The Importance of Fundamental Analysis in Forex Trading

Fundamental and technical analysis are both different types of market or forex analysis. Market analysis helps traders make better informed decisions when they trade, assess risks and organise their trades based on the information gathered. Traders use fundamental analysis to understand the forex market and what could drive prices up or down by analysing economic, social, and political forces. These forces could cause currency volatility as they influence the supply and demand of a currency.

What is fundamental analysis?

While technical analysis involves analysing charts to identify patterns or trends, fundamental analysis involves reading and analysing economic releases and data of the countries whose currencies you’re trading. Traders usually check a reliable Economic Calendar so they know what time certain data will be out and what their impact on the markets may be. Apart from economic data, traders who use fundamental analysis read the news for any headlines that could move markets. Geopolitical factors could influence currency movements and traders tend to pay close attention to news such as tensions between the US and China, for example. The ongoing conflict in Eastern Europe, concerns about the US ceiling debt or US recession fears affect global market sentiment and tend to push risk-sensitive currencies lower.

Also, when global market sentiment worsens, safe-haven currencies such as the US dollar, Swiss franc and Japanese yen tend to attract capital inflows.

Why does fundamental analysis matter?

When trading a currency, you need to understand what drives the price of that currency and what could influence its movement. By understanding the reasons why and how certain events could affect a country’s economy and monetary policy you could speculate whether demand for its currency will dwindle or increase, and thus make more well-informed decisions and increase your chances of trading success.

By gathering all the data and considering all the fundamental factors you can form a more comprehensive idea about a country’s current situation and future economic outlook and determine whether its currency will strengthen. If a country’s economy is faring, then it can attract more foreign investments which in turn will increase the attractiveness of that country’s currency.

When economic data is released, the markets react to it and whether data meets expectations, disappoints or pleasantly surprises markets, then the currency moves up, down or remains flat. Understanding the fundamentals is important as you can prepare yourself better and anticipate certain moves without having to deal with unexpected market volatility that could negatively impact your positions. Obviously, having the right risk management tools in place will also help you reduce losses.

Is fundamental analysis for longer-term traders?

There is this argument among traders, that fundamental analysis is only for longer-term traders and that day traders who trade within smaller timeframes only need to use technical analysis. This is however a mistaken point of view, as fundamental analysis can help all traders, even day traders or swing traders, as it can provide useful information and indications of price direction. Blindly using one or the other type of analysis can result in having a one-sided view of the market and missed trading opportunities.

Economic indicators

Fundamental analysis in the forex markets requires analysing various economic indicators. Economic indicators tend to be separated into three categories: leading, lagging and coincident economic indicators. Coincident economic indicators show the current state of the economy, lagging economic indicators show how well the economy fared in the past and leading economic indicators show how it will do in the future. Below we discuss some of the key economic indicators that traders usually watch closely as they have a significant impact on forex markets.

• GDP. Gross domestic product (GDP) measures the value added from a country’s production of goods and services during a specific period. The GDP also includes the income that was earned, or the total costs of the final goods and services. All OECD countries base their data collection on the 2008 System of National Accounts (SNA).
• Inflation (CPI). One of the most important indicators in the forex market, inflation or Consumer Price Index is released monthly for most G10 countries. When inflation is high, consumers have less purchasing power which can also lead to a decline in living standards. A stable low level of Inflation is positive as it promotes spending and investing, and economic growth.
• Unemployment Rate. The unemployment rate is a lagging indicator, out each month for most G10 currency countries. The unemployment rate is the percentage of unemployed workers in the labour force.
• Purchasing Managers’ Index. Purchasing Managers’ Index is a survey that shows how purchasing managers feel about the market, whether they are positive about business conditions or expect them to deteriorate or stay the same. The survey comes out each month and is represented by a headline number between 0-100. A number above 50 shows that the economy is expanding, whereas a number below 50 means economic activity has contracted. Under the PMI we have two significant categories: the Manufacturing PMI and Services PMI.
• Monetary policy and interest rates. Interest rates are set by central banks during their monetary policy meetings, and they tend to be market-moving events. The banks set the rates depending on the economic indicators and their assessment of the country’s economic conditions. The announcement as well as the press conference and any statements by policymakers are closely watched by traders and can impact the currency.

When the central bank tightens monetary policy, they hike interest rates. Higher rates mean higher borrowing costs which increases demand for the currency. On the other hand, a loose monetary policy, with lower rates and low inflation, means cheap borrowing costs and is meant to help push inflation higher.

Conclusion

The key economic indicators as well as monetary policy decisions by central banks are some of the essential forces that impact on a country’s currency and are closely watched when conducting fundamental analysis. However, as already mentioned, you can get a better and more comprehensive idea of the forex market by combining  both technical analysis and fundamental analysis.

Trading with T4Trade

T4Trade has a wide range of free educational resources to help you delve into the markets and support you when conducting fundamental and technical analysis. From webinars to podcasts, video on demand, as well as Live TV and eBooks, you can get ahead of the markets and organise your trades based on valuable information.

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Disclaimer: This information is not considered as investment advice or an investment recommendation, but is instead a marketing communication