The Importance Of Fundamental Analysis For Forex
Traders and speculators all need to have an understanding of stocks and fundamental analysis is the bridge. It has been used as a tool to understand and interpret economic forces and effects, in an attempt to profit from any future developments. As with any analysis, the ultimate goal is to forecast predictions and benefit from the future movement in prices. There have been many individuals over the years who have been able to use this method of analysing market supply and demand to acquire profits, and sometimes great wealth. However, as with other Forex trading strategies, it requires an in-depth understanding of all its different intricacies and components. It also does not negate the risk involved when you are trading in currency markets.
Fundamental analysis is the study of any underlying forces affecting either an economy, industry or company. Traders study any causes of price movements by looking at the dynamics of supply and demand in any economic activity. For any national economy, the analysis will usually focus on economic data, allowing the assessment of any current and future growth in the said economy. It can encompass a whole host of information including economic news, social forces and policy changes. However, the most critical data for the Forex market are the relevant country’s interest rate policy, GDP, and the interest rates themselves.
Short-term price movements generally do not reflect underlying economic trends. However, all speculative activity is dependent on the availability of money, which is directly influenced by these important economic factors. An immediate or short-term market reaction to a country’s decision on interest rates may not be so critical today, but the longer-term implications are of substantial significance to traders. You can facilitate the understanding of these by using fundamental studies as a guide to predicting these market developments. The analysis may not look at the price action itself; although these market movements are interesting, the focus is on the economic events surrounding them. Governments will inevitably react to these market developments, and usually, their decisions are very significant for subsequent price action.
How does a Forex trader go about this analysis? As you are aware, there is no single, clear-cut method. Most investors will usually proceed in a sequence, which employs a top-down approach, starting with the economy. They will then slowly work down to groups of industries and individual companies. Unfortunately, the vast majority tend to focus on the short-term responses and use the “buy and sell” signals as the basis of their fundamental analysis. This rather short-sighted approach is more in keeping with technical trading, as the interpretation and value are purely dependent on the dynamics of the market.
As an example, within the market, the value of a currency pair is driven up as a reaction to unemployment. If a trader then opts to purchase on the basis that this is a favourable situation, then that trading decision is not based on fundamental analysis. This is because there is nothing to support the belief that the short-term reaction is a reflection of the actual meaning of the data. It is always important to study the fundamental causes that generate any market movements. Basing your actions purely on the technical trading aspect alone would be a much better decision, rather than trying to incorporate the principles of fundamental analysis to make short-term decisions on how to trade. It is vital to grasp that there is no fundamental analysis explanation for these short-term movements in the market.
The principle of utilising fundamental analysis is to concern yourself with the multiple aspects of any activity in the economy. Developments and statistical releases may impact on markets short-term, but they represent a very small part of all the analysis required. It can even be that these developments are indicators that have limited value for any longer-term predictions. Traders have a wealth of analytical tools at their disposal to make their journey more profitable.
Analysing Political And Social Trends
Analysis of all social and political trends is an essential part of the fundamental analysis and covers a wide range of concepts. These include prevailing economic regulations, financial habits, political tensions, and numerous other areas that are directly or indirectly related to the economy as a whole.
Traders who have some experience in using analysis will concur that most currencies respond directly to any small change in the political arena of any nation. The government and regulatory structure can also profoundly influence the economic dynamism of a country. This would initially reflect on the GDP values, and then move to impact the currency rates themselves. These are the basic concepts, but the analysis of a country’s social and political trends can also be instrumental in helping to predict the currency reaction to events on a more global scale.
A good example of this would be following the 2008 economic collapse when many people expected the EU economy to over-perform against the American one following this event. Thoughts at that time were that European consumers were less affected by the real estate collapse and had a minimal debt burden compared to their American counterparts. However, they had apparently not used fundamental analysis tools and were unaware of the specific mentality of European consumers. These consumers have a conservative outlook, and when the crisis hit, they responded by reducing their spending to a much higher degree than was expected.
There are a considerable number of examples where decisions have been based on just the raw data analysis, with no account taken of the different characteristics that present themselves in nations. Making this fundamental mistake can lead to massive errors, so it is critical to incorporate these factors into any analysis of global events or changes to the interest rate. These differing national characteristics also reflect the economic decisions, regulatory mechanisms, and demographics of the country itself. Ultimately, this means that they are not set in stone and can all be subject to change over time.
Analysing The Economic Trends
It stands to reason that any fundamental analysis must include an overall evaluation of the economy. This is the area that focuses on relevant indicators, statistics, and news to define the vital data that can point towards profitable trade. The economy is similar to the ebb and flow of the tide, and if it expands, most industries will benefit. Conversely, if the economy declines, companies will generally suffer. There are many areas that Forex traders will track, as some also have a direct impact on the market direction in the short-term. However, the data that is critical in making predictions on any future movements in price is more limited.
Many economists believe that there is a link between interest rates and the contraction or expansion of an economy, and they are a leading stock market indicator. GDP data should also be followed closely, as the release of these country results produces volatility in the market, although in many cases it has little value in predicting future developments. Once you have developed an overall scenario for the economy, then you can break it down into its impact on the specific industry groups and companies. Let’s take a closer look at some of the major indicators that Forex traders should include in their fundamental analysis.
GDP (Gross Domestic Product)
The GDP of a nation is among the most important economic indicators and provides the most prominent evidence of the general state of the economy. The number is released every quarter and provides a clear, straightforward overview of the economy, as it includes everything produced within the country’s borders. It is the single best indicator of the economic performance and activity overall. The actual growth rate of GDP is also a relevant number to look for. However, bear in mind that the data is backwards-looking, as it relates to the previous quarter, and is based on information already available.
Interest Rate Decisions
The interest rate decisions made by the central banks are the primary driver of currency trends, and indeed the most significant focus within Forex markets. Generally, if the central banks moved decisively in one direction, then the market also reacts strongly, which can produce strong currency pairs. Conversely, when they are indecisive, or the government does not clearly state their policies, then there is high volatility.
Interest rates themselves define the cost of borrowing available within the economy, but the importance is not just restricted to the money supply. In any healthy economy, the demand for money should be in tune with the country’s overall growth. Therefore any decision or policies of the central banks will also reflect on other areas such as unemployment, trade deficits and production. Interest rates also impact highly on the currencies flowing into a country and determine how attractive the country’s currency is for investors. They are potent determinants of supply and demand, which values the currency against others. The central banks are the sole authorities which control the global money supply, so Forex traders should always pay close attention to their decisions and actions.
PPI (Producer Price Index)
The PPI measures the average price pressures at the producer level that dictates the selling price for goods and services over time. Producers reduce or increase their prices due to many different dynamics, such as the prevailing labour or import costs. Interestingly, the actual consumer demand is much less likely to influence any pricing changes, unless there is a very dramatic drop in demand. This means that there is usually a large deficit between PPI and CPI, and the release of PPI figures does not influence the market unless there are unexpected results. Most Forex traders will focus on the CPI and use PPI purely as an indicator, but the gap between them can be extremely useful for looking at the trends in the economy.
CPI (Consumer Price Index)
The consumer price index measures the changes in prices for services and goods used by general households. As such, it represents a critical indicator, as consumers use all the products in any given economy. Any wild fluctuations or price pressures will, therefore, have an impact on wages, which also leads directly to inflation. The central banks pay very close attention to the CPI and its trends, basing their interest rate decisions on the CPI information. It can be the single, most critical indicator for determining their rates. As these interest rates then impact on currency values, CPI is also an indicator that monitored closely in the Forex trading market. Any unexpected movement can quickly change perceptions relating to currency value. Nevertheless, CPI represents a quick snapshot of the overall current price pressures and has limited predictive powers.
COT Report (Commitment Of Traders)
The COT report is released by the Commodity Futures Trading Commission every week. It reflects the holdings and commitment of various participants and speculators in the US futures market. Traders are categorised into non-commercial and commercial traders. Non-commercial are those firms whose primary purpose is to make a profit from any swings in price, but who generally have no interest in purchasing the commodity. Commercial firms, on the other hand, actually buy or use the merchandise. The COT report represents a superb analytical tool. It provides information about the commitment that these traders show towards the prevailing market trends in all of the commodities. The report is useful for traders as it is a volume indicator and can be used for assessing market depth for currency pairs. There are numerous other uses for the COT report, which can also assist in predicting market reversals, but these are covered in detail elsewhere on our website.
Fundamental Analysis In Brief
The reams of relevant information which is contained in statistical releases cannot simply be viewed in isolation. The whole purpose of the fundamental analysis is to achieve a basic understanding of the likely effects of any economic developments. To design a framework that assists in evaluating these price trends, we must also use our own insight and studies, in combination with the data. Without this, any raw data itself is not useful for determining the economic facts that generate any price developments.
If you still intend to use raw data for insights into short-term trading, then you should also couple these news releases with secondary information. Not doing this will limit your ability to implement a successful trading strategy. Immediate market response to any of these fundamental data releases is volatile at the best of times. It is not sound judgement to formulate your short-term strategy based on pure data or news releases. Fundamental analysis is not the appropriate tool for trading markets in this way.
More From The Free Forex Trading Beginners Course
Part 1: Reading A Currency Quote
Part 2: What Are Forex Pips, Leverage, Lots, And Margin?
Part 3: Explore Currency Pairs And Their Different Aspects
Part 4: Fundamental Analysis And Technical Analysis In Brief
Part 5: The Use Of Forex Technical Analysis
Part 6: The Importance Of Fundamental Analysis For Forex
Part 7: You Need To Apply Some Psychology To Be A Successful Trader
Part 8: Finding The Best Forex Broker Online
Part 9: Disclaimer