When it comes to forecasting forex rates, the science of fundamental analysis involves taking into account a variety of relevant economic and political factors for one currency relative to the other currency in each currency pair considered.
A fundamental analyst will review as many of these items as possible on a regular basis for each currency and then compare the two to obtain a forecast. Generally, such forecasts are not specific objective numbers for the exchange rate, but instead an overall directional outlook on the currency pair.
For example, their outlook might be positive, negative or neutral after the analysis. This would mean that the analyst expects the exchange rate for the currency pair to rise, fall or stay roughly constant respectively.
Furthermore, when some new fundamental information enters the forex market in a sudden way, it can prompt significant market moves and volatility as traders react to the new information. At such times, one of the most basic assumptions of technical analysis - the idea that "price discounts all" - breaks down until the new information has been duly assimilated.
If you have a trading system based on purely technical indicators this is really important, as a number of key fundamental factors can and often do influence market moves, which may produce unexpected results when trading using systems based on technical analysis.
As a result, it really pays to know what the likely effects of such key fundamental information could be so that a quick assessment of probably future direction can be made.
Primary Fundamental Information Types
The types of fundamental data items which will most impact a country's currency along with a brief description of its likely effect include the following:
- Growth: Changes in the country's Gross Domestic Product or GDP that gives a useful measure of growth. A growing economy tends to strengthen a currency.
- Rates: The level of short term interest rates, such as the Fed Funds rate, in the currency's country of origin affect forex rates because higher rates provide an investment incentive that should strengthen the currency.
- Trade: The country's trade and current account balance can have an impact on forex rates since persistent trade or current account deficits will tend to depreciate that country's currency.
- Economy: The general economic outlook for one country in relation to that of the other country can affect forex rates. The forex market tends to value currencies of peaceful countries with growing economies and stable politics over the currencies of less stable countries that are at war or having their national security threatened in some other way.
Key Economic Factors
Many forex traders perform a daily review of economic calendars for the currency pairs they maintain positions in. They do so since the release of such key information can often result in considerable short term volatility in the currency market, as well as prompt shifts in market sentiment.
A list of key economic factors that are routinely covered in the current news and which can move the market when they are released includes the following:
- Interest Rates: a key element in evaluating one currency against another. If interest rates are increased, the currency of the country becomes more attractive against other currencies offering lower interest rates.
- Inflation: If the country is in an inflationary economic cycle indicated by the Consumer and Producer Price Indexes, CPI and PPI, this would make it more likely that the central bank of that country would tighten interest rates in order to stem the increase in inflation. An increase in rates would tend to make the currency appreciate.
- Trade or Currency Account Balance: A trade or current account surplus or deficit will either favor the currency rate for the country with a surplus or weaken the rate for the country with a trade deficit.
- Credit: Another economic factor that will influence exchange rates directly. If a country has borrowed excessively large sums of money from other nations or from the IMF, its currency will surely reflect the serious level of debt the country is in.
- Gross Domestic Product (GDP): Represents the total of goods and services a country produces and reflects the level of growth in the economy.
- Commodity Prices: Can affect exchange rates when the country is a producer and net exporter of commodities and if the country imports commodities.
- Employment Data: If a country has an increasing percentage of its citizens employed that will tend to strengthen its currency. This key data typically comes in the form of jobless claims, payrolls statistics or the unemployment rate for a country.
- Industrial Production: A strong industrial base will tend to strengthen a nation's currency.
- Retail Sales: A strong retail sales figure is generally favorable for a currency and the country's overall economy.
- Consumer Price Index (CPI): A measure of inflation. Rising inflation in a country indicates that interest rates may soon be tightened by the national central bank and so will tend to make its currency appreciate.
- Supply and Demand Effects: Substantial flows of capital into one currency and out of another currency, perhaps as a result of large corporate transactions or managed portfolio shifts, can shift the exchange rate for the currency pair to favor whichever currency sees the higher demand.
- Monetary Policy: Because of the effect of monetary policy on interest rates, this makes up an important element in the valuation of a currency. Tighter monetary policy implying higher interest rates, while dovish or looser monetary policy indicating lower interest rates.
- Political Influences: Countries with stable governments tend to have their currencies favored over those of countries with less favorable political situations. Greater fiscal responsibility also tends to support a country's currency, while excessive government spending will tend to depreciate its currency.
- Commodity Price: The prices of key commodities like gold and oil tend to affect the valuation of the currencies of their primary exporters and importers. For example, higher oil prices help the British Pound and the Canadian Dollar, while they hurt the U.S. Dollar and the Japanese Yen, whose countries net import oil. Furthermore, higher gold prices tend to favorably impact the Australian Dollar, and by close association the New Zealand Dollar, since Australia exports that precious metal and so its currency will benefit from a rise in gold's value.
Fundamental Information and Technical Trading
Combining fundamental news analysis along with technical analysis offers the trader the best of both worlds and will minimize surprises while trading.
Some traders purposefully avoid trading on days with economic releases because the market may become temporarily volatile only to settle back towards the original trend.
Also, technical forex traders might avoid known risk events like major economic data releases since one of the key assumptions of technical analysis: "Price Discounts All" tends to break down during the period immediately after the announcement as the new information is assimilated into the price.