Fundamental Analysis

Forex traders almost always rely on analysis to make plan their trading strategies.  There are two basic types of Forex analysis – technical and fundamental.  This article will look at fundamental analysis and how it is used in Forex trading.

Fundamental analysis refers to political and economic conditions that may affect currency prices.  Forex traders using fundamental analysis rely on news reports to gather information about unemployment rates, economic policies, inflation, and growth rates.

Fundamental analysis is often used to get an overview of currency movements and to provide a broad picture of economic conditions affecting a specific currency.  Most traders rely on technical analysis for plotting entry and exit points into the market and supplement their findings with fundamental analysis.

Currency prices on the Forex are affected by the forces of supply and demand, which in turn are affected by economic conditions.  The two most important economic factors affecting supply and demand are interest rates and the strength of the economy.  The strength of the economy is affected by the Gross Domestic Product (GDP), foreign investment and trade balance. 

Indicators

Various indicators are released by government and academic sources.  They are reliable measures of economic health and are followed by all sectors of the investment market.  Indicators are usually released on a monthly basis but some are released weekly.

Two of the most important fundamental indicators are interest rates and international trade.  Other indicators include the Consumer Price Index (CPI), Durable Goods Orders, Producer Price Index (PPI), Purchasing Manager's Index (PMI), and retail sales.

Interest Rates - can have either a strengthening or weakening effect on a particular currency.  On the one hand, high interest rates attract foreign investment which will strengthen the local currency.  On the other hand, stock market investors often react to interest rate increases by selling off their holdings in the belief that higher borrowing costs will adversely affect many companies.  Stock investors may sell off their holdings causing a downturn in the stock market and the national economy. 

Determining which of these two effects will predominate depends on many complex factors, but there is usually a consensus amongst economic observers of how particular interest rate changes will affect the economy and the price of a currency.

International Trade

Trade balance which shows a deficit (more imports than exports) is usually an unfavourable indicator.  Deficit trade balances means that money is flowing out of the country to purchase foreign-made goods and this may have a devaluing effect on the currency.  Usually, however, market expectations dictate whether a deficit trade balance is unfavourable or not.  If a county habitually operates with a deficit trade balance this has already been factored into the price of its currency.  Trade deficits will only affect currency prices when they are more than market expectations.

Other indicators include the CPI – a measurement of the cost of living, and the PPI – a measurement of the cost of producing goods.  The GDP measures the value of all goods and services within a country, while the M2 Money Supply measures the total amount of all currency.

There are 28 major indicators used in the United States.  Indicators have strong effects on financial markets so FOREX traders should be aware of them when preparing strategies.  Up-to-date information is available on many websites and many FOREX brokers supply this information as part of their trading service.

Note: Not all Fundamental Announcements move the Market.

Banks are usually fundamental traders, when the report is released they aggressively start trading. If the announcement or report does not have a change in 'economic value" for the currency or forex market, the market will not break-out and will continue to move in the direction of the previous trend.

If an announcement from the previous trading session moved the market to a new value and a new announcement reflects this value, prices may not move at all.