The propelled increase in the number of online trading platforms has led to widespread growth in forex trading. This growth got coupled with an increase in the available investment resources and active market participants. However, to remain on top of the forex trading game, investors rely on two primary forms of analysis: technical and fundamental analysis.
The application of technical examination in the currency market is equally the same as other securities where technical analysts study price movements with charts being the objects of the test.
But unlike corporations, states and countries do not have financial statements, such as cash flow statements or balance sheets based on which investors can carry out fundamental analysis on the market.
So, how the fundamental analysis gets conducted on forex trading? This article gives you a detailed introduction to fundamental analysis in currency trading.
What are the Market Movers of Fundamental Analysis in Forex Trading?
- Economic events.
- Central bank decisions.
- Fundamental analysis of market sentiment.
- Geopolitical events.
- Natural Disasters.
Fundamental Analysis Explained
Fundamental analysis is a method of evaluating and examining how specified qualitative and quantitative factors of the global economies affect the currency markets.
This form of analysis establishes a security’s intrinsic value by examining related economic conditions that influence the price of a country’s currency.
The analysis comprises of five fundamental factors that drive global currencies, including economic events, geopolitical events, central bank decisions, market sentiment, and natural disasters.
Fundamental vs Technical Analysis
The debate on the efficiency and effectiveness of fundamental and technical analysis has gained traction over the years. Traders and investors get divided on which method of analyzing the currency market is ideal for the success of one’s investment.
While the two methods aim at achieving the same goal- speculating possible profits of an investment- their differences are notably significant.
Notably, the technical method of analyzing forex considers the price and movement of prices in a market, while fundamental analysis examines a country’s economic wellbeing relative to its currency.
However, regardless of the form of analysis you choose, you must be cautious when making a trading decision, as different indicators of the analyses can infer contradictory information.
What are the Fundamental Analysis Drivers in Forex Trading?
This section addresses the primary fundamental factors that impact the supply and demand of global currencies.
1. Economic Events
The stability and overall performance of a country’s economy are measured through its economic events which get released in what is popularly known as economic indicators.
Examples of such indicators include Gross Domestic Product, retail sales, consumer price index, producer price index, and housing data. Here is a brief description of each economic indicator.
• Gross Domestic Product (GDP)
This is considered the most fundamental indicator of the performance of an economy. GDP represents the total value of all the products (goods and services) produced by a country in a specified year.
Growth rates reflected in a country’s GDP indicate economic strength, which has an upward impact on its currency. Most investors focus on the advance and preliminary reports which are issued before the final GDP report.
• Consumer Price Index (CPI)
This is the most adopted measure when analyzing the inflation of a country’s economy. CPI indicates market price levels for different product categories.
Basically, central banks use CPI to establish whether the country is earning or losing financially as far as the consumption of goods and services is concerned.
• Retail Sales Index
This index measures the total sales made by the retail industry of a given country, including the small local stores and large chain stores. The index reflects the immediate direction of a country’s economy.
• Producer Price Index (PPI)
This is another essential measure of inflation for a given country. PPI measures the change in prices of commodities produced by manufacturers.
While CPI reflects the cost incurred by consumers to acquire a product or service, PPI shows the sales price of the manufacturer’s output (what manufacturers receive for what they produce). The higher the PPI, the greater the rate of consumer inflation in the future.
• Housing Prices Index
This metric measures the change in prices in the sale of homes, as well as the total number of new homes in each country. Residential construction is a fundamental factor in the evaluation of the forex market.
This is because high existing home sales and new home starts have a positive impact on the economic stimulus of a country, reflecting a stable and robust economy; the vice versa is also true.
• Trade Balance
Another factor that impacts the demand for a country’s currency is the trade balance. Trade balance indicates the difference in the exports and imports of a nation.
Trade balance surplus shows more exports than imports, while a deficit reflects more imports than exports. Investors use trade balance surplus as the measure of a country’s economic strength as far as the manufacturing sector is concerned.
• Commodity Prices
The currencies of consuming and producing countries are significantly impacted by the price of commodities. For example, when the prices of crude oil are low in a country, the transportation costs are lowered, which consequently affects the cost of goods.
This results in low inflation numbers. When such oil prices spike, transportation costs increase, leading to higher inflation numbers.
2. Central Bank Decisions
The money supply and currency of every major economy are managed by an established central bank. A country’s central bank makes decisions which are used by fundamental investors to speculate shifts in the currency and monetary policy of a given country.
The following are examples of central bank decisions that investors analyze for forex trading.
• Interest Rates
Central banks are responsible for raising, lowering, or maintaining rates of interest of a country to the same levels. The rate of interest established by a central bank has a significant impact on the country’s currency valuation.
For example, high rates of interest attract foreign assets from nations with lower rates of interest, with all the other factors being relative.
• Rate Statements
After releasing a new rate, most central banks issue a statement that describes the reasons behind the rate change and the institution’s committee voting on the monetary policy.
If the statement exhibits an unexpected decision, there is an adverse impact on the currency market.
• Speeches by Central Bank’s Policymakers and Officials
Any speech given by an official of a major central bank, such as the governor or president can affect the country’s currency, especially when the speech points to the future of the bank’s monetary policy.
3. Market Sentiment
This refers to the attitude traders have towards forex trading. The overall attitude that investors exhibit towards forex markets indicates the general direction of the markets.
Here are a few aspects of market sentiment that can impact the overall value of global currencies.
• Risk Aversion and Appetite
These factors refer to the investors’ preference for high-risk and high-yield currencies over secure currencies.
• Sentiment Indicators
These are metrics that indicate the future positioning of forex participants. Generally, sentiment indicators reflect what most investors prefer relative to future market movements.
• Financial Surveys
Every month, most of the major economies will issue financial surveys and indexes, including the purchasing manager’s index and consumer confidence indices.
• Stock Markets
Investors and a market analyst will evaluate the trend in the stock markets to decide on their move-in forex trading.
A drop in the stock price of given security could trigger investors to withdraw from stock markets in such of safe have investments, consequently affecting the valuation of a currency.
On the other hand, growth in the share price of a security reflects stable financial markets.
4. Geopolitical Events
Geopolitical tensions have, over the years, been known to have an adverse impact on security markets, including the stock market and forex markets.
Some of the geopolitical events that fundamental traders use to examine the forex market include the following.
A country’s currency can be influenced by a change in the political majority or exit of the ruling government. If the new government endorses low rates of interest and capital incentives, then the country’s currency valuation is negatively affected.
Popular votes, such as a referendum or presidential impeachment, can also impact the value of the currency in each country.
• Wars and Conflicts
When countries are at war with each other, then the valuation of their currencies is adversely impacted. Wars and conflicts particularly affect the price of commodities and other products manufactured by the conflicting nations. As a result, the currencies in these countries are impacted.
• Power Changes
When nations experience power changes, such as change of a forcible regime or a coup d’etat, then investors can expect to experience effects in the country’s currencies. Such effects can be felt by either through a devaluation or revaluation of the currency.
5. Natural Disasters
When a country is hit by a natural disaster, especially on a large scale, the financial markets are adversely impacted. Such disasters as tsunamis and earthquakes trigger a short-term appreciation of a country’s currency valuation.
This is because of the increased need for repatriation of relief resources. However, in the long run, the currencies are impacted negatively, following the derailed production in the multiple sectors of the country.
What are the Metrics for Fundamental Analysis in Forex Trading?
Fundamental analysts believe that the forex market responds to the bad or good news. When analyzing the fundamentals of the currency market, however, investors must keep track of the following metrics.
1. Price to Earnings (P/E) Ratio
When investors want to establish the value of the forex market relative to the country’s total earnings, they use a metric known as the P/E ratio.
This earnings ratio is the best means traders can employ to determine whether a country’s currency is undervalued or overvalued. A low price-to-earnings ratio implies that the country’s currency has a lower valuation compared to its total earnings.
2. Net Profit Margin
This is a metric used to determine the financial condition of a country. For example, when the net profit margin of a country is high, then the valuation of its currency is said to be high.
On the other hand, a low net profit margin would imply low currency valuation.
3. Quick Ratio
The quick ratio is used to determine the ability of a country to repay short-term liabilities using highly liquid assets.
When the quick ratio declines, then the currency of a country is subjected to an appreciation. The currency would decrease in value if the quick ratio increase.
4. Debt-to-Equity Ratio
This metric is used to establish the ability of a country to finance all its assets. This ratio is calculated by dividing the total liabilities of a country by its equity. The higher the debt-to-equity ratio, the lower the valuation of the country’s currency. When the ratio declines, then the value of the country’s currency also declines.
5. Currency Ratio
The currency ratio establishes the ability of a country to finance its current obligations. Dividing a country’s current assets by its current liabilities gives you the current ratio.
When the current ratio is high, then the value of the country’s currency also appreciates. A decline in the currency ratio, on the other hand, lowers the value of the money in each state.
Fundamental analysis is the best approach that an investor can take to establish the intrinsic value of a security.
With an analysis of fundamental factors, such as central bank decisions, natural disasters, geopolitical events, and economic events, it is easy to speculate the direction towards which the currency market is headed—one thing to take home.
However, is that a combination of both technical and fundamental methods of analyzing the market would augur well for your investment strategies.
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