The fundamental analysis in trading is a method by which we can evaluate an asset’s intrinsic value by assessing economic, financial, and other quantitative or qualitative market factors. It helps traders determine whether an asset is overvalued or undervalued by the market, allowing them to make trading decisions based on perceived value rather than solely on technical analysis (price movements). Fundamental analysis may include examining related economic factors such as inflation, interest rates, and microeconomic indicators.
What is the difference between Fundamental and Technical analysis?
Fundamental analysis is different from technical analysis. When we talk about the technicals, we mean that we analyse what we see on the trading chart, using indicators, volume, patterns, and other tools available on the trading platform to identify potential entry and exit points.
Some traders prefer only to use technical analysis while trading, so they are satisfied with the charts telling them the financial instrument’s direction. Similarly, some traders prefer fundamental analysis, so they only trade off big events such as decisions made by banks and governments, or events related to natural disasters.
Don’t search for an answer about fundamental vs technical? , because there is no right or wrong way to follow while trading. It’s up to you to choose the way you prefer while trading to get the best results from your perspective. Just a note that the confluence between technical and fundamental analysis may enhance your trading decisions, allowing you to make more informed decisions and avoid the risk of significant fluctuations in response to fundamental factors you didn’t notice.
How to Trade Using Fundamental Analysis:
In the dynamic forex trading market, it’s essential to understand the macroeconomic factors that significantly influence a nation’s economic stability, growth, and monetary policy. These factors also impact a country’s currency supply and demand, affecting future and current value. Therefore, when forex traders monitor and interpret these macroeconomic factors, they can analyse the short and long-term trends and anticipate currency movements. allowing them to develop a well-informed trading strategy.
Let’s delve into the details below.
Macroeconomic Factors:
I. Economic growth (GDP):
The gross domestic product (GDP) represents the total value of all goods and services produced within the country’s borders during a specific period. GDP indicates economic health and growth. When GDP rises, the economy expands; conversely, a falling GDP indicates weakness or recession.
Forex traders closely watch the GDP announcements because changes in GDP can significantly affect the currency’s movements, and let the governments make decisions in response to GDP numbers, which also may affect the market. So, Traders usually try to anticipate the release of GDP data and position their trades accordingly.
There are different reactions to GDP, closely watched by investors:
- GDP released lower than expected:
When a country’s GDP numbers are released lower than expected, it indicates a weakening economy and poor performance, which can lead to the currency losing value compared to other currencies. For instance, when the U.S. GDP is lower than expected, that indicates that the monetary policy may decide to ease its interest rate level or not raise it. This will make investment in the US Dollar less attractive. Thus, the dollar might drop.
- GDP released as expected:
When a country’s GDP figures are released as expected, the currency price trades in a mixed manner without a clear direction. In this situation, traders typically seek additional details to interpret what may come next, leading investors to examine GDP figures from the last few years or the same period the previous year for comparison in order to gain a comprehensive understanding.
- GDP released higher than expected:
A higher-than-expected GDP usually strengthens the country’s currency and indicates that this economy is an attractive business environment. It boosts consumer confidence and increases the springs within the country. For instance, if the US GDP is released higher than expected, we might see the US Dollar appreciate against other currencies.
II. Inflation:
Inflation measures the rate at which the purchasing power of money changes over time, as well as the gradual change in the prices of goods and services. When the price inflates, each unit of money becomes less valuable.
The inflation rate is the average price of a basket of selected goods and services over one year. A high inflation rate means prices are going up quickly, while a lower inflation rate means prices are going up more slowly.
In response to the inflation rate, the central banks responded that a higher inflation rate could lead them to raise interest rates to cap rising prices. The higher interest rate will make the country more attractive for foreign investment due to the high interest rate, and thus, the country’s currency will be appreciated.
For instance, when the Federal Reserve Bank raises the interest rate, this will make the dollar more attractive for foreign countries to invest in, due to the high interest rate. So we tend to see the US Dollar index rising in this case; conversely, if the Federal Reserve cuts the interest rate, the US dollar loses appreciation.
III. Interest Rate:
Central bank interest rate changes typically influence the foreign exchange markets. The interest rate responds to economic indicators, so any surprise change in the rate may affect traders.
Interest rate represents the percentage of interest on the principal. Whether for the lender or a charge on the borrower. It is the borrower’s debt cost and the lender’s rate of return.
When you take out a loan, you will pay the principal and an additional percentage to compensate the lender. This extra amount is considered a return for the lender and the cost of the loan for the borrower.
How do interest rate changes affect the currency market, stocks, and commodities?
- For the currency market, when the country’s central bank raises the interest rate, its currency becomes more attractive for foreign investment, which will appreciate its currency against other currencies. Conversely, a lower interest rate can cause the currency to lose its appreciation.
For example, suppose the BOE decides to cut the interest rate, and the Federal Reserve Bank intends to hold a higher interest rate or raise it. In that case, the GBP will lose its appreciation due to increased interest yield compared to the US dollar. At the same time, the US dollar will be strengthened by expected higher interest rates, which will influence the GBP/USD movements.
- For the Stock Markets, higher interest rates will negatively impact stock prices due to increased borrowing costs, which reduce companies’ profitability and slow down expansion. Additionally, this would make the stocks less attractive relative to lower-risk assets like bonds, because a higher interest rate will increase the discount rate used in valuing the company’s future earnings.
- For the Commodities, it’s all about opportunity cost; higher interest rates potentially make assets like commodities( non-yielding assets) less attractive than interest-bearing assets.
Interest rates are a crucial fundamental driver in the financial markets, which traders must monitor. This economic data can help them anticipate market movements and make informed trading decisions.
IV. Unemployment:
The unemployment rate measures the percentage of the labor force seeking employment. This rate is a crucial indicator of the economy’s health and it’s closely watched by the central banks when making monetary policy decisions, especially regarding interest rates.
Higher unemployment rates indicate an unhealthy economy and reduce a country’s consumption and productivity, which can decrease confidence in the country’s currency, and cause it to lose value. Conversely, a low unemployment rate indicates a healthy economy and currency appreciation.
From the market sentiment perspective, low unemployment rates boost confidence and increase risk appetite, which could favour higher-yielding currencies and capital assets. Conversely, high unemployment rates will lower the risk appetite and benefit safe-haven currencies or non-yielding assets such as gold and silver.
V. Fiscal Policy:
Fiscal policy refers to the government’s spending and taxation to influence the economy, whether in recession or growth. During the recession, governments increased spending and cut taxes to encourage the economy. Conversely, when inflation rises, governments raise interest rates and cut spending to cool down the economy.
There are two types of fiscal policy :
- An expansionary fiscal policy: a lower tax rate, high government spending to increase the aggregate demand, and boost economic growth.
This policy boosts the investor’s confidence and strengthens the currency in the long run, while the immediate impact on the market might be mixed without a clear direction for the currency.
- A contractionary fiscal policy: higher interest rates and cutting government spending are ways to prevent or decrease the inflation rate.
This policy has an opposite impact on the expansionary policy effect, so investors may reduce their confidence due to higher borrowing costs and become more cautious while trading. They tend to focus on safe-haven assets in these times and avoid interest-bearing assets and currencies.
VI. Monetary Policy:
The monetary policy refers to a set of actions the central bank takes to control the money supply and achieve economic growth. Primarily through interest rate adjustments and tools such as quantitative easing and quantitative tightening, QE means that the central bank injects liquidity into the market (increases the money supply) to encourage the economy by purchasing assets(Government Bonds). QE can weaken the currency; conversely, the QT is the reverse cycle, in which the central bank absorbs liquidity (reduces the money supply) from the market, thereby strengthening the currency.
Traders should closely observe key economic data and events, including any policymaker meetings and speeches on these major factors, while trading in foreign exchange markets. Any changes in these policies will influence the underlying currency’s price movement, enabling traders to anticipate price shifts based on these macroeconomic factors.
Key economic indexes traders should watch:
Two key indices are closely monitored by the central banks when making interest rate decisions. Traders should also pay attention to these indices to anticipate the central bank’s decisions regarding interest rate policy, which will help them refine their trading strategies.
- Consumer Price Index- CPI:
The Consumer Price Index (CPI) measures the overall change in prices of a basket of goods and services over time. The index shows this change as a percentage on a month-on-month (MoM) and year-on-year (YoY) basis.
The Core CPI is the preferred figure for central banks because it excludes the volatile components of food and fuel, providing more accurate data. When the core CPI exceeds 2%, it usually indicates that central banks will raise interest rates to control the rising inflation rate, and vice versa. When it falls near or below 2%, central banks will likely cut rates to support the economy and slow the pace of deflation.
Typically, a high interest rate attracts capital inflow, which benefits a currency; it can also help reduce high inflation caused by imported goods and services. Conversely, when inflation falls, the opposite is true. Therefore, traders should closely monitor this index to predict market reactions after the data is released, whether it is above or below the 2% threshold. This enables traders to make informed decisions about their trades and avoid unnecessary risks.
- Producer Price Index- PPI:
The producer price index (PPI) measures the average change in the prices for goods and services from the perspective of the product manufacturer or service supplier. High PPI readings indicate that manufacturing costs are elevated and inflated, which signals a potential interest rate hike and has positive implications for the country’s currency. Conversely, low PPI readings suggest that manufacturing costs are moderate and acceptable, predicting interest rate stabilisation or cuts, which will negatively impact the country’s currency.
The producer price index (PPI) measures wholesale inflation, while the consumer price index (CPI) reflects consumer prices. Both are published monthly. Both sets of inflation data will evaluate the trend of interest rate decisions.
The Bottom Line:
The fundamental analysis examines all factors that influence a currency’s intrinsic value using tools such as GDP, inflation, interest rates, unemployment, and fiscal/monetary policies. It includes essential economic data, like CPI and PPI, to assist traders in anticipating the central bank’s decisions and the market’s responses. This differs from technical analysis, which concentrates on chart patterns and technical indicators available on the platform, providing an interpretation of whether the currency is overvalued or undervalued. Consequently, traders should combine both technical and fundamental analysis when trading to improve their strategies and monitor the timing of their trades.