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The Basics of Fundamental Analysis for Forex Market

TABLE OF CONTENTS

The Basics of Fundamental Analysis for Forex Market

The Basics of Fundamental Analysis for Forex Market

Vantage Updated Updated Sat, 2024 January 27 02:02

Fundamental analysis is a trading discipline traders and analysts commonly use to assess the intrinsic value of a financial instrument by examining the underlying assets, industrial conditions and the broader economy. This article provides the basics to fundamental analysis that will come in handy for aspiring traders. 

Key Points

  • Fundamental analysis in forex involves evaluating economic and geopolitical factors to forecast currency prices, looking at data like a country’s GDP, trade balance, and unemployment rates to gauge the health and potential value of a currency.
  • It is a method favoured by long-term traders who wait for market prices to reflect an asset’s intrinsic value, with a top-down approach starting from major geopolitical events influencing economic data, which in turn affects market sentiment.
  • Economic data releases such as GDP, CPI, and Non-Farm Payrolls are key indicators watched by fundamental analysts, and market sentiment, whether fearful or optimistic, can influence investor behaviour towards ‘safe haven’ assets or more aggressive investments like equities.

What is Fundamental Analysis?

Fundamental analysis in forex refers to the examining of the economic and geopolitical factors of different currencies, with the purpose of price forecasting.  

Unlike technical analysts who purely focus on price action, fundamental analysts would examine data such as a nation’s gross domestic product, international trade balance, and unemployment rate, to form a holistic view of a currency. 

Key Factors in Fundamental Analysis

Fundamental analysis is usually adopted by long-term traders who are willing to hold the positions for a longer time frame until the intrinsic value of an asset is fairly reflected on its market price. Patient traders who practise the discipline may find it rewarding when undervalued assets begin to outperform in a recovering market.

The understanding of fundamental analysis follows a top-down approach; major geopolitical events would often impact sensitive economic data, which affects market sentiment. 

Diagram

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Figure 1 – Top-Down Approach For Fundamental Analysis (https://www.tradingview.com/x/RSCvPjRj/)

Central Bank Announcements

Central bank announcements play a role in shaping market expectations and influencing economic policy. Traders closely monitor these announcements as they provide insights into the economic priorities of a country and the likely fiscal strategies that will be pursued.

These announcements, often related to interest rate decisions or monetary policy changes, can have immediate and profound effects on financial markets. 

For example, if a central bank decides to raise interest rates, it typically indicates an attempt to curb inflation and stabilise the currency, which can lead to stronger currency valuations. Conversely, lowering interest rates may signal efforts to stimulate economic growth, often leading to increased investment in equities but potentially weakening the currency. 

Inflation

Inflation is another key economic indicator that reflects the rate at which the general level of prices for goods and services is rising, and subsequently, how purchasing power is eroding. Central banks and inflation are closely tied as inflation reports will influence the banks monetary policy decisions.

If inflation is too high, a central bank may raise interest rates to cool down the economy; conversely, if inflation is low, lowering interest rates can help stimulate spending and investment.

Economic Data 

Economic data measures and represents the wellbeing and financial health of a nation. 

Economic data is so valuable because it determines the value of a currency, which affects the value of a currency pair a trader might be interested in. Most economic data is also scheduled to be released once every month on an economic calendar.

Here’s another example on how the Covid-era in 2020 impacted the US economy. 

After the pandemic started in early 2020, many economies including the US went into lockdowns. This resulted in a rapid increase in unemployment to levels not seen since the Great Depression. With high unemployment rates, the cost of producing goods also increase due to the lack of manpower. The rise of inflation during the pandemic can be credited to increased prices of goods and services due lack of production capabilities [2]

In the example above, let us break down the economic data from the different sectors. 

Economic DataImpact 
Labour MarketUnemployment rate peaked to 14% [2].
InflationConsumer price index rose from 2% to 9.1% [3].

Here are some of the most significant economic data releases with great influence over the market sentiments:

  • Gross Domestic Product (GDP)
  • Consumer Price Index (CPI)
  • Interest Rate Decision
  • Consumer Confidence
  • Retail Sales
  • Non-Farm Payroll
  • New Home Sales

These economic data are typically released monthly. For example, Non-Farm Payrolls (NFP) will be released on the first Friday each month.  

Geopolitics 

Geopolitical events can take place on the back of changes to international relations and politics. Such events can drastically impact a nation’s currency value, and the impacts are usually long-term and could inflict a ripple effect on various sectors of an economy.  

The US-China trade war is one example of how such events can impact the market. China’s rapid ascension into the World Trade Organisation led to US running a trade deficit with China that amounted to US$345.6 billion in 2019. Both nations imposed tariffs on goods imported from each other, which had a severe financial impact on the US economy as the US had to pay higher import taxes to bring China goods into their country [1]

Using Fundamental Analysis: Market Sentiment

As we have learned about geopolitics and its impact on economic data, perhaps the more important question is “how do we use the data to trade Forex?”. In this case, market sentiment is a key factor to consider.

Going back to the example of the US during the Covid-era, as the virus spread across the globe, economies were in full lockdown, and causalities from the infections increased exponentially. The overall sentiment in the financial markets was leaning towards fearful. 

When the market is fearful, investors tend to flock to ‘safe havens’ such as the Japanese Yen, Swiss Franc, or even precious metals such as gold and silver. On the flipside, if the dominating sentiment in the markets is optimism, investors are not pressured to protect their assets in ‘safe havens’, but could instead, invest in the stock market and equities. 

Forex Fundamental Analysis Use Case

The practical application of fundamental analysis in the forex market can be illustrated through the case of the Euro during the European debt crisis. As the crisis unfolded, fundamental analysts examined key economic indicators like GDP growth rates, debt levels, and austerity measures across affected countries. This data informed traders about the potential devaluation of the Euro against other major currencies which could have helped with their trading decisions during a volatile period.

Another example that we can look at is the impact of the Brexit decision on the British Pound. Fundamental analysts would have monitored political developments, voter sentiment, and economic forecasts to anticipate the outcome and its effects on currency stability and international trade relationships. 

Analysts also closely observed the responses from European markets and the Bank of England’s subsequent monetary policies, which were crucial in determining short-term volatility and longer-term economic adjustments. This analysis allowed traders to assess both risks and opportunities, providing a balanced approach to currency trading during this period of significant political change.

Conclusion

In essence, fundamental analysis is a valuation approach based on the idea that each asset has a fair value which is often not reflected accurately on its market price due to the influence of external or broader economic factors. It could be used to determine whether the price of an asset is over- or undervalued and discover long-term trading opportunities as an outcome. 

Interested to apply fundamental analysis in your trading? Try practising it on our demo account here.

References

  1. “What is the US-China trade war? – South China Morning Post”. https://www.scmp.com/economy/china-economy/article/3078745/what-us-china-trade-war-how-it-started-and-what-inside-phase . Accessed 10 Mar 2023
  2. “The Post-Pandemic Labor Market and Rising Inflation – Congressional Research Service”. https://crsreports.congress.gov/product/pdf/IN/IN11711 . Accessed 10 Mar 2023
  3. “United States Inflation Rate – Trading Economics”. https://tradingeconomics.com/united-states/inflation-cpi . Accessed 10 Mar 2023
  4. “Fundamental Analysis: Principles, Types, and How to Use It – Investopedia”. https://www.investopedia.com/terms/f/fundamentalanalysis.asp . Accessed 10 Mar 2023
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