Before we delve into the concept of fundamental analysis in Forex, let us take a step back to the basics of Forex.
Forex is the market for currency exchange, where you buy one currency with another. Tourists do this before they travel to another country. Regardless of the reason why someone wants to buy or sell a currency, this increase or decrease in demand for a currency causes its value to fluctuate. This is fundamentally where fluctuations in exchange rates originate. And since there are infinitely many factors to influence this demand, we see exchange rates fluctuate all the time.
A MARKET AND AN OPPORTUNITY
A lot of people see the global currency market as an investment opportunity. This is so because currencies keep fluctuating in value relative to others and if you could buy them cheap and sell them high, you could make a profit. Now, this is a long-winded answer to the question why a currency market exists, but there you go.
Retail traders look for opportunities to ‘buy cheap and sell high. But to do that, you’ll need to be able to predict with a fair degree of confidence whether a currency will gain in value in future. Future here may refer to the coming hours, days, weeks, months or maybe even years, depending on a trader’s preferred time horizon.
Traders analyze the market in two ways.
TWO METHODS TO ANALYZE THE FOREX MARKET
The first is fundamental analysis, where you look at the factors that make different economies stronger or weaker relative to other national economies. This is because our preference for a currency is, in fact, our preference for its host economy with its political stability, socioeconomic factors, foreign relations, and much more.
Traders who prefer fundamental analysis believe that the average exchange rate for a currency this week may not accurately reflect its fundamental value, but in time the market will find its real value. Its real value may be higher or lower than the current rate. This belief in the power of the fundamentals of an economy to take its currency to its real value in the future is the foundation of fundamental analysis.
Technical analysis maintains that the current price reflects all relevant information. People who hold this view argue that the market is quicker than any fundamental analysis to come up with the real value of a currency. All news is old news, they say, as the current price reflects the latest information as well. We’ll discuss technical analysis in more detail later.
Fundamental analysis seeks to understand the changes in market valuation of a currency by analyzing economic, social, and political forces that affect the supply of and demand for it. There are several such fundamental factors. The following are the most important among them.
ECONOMIC GROWTH AND OUTLOOK
There are many indices that tell us how satisfied and confident consumers, businesses and the government are about their economy. Spending habits of consumers and businesses is an important indicator of its health. Good overall spending levels mean higher tax revenues to the government as well.
Weak economies are less buoyant about its prospects. Consumer spending levels are low, causing businesses to cut spending and this slows down the economy as a whole. The government doesn’t get much by way of tax revenues either.
A growing and buoyant economy makes its currency stronger while a weakening economy sees its currency lose value.
The modern world sees a huge amount of money flowing into and out of economies at the click of a mouse. With the help of a smartphone, you can invest in the New York or London stock exchange, trade an Asian index, or open a Forex account. As large amounts of capital come into and go out of an economy, they also make its currency stronger or weaker.
This is because with more investment coming into a country, demand increases for that country’s currency. As foreign investors sell their currency to buy the local currency, this increased demand causes its value to increase.
TRADE FLOWS AND BALANCE OF TRADE
Countries sell their goods and services overseas. And they buy goods and services from other countries. US importers exchange money with Chinese exporters, and vice versa. All this buying and selling is mediated by the exchange of currency. This exchange, in turn, changes the flow of currency into and out of a country, thus making the domestic currency to gain or lose in value.
Balance of trade is the ratio of exports to imports. A trade surplus is an indicator of a strong and growing economy and every country desires it. A positive trade balance strengthens the domestic currency while a trade deficit pushes its value down.
A well-functioning government is essential to the health of an economy. Political stability is an essential requirement for economies to thrive, though it is, by no means, the only factor. Whenever governments fail or get embroiled in controversies and lose public support, economies also suffer.
A government that drags the country into an unnecessary war with its neighbor hurts the economy more than anything else. A government ruling with the bare minimum majority is a concern to the market because of its inability to make fiscally responsible decisions.
In the end, anything that impacts an economy will affect exchange rates as well.
The rationale behind fundamental analysis is that if a country’s current or future economic outlook is good, then its currency should strengthen. The stronger the fundamentals of an economy are, the more foreign businesses and investors will invest in that country. This results in its currency to gain in value.
Traders who utilize fundamental analysis study the news for information on political climate, international relations, natural disasters and other events to determine what to expect in the currency market. There are other factors as well besides the four mentioned above such as unemployment rates, inflation and fiscal policy changes and natural disasters, among others.
Now, because of the very nature of these factors and the fact that many of them impact currencies in conflicting ways, many traders fail to draw clear enough patterns or insights to guide their entry and exit decisions. They may turn to technical analysis for this guidance. But even when doings this, those traders are trying to complement rather than replace their fundamentals based strategy.