Fundamental analysis is a method that attempts to predict the intrinsic value of an investment. It is based on the theory that the market price of an asset tends to move towards its ‘real value’ or ‘intrinsic value’.
Fundamental analysis in Forex entails predicting the price valuation of a currency and its market trends by analyzing current economic conditions, government policy and societal factors within a business cycle framework. Forex Traders gauge a country’s economic state by examining macroeconomic indicators covering:
- Interest Rates Announcement
- Gross Domestic Product (GDP)
- Consumer Price Index (Inflation) and Spending Indicators
- Employment Indicators
- Retail Trade and Consumer Confidence
- Balance of Trade Surplus or Deficit
- Government Fiscal and Monetary Policy
Fundamental Analysis Benefits
Determining the intrinsic value of an investment
Identifying long-term investment opportunities
Fundamental Analysis Drawbacks
Too many macroeconomic indicators and indicator can confuse novice investors
Macroeconomic indicators are statistics that indicate the current status of the economy of a state depending on a particular area of the economy (industry, labor market, trade, etc.). Capital One Forex provides an Economic Calendar for the dates of critical fundamental announcements and events. When properly used, these indicators can be an invaluable resource for any Forex trader.
Interest Rates Announcement
Interest rates play the most important role in moving the prices of currencies in the foreign exchange market. As the institutions that set interest rates, central banks are therefore the most influential actors. Interest rates dictate flows of investment. Since currencies are the representations of a country’s economy, differences in interest rates affect the relative worth of currencies in relation to one another. When central banks change interest rates they cause the forex market to experience movement and volatility.
Gross Domestic Product (GDP)
The GDP is the broadest measure of a country’s economy, and it represents the total market value of all goods and services produced in a country during a given year. Since the GDP figure itself is often considered a lagging indicator, most traders focus on the two reports that are issued in the months before the final GDP figures: the advance report and the preliminary report. Significant revisions between these reports can cause considerable volatility.
Consumer Price Index
The Consumer Price Index (CPI) is probably the most crucial indicator of inflation. It represents changes in the level of retail prices for the basic consumer basket. Inflation is tied directly to the purchasing power of a currency within its borders and affects its standing on the international markets. If the economy develops in normal conditions, the increase in CPI can lead to an increase in basic interest rates. This, in turn, leads to an increase in the attractiveness of a currency.
Employment indicators reflect the overall health of an economy or business cycle. In order to understand how an economy is functioning, it is important to know how many jobs are being created or destructed, what percentage of the workforce is actively working, and how many new people are claiming unemployment. For inflation measurement, it is also important to monitor the speed at which wages are growing.
The retail sales indicator is released on a monthly basis and is important to the foreign exchange trader because it shows the overall strength of consumer spending and the success of retail stores. The report is particularly useful because it is a timely indicator of broad consumer spending patterns that is adjusted for seasonal variables. It can be used to predict the performance of more important lagging indicators and to assess the immediate direction of an economy.
Balance of Payments
The Balance of Payments represents the ratio between the number of payments received from abroad and the number of payments going abroad. In other words, it shows the total foreign trade operations, trade balance, and balance between export and import, transfer payments. If the coming payment exceeds payments to other countries and international organizations the balance of payments is positive. The surplus is a favorable factor for the growth of the national currency.
Government Fiscal and Monetary policy
Stabilization of the economy (e.g., full employment, control of inflation, and an equitable balance of payments) is one of the goals that governments attempt to achieve through manipulation of fiscal and monetary policies. Fiscal policy relates to taxes and expenditures, monetary policy to financial markets and the supply of credit, money, and other financial assets.
Conclusion: There are many economic indicators and even more private reports that can be used to evaluate the fundamentals of forex. It’s important to take the time to not only look at the numbers but also understand what they mean and how they affect a nation’s economy.