What is fundamental analysis in forex?
Fundamental analysis looks at the forex market by analysing economic, social, and political forces affecting global currency prices.
Fundamental analysis is critical for forex traders as the factors mentioned above will significantly influence the price of any currency pair.
Here we’ll discuss how to apply fundamental analysis to make informed FX trading decisions.
We’ll also cover the value of your economic calendar, how to plan your trading week based on upcoming events, combining fundamental and technical analysis and much more.
What is fundamental analysis?
Fundamental analysis in forex is the science you use to gauge the market’s sentiment by reading the latest economic reports and data releases.
The economic calendar your broker provides you free of charge is your go-to reference for fundamental analysis.
The calendar will list the upcoming events over the coming days and weeks. It’ll list publications such as interest rate decisions, inflation reports, unemployment and employment reports, industry sentiment readings and import and export figures.
Not an exhaustive list; we’re highlighting some of the essential releases you need to watch to make better-informed FX trading decisions.
How can you apply fundamental analysis to your forex trading?
The events listed on your economic calendar get listed as low, medium and high impact events. The highest rankings tend to affect the forex market more when the information is published.
Let’s focus on two high impact examples in this section to help you understand how to put fundamental analysis to work. We’ll look at interest rate decisions and inflation reports.
Central banks typically meet once a month to set the interest rate for their country’s economy. Ironically, the bank’s rate-setting committee members will use many of the fundamental data you also have access to for their decision-making.
The forthcoming interest rate announcement will get listed as high impact on your economic calendar. Many banks will continually deliver forward guidance on rates to give investors and traders plenty of notification that any change is imminent. They do this to prevent any shocks and to help smooth out any sudden price changes.
If the USA Federal Reserve announces no change to the key interest rates, then the value of currency pairs such as EUR/USD, USD/JPY and GBP/USD will remain in a tight range unless the markets were expecting a change.
If there is an unexpected cut or rise in the interest rate, these currency pair values will change. The change will be more extreme depending on how much the rate gets adjusted.
The interest rate-setting announcement is just one part of the central bank’s actions. Traders also carefully examine the accompanying text in the form of a press release outlining the reasons for the bank’s decision.
The bank will also hold a press conference either at once or shortly after the interest rate decision announcement to take questions and justify their reasons.
Currency pairs can rise or fall sharply when the press release gets published, or as the bank holds its conference, as traders and investors will be receiving live information to back up the decision. Currency pairs can spike far more during the panel’s broadcast compared to the actual decision’s publication.
If interest rates go up or the Fed delivers hawkish statements, the price of USD will increase versus its peers. The opposite is true if the interest rate goes down.
This rise or fall relates to traders’ sentiment. They might buy US dollars if interest rates rise because they’ll get a better rate than being in long term bonds. They might also short equity US markets because corporations’ profits will fall if they pay more interest on their debts.
We’ve all experienced the impact of rising inflation; we see it in the price of goods and services we buy. Your energy costs might go up at home, you may pay more at the pump to put fuel in your car, and the prices of staple foods like fruit and veg might go up in your supermarket. But why does inflation rise, causing these price rises?
The interest rates we mentioned previously will affect inflation; if producers and retailers pay more for their debt, they might increase prices to ensure their profit margins remain the same.
Also, we must keep an eye on rising commodity prices when we’re analysing inflation. There isn’t an industrial or manufacturing process that doesn’t involve oil or its derivatives. If the oil price increases on markets, then all manufactured goods might increase in price.
Suppose inflation becomes a concern for a central bank; they might increase the interest rate to cool an economy down, people will then borrow less and consume less.
An inflation report might show the build-up of inflationary pressure, and a central bank or government then issues concerning statements. In that case, traders might bid up the currency because they think an interest rate rise is imminent.
For instance, if inflation rises quickly and sharply in the US, the Federal Reserve might increase the headline interest rate. Investors might bid up USD versus its peers, and other investors might rotate out of low-interest bonds into the higher yield of USD. The stock markets in the US might also fall as investors seek out the safe haven of USD and perhaps precious metals.
The importance of your economic calendar when you trade forex
If you’re a trader who favours fundamental analysis, then your economic calendar is the most valuable tool in your box.
You can tailor it to fit your trading preferences. For example, if you only trade USD pairs, you can use filters to cater to this. You can set your calendar to alert you of announcements during the London and European session only and use added filters to remove low impact calendar events from the feed.
It’s not an exaggeration to state that the moves in the forex market entirely depend on micro and macro fundamental economic events, which then alter the sentiment of a specific currency and its pairs.
We’ll discuss the relationship between fundamental and technical analysis later, but the value of USD/JPY doesn’t alter because a few squiggly or horizontal lines cross. Price adjusts because of changes in the fundamentals relating to a currency.
How to interpret economic releases
As you progress in your FX trading career, you’ll inevitably become a competent part-time analyst and economist. You’ll hear GDP, unemployment, inflation and interest rate news, and your ears will prick up.
How you interpret this news is critical to your success as a trader, and the interpretation only involves some basic groundwork and understanding to put your knowledge to work.
Let’s list a few critical high impact news releases listed on your economic calendar and suggest how they affect the markets when broadcast.
- Central bank interest rates
A Central Bank (CB) raises rates; the currency rises versus its peers. The CB lower rates; the money falls in value. If the CB also engages in QE, more money will circulate, lowering the currency’s appeal and value.
On the first Friday of each month, the BLS publishes the NFP jobs report in the USA. If this figure is bullish, then it might be positive for both equity markets and the value of USD. Conversely, bearish jobs reports can be harmful to financial markets.
Gross domestic product measures the total turnover of all goods and services for a country. If the figure rises, it’s considered bullish for an economy because it’s expanding. Contractions can be damaging for the currency and domestic equity markets.
The purchasing manager reports are valuable publications. Analysts look upon them as leading, not lagging, values. Each month, the PMs get asked for their metrics and opinions on how their industry and sector perform.
When you think about it, this makes perfect sense. If the PMs buy more, place more orders, and have a generally optimistic view of the short-term future of their industries and sectors, then we can’t get a better idea of the direction of an economy.
The differences between technical and fundamental analysis
Technical analysis is a method to examine and predict price movements in financial markets using historical price charts and market statistics.
The idea is if a trader can identify earlier market patterns, they can form a reasonably accurate prediction of future price trajectories.
Fundamental analysis focuses on an asset’s actual value; external factors and value are both considered. In comparison, technical analysis is based only on the price charts of an investment or security.
Technical analysis is based on the identification of patterns on a chart to predict future movements.
Most proficient forex analysts and traders will contest that applying a combination of tech, and fundamental analysis will lead to reasoned and informed decisions.
Even if you are the most committed fundamental analyst and a trader who favours fundamental analysis more than anything else, you can’t ignore the technical aspect.
How can you combine fundamental and technical analysis?
Let’s imagine a report for the UK comes out revealing that inflation has reached 5%. FX traders bid up GBP versus its peers. For example, GBP/USD spikes up to 1.3800.
But many traders and long-term investors look at the technical level of 1.4000 as a handle and round number and conclude that price might experience rejection at that level. They place sell orders at this critical price level. In reality, there might be a lot of buy and sell orders clustered around this handle.
So, as you can see from the example, you can never ignore technical analysis, even at the most basic level. There’s also moving averages that many traders will use, even if they’re not fans of cluttering their charts with indicators. The 50 and 200 MAs plotted on the daily timeframe are time-honoured methods to deduce if a market is bearish or bullish.
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