What is Fundamental Analysis?
Fundamental analysis, involves studying the economy of a country and to determine the effect this has on the value of its currency. When you come to know the relationship between an economy and its currency value, you can then somewhat determine the demand and the rise and fall in value for a particular currency when trading forex. You can say that it helps you to examine the economical, financial, qualitative and quantitative factors that can affect the security value. This can make you understand and compare the current price within the security and what position to take with that security.
How can we apply it to Forex?
One of the reasons that keep the world of finance apart as countries is currencies. Currencies represent each country’s economy and if we all had the same economy, and perhaps one central government, the world will have one currency.
- Currencies somehow are the tool used to measures the strength of an economy versus another.
When trading the Forex (foreign-exchange) market, one can use technical and fundamental analysis in similar ways as it is used for equities (stocks, shares). The purpose of a Fundamental or technical analysis is to predict future price action.
- In Forex fundamental analysis is applied by surveying the economic indicators of a country’s economy.
Such indicators will translate into higher or lower valuations for the currency of that country’s economy. Currencies chart price are assume to reflect countries economics news or economic reports.
Economic indicators are reports mainly released by government institutions or a private organization that survey, research or collect information about an specific indicators such inflation rate, unemployment rate and so on.
These reports are all scheduled into a calendar so that financial markets can somehow prepare and speculate about the upcoming announcement. Before the announcement is released; financial markets created an expectation of what is to come.
- The reports will indicate to the market how is the economy performing and it will be matched against markets expectations.
The report’s economic data can be better than expected or can also surprise markets. Therefore the market price of a currency will be subject to a positive or negative reaction from the market.
Reports v Expectations
Economic conditions change overtime and so will be market expectations. Take for instance interest rates. The market could be expecting lower interest rates and if the Reserve Bank keeps interest rate low or stable, that currency could be punish by the market.
In other occasions, markets could be expecting higher interest rates; if the Reserve bank fails to increase interest rate, that currency could be punished by the market. In this both cases the market sells the currency or pair in question, but what would happen if the Reserve Bank lower or increased the interest rate more than expected?
Some of the most follow Economic Indicators are:
- Interest Rate-When a country increases its interest rates, there will be a greater demand for that country’s currency. So that currency will strengthen.
- GDP-Gross Domestic Product is the value of all goods and services produced within a country over a specific period of time. It is a key indicator of the overall health of a country, and a growing GDP is always viewed as a positive sign for a country’s currency.
- Unemployment-Rising unemployment figures will lead to a weakening of a country’s currency while falling unemployment figures will lead to a strengthening of that country’s currency.
- CPI (Consumer Price Index)-The CPI is one of the most important indicators in terms of moving the markets and setting monetary policy. Consider looking at both the fixed and chain-weighted CPI.
- Inflation-A country with a budget surplus will enjoy a strengthening of its currency, while a country with a budget deficit will experience a weakening of its currency.
- Industrial Production-Investors can see what specific areas of industrial production are doing better than others and analysis of supply chains and which sectors could be benefiting – or suffering – based on the trends in industrial production.
It is common practice for traders to follow the economic calendar and used as trading tool. Traders must know which economic indicators will affect most a currency pair. For instance Australia economic has been very depend on mining, commodity prices will affect the Australian currency. Australian dollar traders are likely to follow the commodities index report.