Fundamental analysis of the stock market consists in analysing the performance of a company in order to anticipate its potential for future growth. The fundamental analysis of a company may include researching the company's financial statements in order to note changes from one year to the next; or perhaps studying the purpose of a company and its background to determine how well it may achieve its goals in the future.
In the forex market, many of these statistics don't exist; traders are dealing with entire economies against each other. In each of these economies, there are thousands of companies trying to maximise their profit potential, so analysing the management structure of a single company or its market share doesn't make much sense.
Due to the nature of the currency exchange market, many traders prefer technical analysis or a combination of this approach with fundamental analysis applied to entire economies. In this article, we will examine in greater detail how fundamentals can influence forex prices.
Currency prices are important mainly for international trade. We have already seen how a primarily exporting country like Japan can be negatively affected by a strong currency. In the case of Japan, the appreciation of the yen has resulted in lower profits and margins for its exporting companies.
The concept of fundamental forex analysis can be summed up in one simple item: interest rates. If interest rates rise, investors are more likely to invest their capital, and if interest rates go down, that incentive goes down. This relationship is the heart and soul of macroeconomics, and it allows central banks to have the tools they need to manage their respective economies.
The decision to increase or decrease rates may also impact other economies. Say for example, that you are an American who has money to invest. After having had little incentive and extremely low rates for a long time, you notice that the UK is increasing its rates by 25 basis points. This rise in British interest rates could and should lead to higher rates for other financial institutions and investment options in the UK. Therefore, as an investor, you may decide to withdraw some of your money from the United States and invest it in the UK to increase your profits through a higher rate of return.
Other investors who think the same way could in their turn rush to invest in UK bonds, and the price of the British pound would eventually increase to reflect this additional demand. In this case, it would be more difficult for the UK to export goods because of the increase in the value of its currency.
The first impact is related to the incentive to invest. If a central bank wants to slow down its economy, it raises rates. If it wants to encourage growth of its economy, it lowers interest rates. Higher or lower rates have a dual impact on the economy.
The second impact involves investment expenditures. If rates go down, the appeal of getting a long-term loan at the new lower rate is much greater than before because a borrower gets to pay less. In addition, the incentive to purchase expensive goods such as homes and cars is also higher.
And when a person buys a home or a car, companies have to pay for materials and workers. If lower interest rates increase the number of houses or cars purchased, that's growth. Home and auto builders may need to hire new workers to meet the new demand, and as demand for workers increases, the wages needed to attract qualified candidates will also increase.
This explains how lower interest rates can lead to higher employment and inflation (often indicated by the CPI or "consumer price index"); and it is at this stage that central banks study growth rates to prevent overheating of the economy.
If interest rates stay low, the effects of "overheating" could be immense. Prices could continue to inflate and, if left unchecked, this could lead to what we call hyperinflation.
As a result, central banks want a moderate inflation rate. This helps maintain growth in an economy; people obtain pay raises, more people are working and paying taxes, and consumers are confident because they can save their money because prices will not go up a hundredfold overnight.
Central banks and forex traders review the macroeconomic data that is published for important information, but their objectives are slightly different.
Forex traders are often interested in the market's reaction and price behaviour as a result of an economic indicator or the publication of relevant economic or political news (such as the result of the Brexit referendum, for example).
For example, if an indicator such as the Non-Farm Payroll goes up higher than expected, then traders will try to position themselves with USD purchase transactions on the currency pairs in which that currency is traded, such as the EUR/USD and the GBP/USD.
Forex traders can quickly absorb important news and generate highly volatile price movements.
Central banks have a much broader view of these statistics. These entities analyse the main benchmarks of an economy in order to make the right decision about their monetary policy.
Inflation and employment are the pillars of these statistics because they are two of the main pressure points in an economy. If unemployment is high, the economy is probably going through a period of underperformance. As an economy's employment and unemployment data are published, this new information is taken into account fairly quickly for decision-making. Foreign exchange traders analyse the probability of a possible rise or fall in interest rates by central banks, taking into account this information and position themselves accordingly, which is then reflected in the prices on the foreign exchange market.
The same is true for inflation: as an economy's inflation data (CPI) is released, traders begin to act quickly to incorporate this new information into prices. In the meantime, central banks are focusing on careful analysis of this data to decide whether or not they want to do something at their next meeting.
Rising unemployment (declining employment) and declining inflation are threats to an economy that often lead central banks to seriously consider lowering interest rates.
Declining unemployment (rising employment) and rising inflation are signs of a growing economy, and it is at this point that central banks are considering the possibility of raising interest rates.
However, central banks and forex traders aren't content to just sit around waiting for the publication of employment or inflation data that show changes in an economy. Many other economic data are currently being analysed by traders to predict changes in inflation, unemployment and interest rates.
Consumer statistics are extremely important in major economies such as the United States or Europe, where consumer activity is of great importance to the global economy. The euro can become extremely volatile when consumer consumption indicators are released, because consumer activity in these established economies is often seen as a precursor to inflation, employment and growth.
GDP or gross domestic product is the direct expression of growth (or contraction) within an economy, which can also be a huge precursor to price movements in markets, especially if the growth rate announced is far from what is expected. But, by itself, GDP increases or decreases don't result in more jobs or higher inflation, so it is often considered more of a "lagging" fundamental indicator.
Production figures can be particularly important in growing economies that are at a highly industrialised stage of the development process. China is an excellent example of this, and it is for this reason that the monthly Chinese Purchasing Managers Index (PMI) is attracting massive interest in many parts of the world.
The PMI is a survey of an economy's producers to measure their sentiment regarding future orders. The basic idea behind this statistic is that if producers believe that there is growth in the economy, then this growth will continue and eventually reach consumers; after all, if someone wants to buy a particular good, it must first be manufactured - and producers make more money if they feel that demand for their products will increase in a positive economic environment.
|Ascending fundamental data||Decending fundamental data|
|GDP increase||GDP decrease|
|Rising inflation||Falling inflation|
|Rising employment||Falling employment|
|Declining unemployment||Rising unemployment|
|Increased consumer confidence||Decreased consumer confidence|
|Increased PMI||Decreased PMI|
Regardless of the published economic indicator, the market response still stems from interest rate cycles and how an improvement or decrease in measured business activity can lead to higher or lower interest rates.
As far as fundamental analysis is concerned, we can say this: we can't know exactly what the result of an economic indicator (or news important to the market) will be, and we can't be sure of the market's reaction to an event.
This makes forex trading on the basis of fundamentals dangerous: for example, if a trader thinks that an indicator such as GDP will come out better than expected, he could take a position in the market as a result - and yet that very same trader could end up losing money because of an unexpected market reaction or simply because he made a mistake. By trading on fundamentals, a trader can be right and lose anyway, even if this seems contradictory.
As far as equities are concerned, trading using fundamental data makes a lot of sense. We can compare company A with company B in the relevant markets. Here we operate with a small part of the economy, in the world's largest macroeconomic environment.
The market capitalisation of the company we are dealing with could reach a few hundred billion dollars at most. According to estimates, though, the foreign exchange market is trading around $6 trillion every day.
When we trade currencies, we are speculating on entire economies against each other, and it may be much more difficult to use fundamental benchmarks to project future growth potential, as many factors can affect an economy.
For this reason, many forex traders integrate or add technical analysis to their trading ideas that are based on fundamental analysis. This approach can be very useful for a trader who wants to determine a currency pair's trends or biases. This in turn can be used to determine the best entry and exit points for a trade.
At the beginning of this article, we used the hypothetical example of a 25-basis point increase in the Bank of England's interest rate. If something like this happens, one of the most likely consequences is that traders will buy British pounds to take advantage of this new, higher interest rate.
However, it isn't just the rise of an interest rate that triggers a currency purchase, because in most cases, traders don't want to wait for the central bank do what they know it will probably do anyway.
So, like the British pound, if we see more and more positive data coming from the UK that could lead to higher interest rates, we will certainly see an increase in demand for the pound, which will lead to a higher price for it.
This is therefore a fundamental question - which is clear and obvious in the technical information presented in the price chart. If there is an upward trend in the market, prices are going up for a good reason, right?
Prices may demonstrate biases and trends in their fundamentals.
Traders can incorporate price action analysis to see where these trends are going and how useful they can be for trading. From there, they can also use price action to determine the best sectors to buy in and the most appropriate sectors to sell in with the least risk, so that if market momentum continues, they can benefit from good prices and therefore profits on their trades.