Education

What is Fundamental Analysis in Forex

Many forex traders rely on fundamental analysis to understand which direction the price of a currency pair could move in. In the forex market, factors which can influence the value of currencies include economic, political and social circumstances of a country or a region. 

Fundamental analysis is a very subjective and sentiment-driven form of research, which means two traders can look at the same information but make different conclusions. The reason that traders can produce different decisions depending on their own experiences and other data they have collected. Fundamental analysis is a broad subject which involves absorbing seemingly endless amounts of information and forming judgments about price movement and momentum.

Because fundamental analysis can be interpreted in many different ways, forex traders have varying opinions on the significance it should play in their trading strategy and decision-making criteria. Some traders go as far as shutting their eyes from this form of analysis and prefer to focus on technicals.

Why do traders use fundamental analysis in forex?

Traders use fundamental analysis to investigate anything that has the ability to impact the value of an asset or signal potential for the price to change. The main factor which influences the price of an asset is supply and demand. Determining the strength or weakness of a country’s economy concerning other countries can indicate potential changes to supply and demand.

Essentially traders act as detectives. A single event, piece of news or economic statement is unlikely to cause a drastic impact on the price of a currency pair. However, each bit of news is a piece of a puzzle which can provide context and nuance to the current state of the market and any possible changes.

Using fundamental analysis techniques in forex can be helpful for traders to gauge the real value of a currency pair and understand what has driven recent market developments. The method can show if a currency pair is either overvalued or undervalued, which would suggest that a pivot can be expected. Technical analysis would still be required to help pinpoint at which level the trend will change and which price it will gravitate towards. Therefore, fundamental analysis is often combined with technical analysis. 

Overview of fundamental analysis in forex

Fundamental analysis in forex is a method of assessing the intrinsic value of an asset, and it is by no means a technique that is exclusive to the forex market. Because the forex market is so incredibly vast and currencies are bought and sold for so many different reasons, it’s unlikely that one piece of data will have a significant impact. 

Fundamental analysis in forex is very different from the stock market. The reason people buy and sell stocks is pretty straightforward; they think the company is doing well or going to do well, or not. Therefore, things like an earnings report, dividend payouts and regulatory changes which affect the industry the company operates can impact price quite significantly. A statement such as a month on month retail sales report for Italy is unlikely to influence the price of the euro. There are many countries in and out of Europe using the euro for transactions on a daily basis. That is not to say that economic reports with low significance on their own can be substantial when combined. 

Stock traders use fundamental analysis on a daily basis, sometimes without combining it with technical analysis, especially if they are position traders. Assessing the value of a stock is much easier (not to say that it is easy) than a currency pair which has many driving factors pushing and pulling the price.

What do forex traders observe in fundamental analysis?

Numerous elements can affect the value of an asset. Forex traders study various macroeconomic indicators, follow financial markets and business news, read dossiers, trade statistics and other data related to economics, finance, politics and society. 

Traders aim to determine if an asset (i.e. a currency pair), is worth the current price. If a currency pair is deemed to be overvalued or undervalued, the market is likely to correct itself.

The primary sources of fundamental data that forex traders observe include;

  • Labour market statistics; changes to unemployment rates and breakdowns according to the sector.
  • Economic growth and decline; positive and negative changes to the gross domestic product (GDP).
  • Trade balance; the difference between imports and exports of a country, high imports show a healthy domestic demand for goods. High exports show an interest in goods produced in a specific country.
  • Manufacturing reports; are countries producing more, less or the same amount of products compared to the previous period.
  • Interest rate changes; interest rates going up or down can be good or bad depending on the context.
  • Retail sales figures; are consumers spending money and what they are spending it on.
  • Speeches; heads of state, central banks and regulatory authorities have the power to influence markets with their words.

Just knowing that any of these factors could influence a currency pair in some way doesn’t help your ability to make trading decisions. When using fundamental analysis in forex, you need to know how to interpret all of this information, and that is the hard part. Depending on the context, one action can be interpreted as good or bad. For example, high-interest rates could be a positive sign, so can low-interest rates, and vice versa.

Because actions can be interpreted in different ways, it means that having a constant birdseye view of the financial markets is critical. Using a piece of fundamental data in isolation can lead to misinformed decisions. 

High-interest rates are a sign of a healthy economy, and investors like healthy economies. However, high interest rates can reduce borrowing, lower investment into businesses and stifle consumer spending. Meanwhile, low-interest rates are a sign of a weak economy that needs stimulating. Still, at the same time, that stimulus can boost consumer spending and more active investment into businesses as opposed to corporations holding their cash in financial products like bonds.

How can fundamental factors affect the forex market?

Almost anything can influence the stability of a country’s economy and the demand for the nation’s currency. By using fundamental analysis in forex trading strategies requires a lot of research. Fundamental forex traders often spend many hours each week scanning headlines and studying economic statements. They look at everything from international and local news, the performance of other financial markets like stocks and commodities. They listen to announcements from central banks, keep abreast of any political stability, civil unrest, international relationships, trade partnerships, policy changes and new business regulations. As you can see, the scope of information required is broad. So many factors can influence the strength of a currency, even the price of other markets. 

What is essential when applying fundamental analysis to your forex trading strategy is to make sure you thoroughly understand the significance of each economic indicator and associate it with previous data and related information. As another example of why you should not take things out of context, imagine labour statistics say employment rate fell, that is bad, but if they had dropped less than the previous five months, that could be good.

Some events have more of an impact than others. For example, the Non-Farm Payroll (NFP) is renowned for causing wild moments of volatility and triggering breakouts and reversals. 

Trading with fundamental analysis in forex is not a case of good or bad, but it should be used to paint a picture of economies as opposed to helping to make individual trades.