What is Fundamental analysis?

• xChief Content Team
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One of the important types of analysis in financial markets, especially the forex market, is fundamental analysis. This type of analysis focuses on the overall state of the economy and examines various factors such as interest rates, employment rates, gross domestic product, international trade and their relative impact on the value of each country’s currency. In this article, we will get to know the fundamental analysis in forex, the advantages and disadvantages of this type of analysis, the forex economic calendar, and the steps to perform forex fundamental analysis.

Table of Contents

• What is Fundamental analysis?
• Important data of Fundamental analysis
• What is the forex economic calendar and how can it be used?
• Advantages and disadvantages of Fundamental analysis in Forex
•  A step-by-step guide to forex Fundamental analysis
• The difference between Fundamental and technical analysis in forex
• Conclusion
• Frequently asked questions

What is Fundamental analysis?

Fundamental analysis is one of the most important types of analysis in financial markets that examines the real value of an asset. In fundamental analysis, it is assumed that an asset may be priced higher or lower than its true value. Fundamental analysts try to find good insight into the right trading opportunities by discovering the fair value of an asset and comparing it to the current price. Fundamental analysis in forex involves examining all the data that is likely to significantly affect the price of a currency pair. These data include economic data, political factors and unexpected events such as natural disasters.

It should be noted that Forex fundamental analysis is not limited to comparing the current data of a single economic index with its previous data. There are various economic theories that are used in forex fundamental analysis and try to put different economic data in a specific framework so that they can be compared with each other.

Important data of Fundamental analysis

In general, fundamental analysis data are divided into two large groups: economic data and political data;
Let’s check them out.

1. Economic data

The value of each country’s currency compared to other countries depends on the economic situation of that country. There are many economic indicators that determine the conditions of a country’s economy; But we don’t need all of them in the forex market. These fundamental indicators allow traders to assess current economic performance and predict future economic health.
The most important indicators that should be checked in Forex fundamental analysis are:

• interest rate
• Inflation data
• Gross Domestic Product (GDP)
• Consumer Price Index (CPI)
• Retail Sales Index
• Industrial production index

Interest Rate

Interest rate is a major indicator in Forex fundamental analysis. There are different types of Interest Rates; But what is important in forex fundamental analysis is the nominal or base interest rates set by the central bank of each country. Central banks print money and private banks borrow that money. The percentage that private banks pay to the central bank to borrow currency is called the base or nominal interest rate. One of the main tasks of central banks is the manipulation of interest rates, which constitutes a large part of their monetary policy. Interest rates are the great equalizer of the economy, and arguably affect the value of money more strongly than any other factor. Interest rate even affects inflation, investment, production and unemployment.

The goal of central banks is to strengthen the economy and reach the inflation level set by the government. For this purpose, they have to lower the interest rate. As interest rates fall, private banks borrow more and lend more to people. This issue leads to encouraging consumption, production and strengthening the economy. Low interest rates can be a good method, but a poor strategy; Because in the long run, low interest rates can inflate the economy with too much cash and create economic bubbles. To solve this problem, we will probably see a policy of increasing interest rates. From the perspective of forex fundamental analysis, the best time to start looking for trading opportunities is when interest rates change.

Inflation Data

Inflation occurs when the purchasing power of a given currency decreases. Excessive inflation, changes the balance of supply and demand in favor of supply and lowers the value of money. This is something that central banks are usually tasked with controlling. Of course, controlling inflation does not mean reducing inflation; Because a sharp decrease in inflation may have a negative effect on the economy of a country. Money is the fuel of the economy and makes it move forward. Consequently, as the economy grows over a long period of time, the amount of money in circulation, which is the definition of inflation, must grow. This means that every economy must have a level of inflation that is called healthy inflation (usually around 2%).

Gross Domestic Product (GDP)

The next indicator is the gross domestic product (GDP), which means the market value of all goods and services produced in an economy in a given period, and is believed to be the best indicator for evaluating the overall health of an economy.

However, GDP by itself is not a useful indicator; The change of this rate in a period of time can give us information about the health of the economy. An increase in GDP is likely to have a positive effect on the value of a currency.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is an important economic indicator that measures the average change in prices for goods and services that consumers pay for them. This index is the most important criterion for measuring inflation and is considered as a useful tool for fundamental analysis in forex. A high consumer price index means an increase in the price of goods and services and, as a result, an increase in inflation. This leads to changes in the government’s monetary policies to control inflation by regulating the flow of money in the economy.

Retail Sales Index

Retail sales index data measures consumer demand for finished goods that have already reached the end of the supply chain. The high level of this index means more spending by consumers in the economy and possible economic growth in the future, which can be positive news in the forex market.

Industrial Production Index

This index is obtained from reports on production changes in mines, facilities and factories in a country. These reports help to identify the amount of production of a country in a certain period.

2. Political Data

The data that should be examined in Forex Fundamental analysis includes political factors affecting price changes:

• News and political events
• Geopolitical factors

News and Political Events

The news related to the domestic and foreign policy of a country affects the national currency of that country. For example, the instability of the domestic situation during the period of presidential or parliamentary elections can weaken the strength of the currency and reduce its value. In such a situation, prices may fluctuate only because of rumours, many of which are unfounded. Some political news has little effect on the market. For example, a political leader’s position on an issue is something that is usually predetermined. As a result, when an official speech is broadcast from them, there will be no serious price fluctuations. In these types of situations, there is generally a sudden spike or decline before prices return to the initial level. Forex fundamental analysis usually considers political news as an additional factor that has more of an impact in the long term than in the short term; Because the impact of political news is often less than that of economic events.

Geopolitical Factors

Geopolitical factors can also be important. For example, an increase in conflict or war in the Middle East can put pressure on world oil supply and increase its price. As a result, businesses that rely heavily on oil may see their profitability decline. At higher levels, this issue may affect the exchange rate of countries and consequently the forex market.

3. Data Related to Emergency Situations

Contingencies are situations over which there is no control and the trader only sees their effect on the market when they have already happened. Floods, earthquakes, droughts and other natural disasters, especially events such as the Covid-19 pandemic, can be dangerous for businesses and economies, affecting supply chains and even currency markets. On the other hand, it is easier to examine social factors such as coups, military conflicts, revolutions, strikes and wars. These events often do not happen suddenly and it is possible to predict them in advance. Such developments can decrease the value of countries’ currencies.

What is the forex economic calendar and how can it be used?

The forex economic calendar is an important tool for traders. This calendar provides a complete timeline of upcoming economic indicators, central bank meetings, political events and other factors that significantly affect the forex market. If we know how to interpret the data included in the forex economic calendar, we can increase our chances of profitable trading.

Forex Calendar Data

These data include various economic indicators such as inflation rate, gross domestic product, employment and unemployment rate data, and consumer sentiments, which we said reflect the overall economic performance of a country. Using the forex economic calendar, we can learn about important news events, economic data reports and their impact on forex market developments. By understanding the expected impact of economic events, we can predict market movements and adjust our trading strategies accordingly.

Advantages and Disadvantages of Fundamental analysis in Forex

Like any other type of analysis, fundamental analysis has its own advantages and disadvantages. In the following, we examine some of these advantages and disadvantages.

Advantages of Fundamental analysis in Forex

Some of the advantages of Fundamental analysis in forex are as follows:

1) Competitive Advantage: Fundamental traders research several factors affecting the exchange rate and its fluctuations, so they are one step ahead of other traders.

2) Observing Ideal Trading Opportunities: Fundamental traders in forex closely follow the up-to-date economic news of several countries. As a result, they can enter quickly when they see the first ideal trading opportunity. For example, an increase in the GDP of the US economy is more likely to cause the dollar to rise, and traders who use fundamental analysis in forex will be informed earlier than other traders and will buy more currency to take advantage of inflationary conditions.

3) Risk Management: Traders who use fundamental analysis believe that discovering the main causes of price fluctuations is very useful in predicting asset movements. Understanding the factors affecting market valuation can provide more accurate predictions about trends and setting the appropriate stop loss.

Disadvantages of Fundamental analysis in Forex

Some of the disadvantages of fundamental analysis include the following:

• There is no guarantee that your chosen currency pair will move towards its true value. For example, an unforeseen event can have a significant impact on currency prices. Additionally, sometimes the market may stay at an irrational price longer than you can hold your position open.
• Fundamental analysis examines a vast amount of global data and, as a result, takes a lot of time. Therefore, in the short term, it may be difficult to use and may mislead traders.

A step-by-step guide to Forex Fundamental analysis

Together, fundamental and technical analysis help forex traders spot potential opportunities under changing market conditions. However, forex fundamental analysis has its own difficulties. For example, retail traders may not have access to sufficient resources or key information. On the other hand, it may be beyond their ability to read and analyze the huge amount of data that is released on a daily basis.

Big banks, hedge funds and institutional investors have all the resources and data at their disposal and have the ability to study large volumes of data; But even they find it difficult to make accurate predictions about how market forces will evolve. Therefore, the general recommendation is to use more fundamental analysis to determine overall market directions, the interplay of fundamental variables and existing monetary policy differences to identify which currency pairs offer the most opportunities at a given point in time. In the following, we explain the fundamental analysis method, starting from the macroeconomics and finally selecting currency pairs.

First step: studying the field of macroeconomics

To conduct a successful fundamental analysis, we must have a regular analytical structure or framework. We begin by studying macroeconomics on a global scale and analyze factors such as economic cycles, monetary policies of major central banks, and other similar key indicators. The past behavior of financial institutions such as central banks has a lot to do with predicting their decisions in the future; Therefore, we must keep historical data in mind when analyzing the future direction of the markets.

During economic prosperity, volatility is low and liquidity is high on a global scale; On the contrary, during the recession, we face high volatility and low liquidity. However, it is very important that the trader knows how to distinguish noise (unreal data) from real data; Otherwise, it will fail in its analysis, influenced by political or media atmospheres.

Determining the Global Economic cycle

Economic cycles usually oscillate between boom and bust. It is very important to make a decision about trading in the forex market. There are important indicators that can show signs of a cycle phase change. Some of these indicators include the global default rate (increasing which can be a sign of recession), the accumulation of international reserves (which can be a sign of economic problems), and the lending status of major banks (which can be a sign of recession).
Although these indicators are considered second level and may show a phase change a little later than the main indicators such as industrial production and unemployment rate, they can be trusted.

Examining new Technologies, Political Environment and Emerging markets

After determining the stage of boom or bust, we need to determine the dynamic factors that can increase productivity and at the same time create a period of non-inflationary economic growth on a global scale. When emerging economies implement new technologies from the developed world for the first time in their industrial sector, their productivity increases and a period of non-inflationary growth begins.
The global political environment also has a great influence on international currency fluctuations. For example, the rampant inflation in Germany after World War I was caused by political developments at the time, which negatively affected the natural course of economic events.

Second step: studying the global Monetary environment

In this step, we extend the general studies of the first step to a more specific study of developed world economies. We take a closer look at monetary policies and try to determine the length and depth of the current phase of the economic cycle.

Studying Interest Rate Policies in big countries

At this point, we should examine the monetary and interest rate policies set by the central banks of the world’s major powers, such as the Federal Reserve, the Bank of Japan, and the European Central Bank. To do this, we need to consider their past behavior, policy biases and stated goals of these important monetary institutions. Knowing the policy biases of these central banks helps us determine variables such as the growth potential of emerging markets, market fluctuations and interest rate expectations in the domestic market of countries that can lead to exchange rate differences between the two countries. This exchange rate difference is very important in forex.

Comparison of money supply growth and credit standards

After understanding the policies of global central banks, we should compare them with previous periods and assess their possible impact on the global economy. Expansionary monetary policy after economic recession is a natural thing and it increases credit facilities and injects liquidity into the economy. Therefore, we should increase the risk tolerance of our portfolio. On the contrary, contractionary monetary policy after a period of economic prosperity means that the global economy is going through a period of reconstruction and we should reduce the risk tolerance in our portfolio. In a long period of monetary policy with low interest rates, we will face a bubble in the forex market; That is, the currencies of weaker countries gain a value beyond their reasonable value and provide traders with a suitable trading opportunity. The opposite of this is also true if the period of contractionary monetary policy is prolonged. Don’t forget that the bursting of the bubble, sudden and drastic changes in the price of basic commodities and raw materials such as oil and… (commodity shock) and major political events can create exceptions in the above scenario.

Investigating the volatility index (VIX) and the loan payment rate in the private sector

Now that we have determined the stage of the cycle, we need to find a way to determine our portfolio’s risk tolerance. Stock market fluctuations and loan default statistics of companies and private banks play an important role in determining forex market fluctuations; Because the perceived low risk in the economy allows forex traders to increase leverage and liquidity. Of course, fluctuations are temporary phenomena; Therefore, analyzing these fluctuations, the causes of their formation and the factors that reduce their effects on the market, will help us to quickly react to sudden changes in the market and minimize our losses.

The third step: Deciding on the choice of currency pairs

Finally, we decide whether to buy or sell currencies and how long we will stay in our position. The most important indicators that we should study are:

Interest rate differences between countries

By studying the statistics of unemployment, capital expenditure and output gap, it is possible to predict the direction of interest rates of central banks. When the capacity of the economy is limited and unemployment decreases, that means wage pressure is created, which will lead to an increase in prices and inflation in the economy. To solve this problem, the central bank should raise the interest rate and keep it high until there are signs of rising unemployment.

Balance of payment of currencies

The country’s balance of payments is like a company’s balance sheet. The healthier the balance of payments, the stronger the country’s currency will be in times of economic crisis. We examine the countries’ balance sheets in terms of current account and capital account status. Do bank deposits and asset sales, which can easily be revised, maintain the country’s external position, or long-term developments such as foreign direct investment or reserve accumulation? Examining these matters will help us better understand the power of currencies.

The difference between fundamental and technical analysis in forex

Forex technical analysis focuses most on the current price of currency pairs, fundamental analysis considers almost all factors affecting a currency pair and does not pay attention to the current price. It is often said that fundamental analysis is not the best tool for a short-term day trader and is more responsive to what happens in the long-term. The following table shows some important differences between technical and fundamental analysis:

Final Word

In this article, we talked about fundamental analysis in forex. Unlike technical analysis, fundamental analysis examines the factors influencing their value instead of the current price of currencies. Interest rate, inflation and gross domestic product are the three main economic indicators that we use in forex fundamental analysis. However, fundamental analysis is not limited to these and includes many economic data that are all published in the forex calendar. To be successful in the forex market, technical analysis will not be enough and we must acquire skills in fundamental analysis.

Frequently asked questions

1. What does Fundamental analysis mean in Forex?

Fundamental analysis in forex is a method of market analysis in which all economic and political factors affecting the real value of countries’ currencies are investigated and researched. With this analysis, it is possible to predict the price movements of currency pairs in the future.

2. What are the indicators and factors used in Forex Fundamental analysis?

Some important data in forex fundamental analysis include macroeconomic indicators such as interest rates, inflation rates, gross domestic product, unemployment rates, economic news and political developments.

3. What is the difference between Technical and Fundamental analysis?

Technical analysis focuses on examining the current price of currencies; But fundamental analysis deals with the examination of macroeconomic factors, political data and news and important events in the world.

xChief Content Team