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Basics of Fundamental Analysis

Basics of Fundamental Analysis

Basics of Fundamental Analysis

4.1 What is fundamental analysis? 

Fundamental analysis is a core skill that provides a way for investors to assess the intrinsic value of an asset. This information is important in making trading decisions.  

As forex trading depends on the movement of a currency’s price relative to another, fundamental analysis in forex therefore revolves around analysing the forex markets for economic, social and political factors that can impact the valuation of currencies.  

Here’s the gist behind fundamental analysis forex: In general, a country with a good current or future economic outlook tends to see its currency strengthen, whereas a poor or worsening outlook will likely see its currency weaken.  

This is because economies that are doing well tend to attract more investor capital, which drives up the need to purchase that country’s currency (thus increasing demand).  

In practice, fundamental analysis simply means keeping up with the news and what’s going on around the world, especially in and around countries whose currencies you are interested in trading.  

What to look out for in forex fundamental analysis

Economic reports Gross Domestic Product (GDP) numbers Consumer spending Industrial production Consumer Price Index (CPI) 

Economic reports 

Governments and private organisations put out various reports that detail aspects of a country’s economic performance, such as unemployment rate and housing stats. 

Published at regular intervals, these economic reports can make for a reliable benchmark of a country’s economic performance, tracking improvements or declines in various economic markers over time. 

While no doubt a handy and reliable source of information, bear in mind that no single report will be able to capture the full picture, and there may be other factors that could influence a country’s economic health working in the background.  

Nonetheless, economic reports are closely watched by forex traders, and deviations from the norm have been observed to cause large movements in the forex markets.  

Gross Domestic Product (GDP) numbers 

The GDP is considered the widest economic measurement of an economy, encompassing the total market value of all goods and services produced in a country during a given year. 

In theory, GDP figures should act as an authoritative indicator of a currency’s valuation. It’s not so simple though; the official GDP numbers are a lagging indicator, so traders tend to focus on the advance report and the preliminary report – the two reports that are published before the final GDP figures.  

As there may be revisions from one report to the next, GDP figures can sometimes inspire volatility in the forex markets. This is especially so if the change in numbers is particularly significant.  

Consumer spending 

Levels of consumer spending are also of importance when discussing an economy’s health. This is a measurement of the total receipts of all retail stores, derived from a statistically valid sampling of consumer retail outlets across the country.  

Consumer spending reports are a useful indicator of broad consumer spending patterns, and can often act as a gauge of the direction of an economy in the immediate and short term. This is because high consumer spending can indicate increased confidence in the economy, while low consumer spending can point to fear or uncertainty, or expectations of a downturn.  

As with GDP numbers, consumer spending reports may also undergo revisions, and significant changes in numbers may promote volatility in the forex markets. 

Industrial production 

Industrial production reports track changes in levels of manufacturing and industrial production in a country across factories, mines and utilities. These reports measure capacity utilisation, which is the degree to which the capacity of each factory or manufacturing facility is being utilised. An increase in production while capacity utilisation is at or near maximum capacity is usually seen as favourable. 

Traders should pay particular attention to utility production, which is linked to the trading of and demand for energy. This, in turn, can be heavily affected by weather conditions, and significant revisions in industrial report numbers can affect the stability of a currency.  

Consumer Price Index (CPI) 

The CPI is a widely-quoted economic indicator that measures the prices of consumer goods across several categories (and thus also making it a measure of inflation in a country).  

When compared against a nation’s total exports, the CPI can tell us if a country is making or losing money on its products and services – this can impact the strength of its currency. Traders should also pay attention to export numbers, as the prices of exports often change in tandem with the rise and fall of a currency.  

Besides the CPI, other important reports to pay attention to include the purchasing manager’s index (PMI), employment cost index (ECI) and producer price index (PPI). In their own ways, each of these reports can illuminate trends and impact currency valuations. 

4.2 Economic calendar – what it is and why you should keep one 

Clearly, there is a lot of information and data to keep up with in forex fundamental analysis. To help keep track of it all, traders can make use of a tool known as an economic calendar. 

Simply put, an economic calendar is a record of all the major economic news and events that are of interest to a forex trader. Besides release dates of reports, forecasts and analysts predictions may also be included.  

You can choose to create your own economic calendar which can take any number of forms, ranging from spreadsheets stored in the cloud with links to relevant pieces of content, to paper journals in which you jot down your own notes.  

Or, you can also defer to economic calendars offered by various online brokerages and websites. These are usually offered free of charge, and may come with basic capabilities such as filtering and sorting. 

No matter if you decide to create your own, or use one provided by your broker, remember that the main purpose of an economic calendar is to help you track incoming events or updates that can have a significant impact on the forex markets, creating potential entry points, or highlighting increased risk. 

With practice, your economic calendar can help you see certain patterns or correlations between global macroeconomic occurrences over time, acting as an invaluable tool in deepening your knowledge and providing ideas for investment theses and strategies. 

4.3 Forex fundamental analysis – A case study  

On 23 June 2016, Britain voted to exit the European Union – an event famously known as Brexit. Immediately following the news, the Pound plunged versus the Dollar, charting a massive 13% drop not seen in 30 years. [1] 

Forex traders would no doubt have been keeping tabs on the vote, but with even British voters themselves not expecting the vote to go through [2], most retail traders likely didn’t seize – or even recognise – the chance to profit by shorting the Pound.  

While an anomaly, Brexit demonstrates the importance of fundamental analysis in forex trading.  

Traders taking a more conservative approach could have decided to close their positions temporarily to avoid the volatility and wait for clarity to return to the markets. 

Instead, forex traders who were unaware, or failed to recognise the importance of Brexit and kept their long positions would have woken up to a shock – one forex trader was reported to have lost GPB 600,000 overnight. [3]  

Check out a more in-depth article regarding fundamental analysis.

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Module Recap

  • Fundamental analysis in forex involves reading and analysing key economic data and indicators to glean the economic health of a nation. 
  • The main purpose of forex fundamental analysis is to suss out events and developments that are likely to have direct impact on the valuation of a currency. 
  • If an economy is doing well, the value of its currency tends to appreciate; if an economy is slowing down or weakening, the value of its currency tends to depreciate. 
  • Forex fundamental analysis should cover economic reports, consumer spending, GDP, CPI and industrial production levels, among others. 
  • An economic calendar is a commonly used tool that can help forex traders during fundamental analysis. Its main purpose is to organise and track events and happenings that are of relevance to the forex markets. 
  • Traders may make use of free online economic calendars, or create their own using cloud-based software, or paper journals. 
  • As seen during Brexit, fundamental analysis can be highly beneficial as a signalling tool. 

References 

  1. Financial Times, Pound tumbles to 30-year low as Britain votes Brexit, https://www.ft.com/content/8d8a100e-38c2-11e6-a780-b48ed7b6126f 
  2. CBS News, Brexit Result Shocks Some Voters, https://www.cbsnews.com/news/brexit-result-shocks-voters-uk-leave-european-union/ 
  3. Bloomberg, The Always Exhilarating, Sometimes Lucrative Lives of Brexit Currency Traders, https://web.archive.org/web/20191210074153/https://www.bloomberg.com/news/features/2019-10-29/the-always-exhilarating-sometimes-lucrative-lives-of-brexit-currency-traders