What is fundamental analysis?

If you’re new to Forex trading, one of your first tasks is to find a ‘strategy’. This strategy will help you make trading decisions – and hopefully make you profitable. Fundamental analysis is one of the strategies you can choose. In fact, it’s the strategy I encourage you to choose – as it’s the preferred methodology of professional traders across the globe. So what is fundamental analysis? To understand this concept, you first need to recognise the link between real-world events and market price.

Events move the markets

Have you ever noticed how real events move the markets? For example, when something bad happens – such as an act of terrorism or natural disaster – the relevant country’s financial markets often fall.

Trust me, this principle is absolutely sound. As events (good or bad) unfold, they feed into the sentiment of market participants, which then results in price movements. Good events support currency price, while bad events weaken a currency.

Put another way – when something significant happens in the world – you can expect a price reaction in the world’s major currencies.

Fundamental analysis explained

Fundamental analysis is a method of evaluating a currency (or anything else) in order to identify its true tangible value.

This evaluation can include anything that could be identified as a reason behind why the price is moving in a particular direction. For example, if the price of a currency is falling then fundamental analysis would try and determine why that was happening.

Fundamental analysis is also used to try and determine which way a currency might move in the future. It can be utilised for both short-term and long-term trading.

Remember, the key drivers of currencies are central banks. The key drivers of central banks are economic indicators. The key drivers of economic indicators are the performance and health of the overall economy.

When a central bank wants to improve the health of the economy it will implement tools to do so. Traders make money by watching the same information and then jumping into the markets – just before they believe the banks will act. This is a constant cycle and almost every major price move in the markets is caused by traders trying to second guess what the central banks might do next.

Other world events can affect currency price too.

Real-world examples

But don’t just take my word for it. Recent history is scattered with examples of global events shifting the direction of the market.

Let’s look back to 2016. Britain’s decision to leave the European Union caused the pound to plummet against the US dollar. The reasons for this are deceivingly simple. Brexit is broadly seen as something that will cause uncertainty for the UK economy. This is bad for the pound, as uncertainty will deter future foreign direct investment – hampering future economic growth.

Hopefully, you can see the power of understanding the ‘fundamentals’. By knowing the drivers of economic growth – and being in tune with current events – predicting market moves becomes an easier exercise.

What events move the markets?

But it’s just not events like Brexit which affect currency price. In fact, on any given day there are a number of events that can affect price. They are as follows:

Employment Data

When a country releases employment data, it usually has an impact on its currency. This is because a country’s level of employment is a good indicator of its economic health. Employment data that beats expectations usually causes a currency to rise in value, while data that misses expectations often has the opposite effect.

Inflation Data

Inflation is another key piece of economic data. It’s simply the rate at which the prices of services and goods are increasing. Major economies are expected to maintain a rate of inflation of around 2%. Inflation that is too high or too low can be bad for an economy and its currency.

Interest Rate Decisions

Interest rate decisions should be something that every Forex trader monitors. A decision to increase interest rates is usually taken because an economy is performing well. This acts to strengthen a currency over the long-term. A cut in interest rates usually means that an economy is struggling to grow; this is something which weakens a currency over the long-term.

Statements from Central Banks

Press conferences from the heads of major central banks can also cause ripples in the markets. This is especially true when they detail monetary policy forward guidance (e.g. whether interest rates will be increased/cut).

Statements from politicians

Governments are in charge of fiscal policy (taxation and public spending). Fiscal policy can have a drastic impact on the price of a currency. For example, if a country has a low level of corporation tax, it can drive foreign direct investment, acting to strengthen a currency.

Natural disasters

If a country has the misfortune of experiencing a major natural disaster, this can have a detrimental impact on their financial markets and currency.

Wars & terrorism

War and terrorism cause uncertainty and panic – something which the markets do not like. In these scenarios, it’s not unusual to see the price of a currency fall.

Elections

Elections also have the power to move currency price. We’ve seen examples of this in the UK recently. The EU referendum (2016) and UK General Election (2017) both produced unexpected results, shocking the markets and causing the pound to fall.

Keeping track

So how does a trader keep track of global events? Surely there’s too much information to absorb? Well, it’s simply a question of knowing where to look and prioritising information.

Firstly, let’s look at economic data releases. Respective countries usually release economic data once per month. Therefore, Forex traders can plan to trade data releases in advance. Data releases are collated in something called an economic calendar.

There are many free economic calendars that you can use on the internet. But in my view, the best one I’ve used comes from Forex Factory. Their economic calendar is exceptional – listing everything a trader would need to know about an up and coming trading event.

Criticisms

There are some traders who criticise fundamental analysis. The criticism is often centred at the methodologies inability to quantify the impact of an event in specific terms.

But I believe this criticism is misguided.

Fundamental analysis is incredibly powerful in letting you determine the direction of future price movements.

You only need to look at the 24-hour news coverage of the markets to realise that they are extremely sensitive to real-world events.

Getting started with fundamental analysis

One of my goals as a trading educator has been to simplify fundamental analysis. The strategy is often made to look more complex than it is.

If you’re interested in using fundamental analysis, this is how I suggest you get started.

  • Bookmark an economic calendar.
  • Monitor an online news source which reports on market moving events in real-time (I suggest Forex Live).
  • In every news article you read, attempt to identify four key things. Firstly, the currency pair the news will affect. Secondly, the current price direction of that currency pair. Thirdly, the reason for that price direction. Finally, how the author thinks price direction might change in the future.
  • Try and put your analysis into practice. If it’s your first time trading, perhaps try using a demo account first.

I hope you’ve found this article useful. If you have any questions, please leave them in the comments below.

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