Fundamental Analysis

Fundamental analysis usually would consider all of the forces that affect the economy, for instance production capacity, consumer confidence, employment data , etc. Fundamental analysis can assist in explaining past price movements and foresee future ones.

While financial news is critical to the fundamental analyst, it's important to be aware that fundamental analysis involves more than just following and comprehending financial news. The fundamental analyst isn't just guided by the news throughout the day, but is instead trying to bring about conclusions with regards to a currency's direction in the medium to long term. Subsequently, he opens positions available on the market (partly) according to these conclusions.

Fundamental analysis concerns to just about each and every trader even if trading based on technical analysis is more desirable to most traders these days. The reason behind the ongoing necessity of fundamental analysis is that the value of every currency is based on the economic situations in the location using the currency. Adjustments in those economic conditions influence that value.Being a currency trader you might therefore want to bring those (shifting) economic circumstances into consideration.

One of the difficulties of fundamental analysis is the fact that it doesn't really consist of market sentiment.

Someone using a trading strategy based primarily on fundamental analysis will consequently regularly believe that the price is shifting in the unsuitable direction, given the fundamental economic data.

However, a specialized day trader that doesn't take publications of economic information into account will also discover himself stopped out often. Prices of currency pairs can turn into highly volatile right before and after crucial economic numbers are published and technical indicators cannot foresee these type of swings.

Thus the most successful forex traders use both fundamental and technical analysis. To highly successful billionaire trader Bruce Kovner had something very relevant to say about this. When asked whether he regarded technical or fundamental analysis more handy, he replied: “This is like asking a doctor whether he would prefer treating a patient with diagnostics or with a chart keeping track of his condition. You need to have both.”

Why Economic News Is Significant

Economic indicators give all sorts of hints about the status of a nation's economy and the needs of both foreign and domestic businesses operating in that economy. Has the central bank of a country reduced its interest rate?

That indicates it will be cheaper to borrow money and also to invest. The money market will grow, generally leading to the currency to weaken compared to other currencies.

Governments and multinational corporations ‘create' the financial news. This news has both real and assuming value. The real value is determined by the actions and reactions of companies and governments, the speculative value is decided by traders.

Forex traders big and small respond to financial news because:

It suggests something about how multinationals (together with smaller companies) have operated within the preceding period and how they are likely going to operate in the next period. They might reduce economic process in a specific country for instance, and therefore have much less need to hedge against price movements in the currency of that country. Example: has the GDP of a country increased significantly compared to other countries? Then the currency of that country will possibly go up in demand. Not surprisingly, companies like to invest in a country that is doing efficiently. The value of the currency compared to other currencies will as a result probably go up.

It says something about the likely, future behavior of the authorities who's country the news was about.

Example: has the inflation within the Eurozone heightened to 5%? Chances are that the European Central Bank, the ECB, will increase the interest rate, shrinking the money market, (hopefully) triggering inflation to decline.

The value of the euro will likely go up in this scenario.

Other traders big and small will also take action to this news. Perhaps this is the most important factor why traders react to financial news: the anticipation other traders will also react to it.

Fundamental Analysis At Work

The currency market is active and transparent. News often has a direct influence on rates. Real news, but also and at least as vital speculative news.

As one age old saying from the financial markets goes: Buy on the rumor, sell on the news. It implies that the rumor about a specific future event is usually enough to push the price up or down. This is so much so the case in fact, that by the time the event itself happens, it's often already priced in meaning the outcome of the event, positive or negative, has already been added to the price. Often, the real event can even cause a reverse move, due to profit taking and/or expectations that weren't matched.

The effect of remarks made by major board members of important central banks like the ECB, the FED and the BOE is a widely recognized example of this. Each and every word the chairman of the Federal Reserve (the American central bank) utters, is picked apart and analyzed. The chairman is aware of this of course, and will therefore pick his words very carefully. Over the years, an entire dictionary of special words and phrases has come about, allowing the chairman to send out signals while not saying much. For instance, when the Fed chairman suggests that “inflationary indicators point towards a more protracted, higher level of inflation than earlier thought”, chances are that the American central bank will quickly raise the interest rate. In anticipation of the official judgement to raise the rate, traders will begin increasing their long positions on the dollar, causing it to go up, so that the interest rate increase is priced in long before the Fed broadcasts the actual decision to raise the rate.

Therefore, when you anticipate a currency pair to react to the publication of a particular economic event, first try to decide if that reaction hasn't already occurred, based on rumors about the approaching event. On the other hand, when a fresh rumor presents itself and you think it's trustworthy, it could certainly be worthwhile to open a position according to that rumor. When more and more traders pick up on the rumor and apply to similar positions, the trade will move in your expected direction. This will permit you to close the position before the rumor ever turns into news, and to pocket a nice profit.

It's important to think about what positions you want to placed on and why. Are there several websites forecasting a temporary rally of the US dollar? Is the media questioning about important macro-economic data generated from Japan? Is the ECB poised to come out with an interest rate conclusion? It might seem tough at first to keep track of all that information, but eventually you'll develop a critical sense and be able to examine the importance and possible impact of different news events on the forex, enabling you to use this information to your benefit in trading.

Simply put, fundamental analysis at work suggests getting information from diverse, reliable sources, distilling the direction of the currency pair influenced by that information, studying a candlestick chart to see the way the currency pair has been doing and consequently putting on a position (don't forget to restrict your risk in advance).

Let's look at an example. On the homepage of forexfactory.com you learn the headline: ‘Euro under pressure due to rumor no more German support for Greece'. Read the article and decide if the rumor is backed up by arguments. Next, check other financial news press like Bloomberg or Reuters to see if they support the story. If they do, it's time to evaluate the (candlestick) charts of the EUR/USD, choosing time frames that suit your strategy (for illustration, if you're a day trader you won't have much use for a weekly chart, but should instead look into daily, hourlyand 15 mincharts). If you see a loss of the rate of the EUR/USD in the course of the past couple of days, does it look to be part of an established downtrend, or did it start to drop only after negative news concerning the Greek crisis started coming through yet again, following weeks of relative peace and quiet? And how has the EUR/USD been moving during the earlier hours? If it looks like the pair is responding to the rumor, it might be wise to put on a position and ride the wave.

Always make sure you put a stop loss in place, restricting your losses when the movement of the pair in your direction ends up to be short lived.

Once you've chosen a good stop loss and profit target for your position, it's vital to stick to your guns. Don't start questioning yourself after you've put on the trade. You set up the trade to the best of your capabilities, so have a little faith in yourself. Many traders amass more losses than necessary by moving their stop loss when it seems like they're going to be stopped out, hoping the trade will still turn in their favor at some point (unfortunately, hope seldom gets you anywhere as a trader). Or they close their position too early, before reaching their profit target, thus limiting their profits, out of worry the trade will turn for the worse. Don't fall prey to these illogical hopes and fears, remain firm in your trades.

The Four Fundamental Themes Influencing The Forex

There are four fundamental themes driving the currency market:

1. Economic growth
2. Interest rates
3. Trade balance
4. Political stability

Economic growth

The strength of a currency is first of all determined by the strength of the economy in which it operates. And just as quarterly and annual reports of a business tell you a lot about the economic well being of that company, so does economic data put out by a country indicate to you a lot about the economic health of that country.

Important data about economic growth:

Gross Domestic Product (GDP)
Usually published a month right after the quarter ends, these are in essence quarterly growth reports.

Employment data
Most developed countries release employment figures, but the most significant employment data is the so called non farm payrolls, which are the employment numbers for the U.S economy, authored by the Bureau of Labor Statistics. These reports show the number of jobs were gained or lost in the US economy, not including jobs in the agricultural industry and government.

Consumer spending
 In many economies domestic consumption shapes the largest sector of the economy. In the United States for instance, 70% of the GDP is comprised of domestic consumption.

Consumer confidence
When citizens no longer have trust in their economic future, they'll reduce expenses and save more, in expectation of challenging times. Lower consumer confidence therefore results directly into lower consumption.

Production figures
When companies produce more, they hire more employees and will invest more often in new equipment, which in turn gives more work to companies making those machines, causing them to employ more workers , etc. Put simply, higher production figures indicate higher economic growth.

Interest rates

Anybody that took high school economics knows that economies are governed by cyclical tendencies, rising and falling with time. The highs and lows of those trends alter more frequently in the short term than in the long term (say 50 years).

In relation to this, two of the most important responsibilities of the state when it comes to macro-economics are to motivate GDP growth and to control the cyclical movements of the economy in an effort to prevent extreme highs and lows.

The first point seems sensible. The more Gross Domestic Product grows, the wealthier the country and the more profitable its citizens (well, most of the time anyway) The second point makes equally as much sense, but perhaps this is not instantly apparent. Obviously, cyclical lows should be countered, nobody likes recessions and depressions, but what's bad with a high flying economy, with businesses that are on fire, jobs for everybody and then some? Well, that has to do with the old saying what comes up, must go down. A thriving economy is great, but if left out of hand it will lead to an overheated economy, with real estate bubbles, substantial inflation, rising wages, a tighter labor market and an ever growing money market, because everyone wants to invest in that hot economy.

Until….The Big Turn Around. The market sentiment adjusts, companies are affected by a huge overproduction, people have to be let go, applications for unemployment benefits rise over the top, government expenses increase while tax revenues drop (thus setting up huge budget deficits) the money market tightens, investments fall and the economy takes a nose plunge.

Since nobody desires a situation like that, governments normally try to rein in the excesses of the economy's cyclical movements by targeting lower highs and higher lows. One important part of this is retaining price stability. Traditionally, this is the duty of a country's central bank. A central bank can, among other things, expand or cut down the available capital by altering the interest rate it charges commercial banks. For instance, when it happens to be more expensive for commercial banks to acquire money, it will also become more expensive for businesses to borrow money from banks to invest; the economy will therefore likely cool down.

Conversely, when borrowing money becomes less costly, an economy will likely draw in more investments.

Remember: when the interest rate is increased, the money market tightens because it becomes much more expensive to borrow and the worth of the currency rises. When the interest rate is reduced, the money market grows and the value of the currency typically decreases.

Central bank policy has been one of the most crucial factors driving the forex these last few years. Examples abound some of them notorious of central banks trying to affect the currency market by lowering the interest rate or by directly intervening on the forex itself through the purchasing or selling of currencies. The Bank of Japan (BOJ) for example is known for intervening on the forex, taking on huge positions to have an effect on the rate of the yen.

Two interest rate increases by the European Central Bank, in mid 2011, make up another noteworthy case of central bank policy affecting the forex. The EUR/USD rose 700 pips after then ECB President Jean-Claude Trichet gave of a first hint that he would increase the rates if inflation continued to be above 2 percent. Upon coming into office a few months later, Trichet's successor, Mario Draghi, instantly cut the interest rate once again, back to what they had been. Many economists have agreed with Draghi, believing Trichet had focussed far too much on

inflation, and thus ignoring the quickly worsening state of the European economy, which needed more liquidity (meaning cheaper money, and thus lower interest rates) to rebound.

Mind, that it's not just the actual rate decision of the Federal Reserve, Bank of England, Bank of Japan or ECB that counts, but also the feedback from central bank board members, especially chairmans / governors / presidents. Their messages and press conferences are carefully observed for indicators about future policy decisions.

That doesn't mean you have to place the microphone in the face of the chairman of the Federal Reserve on your own, or listen to each speech in its entirety, but be sure to keep close track of the financial news media about noteworthy responses from central bank members.

 

Trade balance

Suppose the United States imports 100 billion dollars more products more from the Eurozone than it exports. To bring in those goods the Americans will need euros. So in effect, they will obtain 100 billion dollars worth of euros. The US trade deficit therefore triggers the euro to rise in value in comparison to the dollar.

Of course the reality is more complicated than the above illustration (what to think of US firms that export goods from within the eurozone to the United States for example?). However, it is crucial to recognize that the value of a currency can decrease when the trade balance deteriorates.

Therefore, when it ends up that the US trade balance dropped by 3% after it was predicted to decline only by 2%, there is a pretty good possibility the US dollar will drop in value.

 

Political stability

The FX is swayed by politics much more than stock markets are. This is easy to understand, because on the forex one basically trades in national economies, not in specific companies. Political fluctuations of a nation can harm economic advancement in that nation and thus decline its currency. Think about the euro crisis; at least part of the euro's decline in value was brought on by the steady bickering of European leaders as to how best resolve the credit crisis that first swallowed up Greece, Ireland and Portugal, succeeded by Italy and Spain, and ultimately the whole of the Eurozone.

 

Note
Although you might see more value in technical trading (which we'll discuss next) it would still be wise to keep an eye on these four fundamental concepts. Information about employment, economic growth, important developments in national legislatures/politics (for instance, the argument in the US Congress over raising the national debt ceiling, in 2011, causing worry over the financial markets) and interest rate decisions, they can more or less all have a direct influence on a currency pair, regardless of technical indicators say.