Throughout the ages, traders, producers and speculators have made use of fundamental analysis to understand and correctly interpret economic developments, and attempted to profit from them. Past or present, there has been no shortage of individuals who have used their understanding of supply and demand in the markets for acquiring great wealth. Until the beginning of the 20th Century, all the speculative wealth generated by speculative activity was created through the guidance of fundamental analysis. Like any theories or trading strategies, fundamental analysis require deep knowledge and understanding of its different components. There is always a risk involved when trading the currency markets, regardless of the analysis method used.
Fundamental analysis is the study of the causes of price developments, as determined by the supply and demand dynamics of economic activity. To be sure, markets are independent of underlying economic dynamics in the short term. The speculative enthusiasm of major market actors does not allow short term price developments to reflect the underlying trends of economic activity. On the other hand, since all speculative activity is eventually dependent on the availability of money, and as the availability of money is determined directly by fundamental economic factors, fundamental analysis is the best guide to understanding and predicting market developments in the long term. To give an example, regardless of the immediate reaction of the markets to an interest rate decision, the effects of the decision will be powerful in the course of years, the understanding of which is facilitated by the use of fundamental studies.
The fundamental analyst does not necessarily analyze the price action, although market movements must be inevitably be taken into account when studying economics. Economic events and government authorities do indeed react to market developments, and in many cases these reactions can be of momentous significance for both economic events and price action.
How does the analyst perform his study? There’s no single approach to this matter among traders. The vast majority of traders focuses on the short term market responses to fundamental data releases, and call the buy or sell signals generated by those reactions fundamental analysis. However, this approach is just another form of technical trading, since the interpretation and short term value of each news release is only dependent on the market’s internal dynamics. For instance, if the market reacts to a particular unemployment number by driving the value of a currency pair up, and the trader decides to buy that currency pair on the basis that the release is favorable to that currency pair, he certainly is not basing his decision on fundamental analysis. There’s no justification for the belief that the market’s short-term reaction to a piece of data is a guide to the meaning of that data. In that sense, the trader who completely ignores the purported fundamental causes behind market movements, and bases his actions on the technical aspect of trading alone is far more sensible than one who tries to incorporate fundamental explanations into his short-term trading decisions for the simple reason that there’s no fundamental explanation for short term market movements.
Fundamental analysis is concerned with all aspects of economic activity. Consequently, the statistical releases that shake the markets in the short term are just a small part of the analytical tools which are at the disposal of the fundamental trader. Indeed, it is often the case that news releases, statistical data are just backward-looking indicators with limited predictive value for the long term.
Social and Political Analysis
Under this heading a large number of concepts, including economic regulation, geopolitical tensions, economic habits of a nation, and many other aspects indirectly related to economic functions are analyzed.
Traders with just a little bit of experience will admit readily that the currency rates are strongly responsive to changes in the political environment of a nation. In addition, it is well known that the regulatory structure of a country can be very influential on its economic dynamism, which would be reflected on GDP values, and eventually on currency rates. But beyond these basic concepts, social and political analysis of a nation’s character can be very helpful in predicting the economic reactions of currency to all economic events at the global scale.
In example, many people were expecting the EU economy to perform much better than the American one in the aftermath of the 2008 collapse in economic activity, as the European consumer had a much smaller debt burden, and was affected by the collapse of the real estate bubble to a lesser extent. But those who defended this proposal were neglecting to perform the social analysis on the mentality and habits of the European consumer. Eventually, when the impact of the crisis was felt by Europeans, the reduction in spending was much more severe than initially expected due to the conservative mindset of the European consumer.
There are many cases where a raw analysis of the data, without accounting for the various different characteristics of nations, can lead to mistakes and errors on a grand scale. It is therefore important that we incorporate these characteristics into our analysis of interest rate changes or global shocks. On the other hand, the differences in national characteristics are not a result of genetics, and they are not irreversible; they merely reflect the divergent economic paths taken by nations, the varying regulatory mechanisms, and demographic trends which can all change in time.
It is self-evident that fundamental analysis will include economic analysis as per the definition of the term. This is the aspect of fundamental analysis which focuses on indicators, statistical releases and economic news to derive the data that can signal profitable trades to us. There are a very large number of releases that many traders keep track of, and many of those have an important impact on the short-term direction of the markets. But the kind of data that can allow us to make predictions and form conjectures on future price movements is more limited in nature. The GDP data, for instance, is carefully followed by market participants and its release results in volatility and excitement among market participants. However, since it’s backward looking, in many cases its value for understanding future developments is less than the inventory component of the release.
Let’s review a few of the major indicators used by the forex trader for generating signals.
The gross domestic product of a nation is the data that provides us the clearest and most straightforward snapshot of the economic situation of a nation. The GDP number includes everything that is produced inside the borders of a nation, and as such, it is the best indicator of overall economic activity in a county. One drawback associated with this data is the fact that it is backward looking. All the information contained in it relates to a previous quarter, and the number itself is usually calculated on the basis of information that is already available to the market. Many analysts use the available data to create their own estimates of the GDP number, and the market evaluates the actual release based on how much it diverges from the analyst consensus as surveyed by news channels and other media sources.
Interest rate decisions of central banks have long been the most important drivers of currency trends. In general, when central banks are moving in one or the other direction decisively, markets react in a similarly strong fashion and establish strong trends in currency pairs. Conversely, when central banks and government authorities are unclear about the future, and their own policies, volatility rises, and sometimes it is even possible that directionality in the markets disappears.
Interest rates are important because they define the cost of the cheapest borrowing available to anyone in an economy. As the Central Bank is the sole authority controlling the money supply at the lowest level, traders are very attentive to the decisions and declarations of these institutions. And the importance of interest rates is not limited to money supply either. In a healthy economy where money demand is in tune with growth, stimulatory or contractionary policies of central banks have great importance for determining unemployment, industrial production, trade deficits, and many other statistics.
Finally, since interest rates determine the attractiveness of a currency for speculators and investors all over the world, interest rates are powerful determinants of currency flows to a nation, which, by virtue of supply and demand dynamics, determines the value of a currency against its peers.
The PPI (the producer price index) measures the pipeline price pressures at the producer level. Producers increase or reduce prices in response to many dynamics including import and labor costs, but consumer demands are less relevant to their pricing choices, unless there’s a general slack in demand. Thus there’s often a large gap between the PPI and the CPI, depending on the overall economic conditions of a nation.
The release of the PPI is rarely a market moving event unless the numbers are too surprising and unexpected. Otherwise, most traders focus on the close relative of this statistic, the CPI, and only use the PPI data as a kind of preliminary release of the consumer price index. Nonetheless, especially the gap between the CPI and the PPI can be very useful for analyzing economic trends.
The consumer price index is one of the most important fundamental indicators, measuring price pressures at the consumer level. Since consumers are the end users of all products and services in an economy, price pressures on consumer goods must eventually be reflected on wages which leads to inflation. Central Banks are very attentive to the CPI and base their interest rate decisions on the changes in the underlying CPI trend. For some central banks, the CPI is the single most important indicator for determining policy rates.
As the importance of interest rates in determining the value of currencies against one another is well-known, the CPI is one of the most closely watched indicators in the currency market. An unexpected number has the potential to change market perceptions about a currency’s future value drastically. Nonetheless, CPI is just the snapshot of price pressures as of the day it is released, and it is predictive power is limited.
The commitment of traders (COT) report is released by the Chicago Board of Trade each week reflecting the commitment of various small and large speculators in the US commodity futures market. The report categorizes traders according to their purpose: non-commercial traders are financial firms and speculators whose main purpose is to profit from price swings, with no real interest in buying or using the underlying commodity. Commercial firms are those that use the commodity bought for purposes other than speculation.
The COT report’s main use for currency traders is as a volume indicator. Since there’s no central authority for the currency exchange market, traders turn to the COT report for gauging the depth of the market with respect to any currency pair. There are many other uses of the COT report including for predicting market reversals, but those lie beyond the scope of this introductory article.
The information contained in these statistical releases is not very helpful when it is used by itself alone. Since the purpose is to gain an understanding of economic developments, and to establish a framework within which we can evaluate price trends, we must combine the data with our own insight. Without that additional angle provided by study and analysis, raw data has very little use for explaining the economic facts behind price developments.
If you choose to use the data for short-term trading, fundamental news releases must still be coupled with some kind of secondary information in order to allow the successful implementation of a trading strategy. It is well known that immediate market responses to fundamental releases are erratic and unpredictable. As a result, unless the news release is very surprising, it is not a good idea to formulate short term strategies purely on the basis of news releases. Indeed, fundamental analysis is perhaps the worst tool for trading markets in the short term.
Next, part 8 >> Forex Trading Psychology: The Four Demons of Trading Psychology >>
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Forex Lessons in this Forex Trading Course:
Lesson 1: How to read a currency quote
Lesson 4: Currency Pairs and Their Characteristics
Lesson 6: Forex Technical Analysis
Lesson 7: Forex Fundamental Analysis
Lesson 9: Choosing the Right Forex Broker
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