as an indicator of where the price might be heading is straightforward. The hard part is analyzing all the factors that influence supply and demand. In other words, you need to look at different factors to determine whose economy rocks like a Taylor Swift song and whose economy sucks.
You need to understand why and how certain events such as an increase in unemployment affect a country’s economy and monetary policy which ultimately affects the level of demand for its currency. The idea behind this type of analysis is that if a country’s current or future economic prospects are good, its currency should appreciate. The better shape a country’s economy is in, the more foreign companies and investors will invest in that country. This results in the need to buy the country’s currency to obtain these assets.
For example, let’s say the US dollar has gained strength because the US economy is improving. As the economy improves, interest rate hikes may be needed to control growth and inflation.
Higher interest rates make dollar-denominated financial assets more attractive
To get their hands on these wonderful assets, traders and investors need to buy some greenbacks first. This increases demand for the currency. As a result, the value of the US dollar is likely to increase against other currencies with less demand.
In order to use fundamental analysis, it is important to understand how economic, financial and political news will affect exchange rates. This requires a good understanding of macroeconomics and geopolitics. Let’s take a closer look at some different numbers that are important for fundamental analysis in the forex market.
Economic indications
Economic indicators are reports published by the government or a private organization that describe a country’s economic performance. Economic reports are the way in which a country’s economic health is directly measured, but remember that many factors and policies will affect a nation’s economic performance.
These reports are released at scheduled times, giving the market an indication of whether a nation’s economy has improved or declined. The effects of these reports are comparable to how earnings reports, SEC filings and other releases can affect securities. In forex, as in the stock market, any deviation from the norm can cause large price and volume movements.
You may recognize some of these economic reports, such as the unemployment figures, which are well publicized. Others, such as housing statistics, receive less coverage. However, each indicator serves a specific purpose and can be useful.
Gross domestic product (GDP)
GDP is considered the broadest measure of a country’s economy and represents the total market value of all goods and services produced in a country in a given year. As the GDP figure itself is often considered a lagging indicator, most traders focus on the two reports issued in the months before the final GDP figures: the advance report and the preliminary report. Significant revisions between these reports can cause significant volatility. GDP is somewhat analogous to the gross profit margin of a listed company in that they are both measures of internal growth.
Retail sales
The retail trade report measures the total revenue of all stores in a given country. This measurement is derived from a diverse sample of stores across the country. The report is particularly useful as a quick indicator of broad consumer spending patterns adjusted for seasonal variables. It can be used to predict the performance of major lagging indicators and to assess the immediate direction of an economy. Revisions to advanced retail sales reports can cause significant volatility. The retail sales report can be compared to the sales activity of a listed company.
Industrial production
This report shows a change in the production of factories, mines and utilities within a nation. It also reports their ‘capacity utilization’, the extent to which each factory’s capacity is used. It is ideal for a nation to see an increase in output while being at its maximum or near-maximum capacity utilization.
Traders using this indicator are usually interested in energy production, which can be extremely volatile since the electricity industry and, in turn, the trade in and demand for energy is heavily influenced by weather changes. Significant revisions between reports can be caused by weather changes, which in turn can cause volatility in the country’s currency.
Consumer price index (CPI)
The CPI measures changes in the prices of consumer goods in over 200 different categories. This report can be compared to a nation’s exports to see if a country is making or losing money on its products and services. However, be careful to monitor exports – it’s a popular focus for many traders as the prices of exports often change in relation to the strength or weakness of a currency.
Other important indicators include the Purchasing Managers’ Index (PMI), Producer Price Index (PPI), Durable Goods Report, Employment Change Index (ECI) and Housing Starts. And don’t forget the many privately published reports, the most famous of which is the Michigan Consumer Confidence Survey. All of these provide a valuable resource for a forex trader if used correctly.
Using economic indicators
As economic indicators measure a country’s economic condition, changes in the reported conditions will therefore affect the price and volume of a country’s currency. However, it is important to remember that the indicators discussed above are not the only ones that affect the price of a currency. Third-party reports, technical factors and many other things can also drastically affect a currency’s valuation. When doing fundamental analysis in the foreign exchange market:
– Have an economic calendar at hand showing the indicators and when they should be released. Also keep an eye on the future; often markets move in anticipation of a particular indicator or report due to be released at a later date.
– Be informed about the economic indicators that capture most of the market’s attention at any given time. Such indicators are catalysts for the largest price and volume movements. For example, when the US dollar is weak, inflation is often one of the most observed indicators.
– Get to know the market’s expectations for the data and pay attention to whether expectations are met. It is much more important than the data itself. Sometimes there is a drastic difference between expectations and actual results. If so, be aware of the possible justifications for this difference.
– Do not react too quickly to the news. Often figures are released and then revised, and things can change quickly. Pay attention to these audits, as they can be a useful tool to see the trends and react more accurately to future reports.
There are many economic indicators and even more private reports that can be used to evaluate forex fundamentals. It is important to take the time to not only look at the numbers, but also understand what they mean and how they affect a nation’s economy. When used correctly, these indicators can be an invaluable resource for any forex trader.
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