Key Fundamental factors and fundamental analysis.

The analysis of financial markets consists of two main schools of thought: fundamental and technical analysis.

Although some technical analysis buffs tend to dismiss fundamentals by considering any fundamental news already discounted into the exchange rate, this assumption breaks down during volatile time periods surrounding the release of major economic data or news that differs from what the market is expecting.

Furthermore, the analysis of fundamentals makes up a very important tool, not just for forex traders, but also for central banks and monetary policymakers whose actions often drive forex rates into notable trends.

Accordingly, many experienced traders prefer to use a combination of both technical and fundamental analysis, taking a long term view of the market and trading on economic news using fundamental data, while timing market entries and exits objectively using technical analysis.

Fundamental Analysis

Basically, fundamental analysis in the forex market consists of analyzing the different economic releases in each currency’s country to determine the state of that nation’s economy, as well as their economic prospects versus other countries. It helps forex traders understand the moves that occur in exchange rates.

The most widely watched indicators used in the fundamental analysis of currencies include:

  • Interest Rate Policy
  • Gross Domestic Product or GDP
  • Political stability
  • Fiscal responsibility
  • Employment Data
  • Trade and Current Account Balance
  • Producer and Consumer Price Indexes
  • Sentiment Indicators
  • Housing Market Data
  • Industrial Production and Capacity Utilization
  • Commodity Prices
  • Stock and debt markets

The above contains only a partial list of fundamental indicators, and many other economic indicators make up the various components of a comprehensive fundamental analysis.

Besides governments, the U.S. Federal Reserve, as well as most of the world’s other central banks, keep a watchful eye on fundamental economic events in their home countries and abroad. They use this information to gauge inflation and employment levels in their respective countries which are used as the basis for adjustments made in interest rates.

As a result, governments, think tanks and private financial corporations pay out billions a year to retain the services of fundamental analysts to research the major national economies and provide relative currency forecasts based on fundamental data.

Forex traders will sometimes take either a fundamental or a technical approach to their analysis of the currency market. Nevertheless, in many cases, a combination of both techniques works quite well.

Fundamental analysis basically uses underlying economic factors for both countries to forecast future exchange rates for a currency pair.

The process of assessing each country’s economic prospects is somewhat analogous to how analysts review stocks, although the analysis then needs to be made relative by comparing the economy of one country to that of the other country.

Traders can then take positions based on this prediction, usually over longer term time horizons. They might also look for higher interest rate currencies in which to invest their extra cash.

In addition to news events and political factors, the fundamental economic indicators most often used in forex analysis include the following:

  • Interest Rate Differentials – the difference between the interest rates of two countries make up a key component to currency valuation and strongly affect investment.
  • Economic Gauges – the level of a country’s production levels, as well as the spending habits of the country’s population, can also be important in currency valuation.
  • Future prospects – the country’s economic prospects in relation to other world economies affect the value of its currency, as well as the level of trade both domestically and globally.
  • Imports and Exports – the level of international trade and the level of foreign investment also play a major role in the valuation of a currency.

Gauging market sentiment in the Forex market can be a valuable trading tool if done accurately and used with caution. Nevertheless, market sentiment remains somewhat difficult to pin down because of the ever changing perceptions in the market.

Furthermore, prices will usually have already discounted the effects of market sentiment before a trader can take advantage of any change as it occurs.

Nevertheless, once sentiment has been determined, the trader can then establish suitable positions with appropriate stop levels and then attempt to gauge when market sentiment has changed again.

Fundamental Factors Indicating Market Sentiment

News and economic releases make up the traditional avenues of analysis which traders use to gauge market sentiment.

If indicators in a particular country show that the economy is strengthening more than other nations, by an expanding GDP for example, this will tilt market sentiment in favor of that currency relative to other currencies.

Rising consumer and business confidence survey indexes in a national economy also tend to result in improving market sentiment for that country’s currency.

If subsequent economic numbers for the country then continue to support the previous survey numbers, market sentiment will also tend to continue to favor the currency.

Nevertheless, market sentiment may change if an economic number is released which puts in doubt the strength of the economy in that nation or if consumer confidence reverses significantly and heads towards lower levels

Currency Valuation Theories

Currency valuation has traditionally relied upon widely followed economic theories. Several of these theories are described in further detail in the sections below.

Supply and Demand

The most basic of economic theories, it implies that when the aggregate size of buying interest exceeds that of selling interest, the market will rise. Conversely, it will fall when sellers overwhelm buyers.

While this may be something of an oversimplification, this theory underlies all markets, financial and otherwise.

Purchasing Power Parity or PPP

Purchasing Power Parity theory states that the level of prices for goods and services should be roughly equal between two countries after exchange rate adjustments.

Based on the premise that the same item should cost the same in one country as another — also known as the Law of One Price — this theory implies that one of the currencies would be over or undervalued depending on the difference in the price of the same item in both countries.

In theory, this would eventually be corrected by arbitrageurs buying the product in the lower cost country to sell it in the higher cost country.

Interest Rate Parity

Interest Rate Parity holds that equivalent financial assets with the same risk factors in different countries should carry the same interest rate after adjusting for exchange rates. Although the determination of risk in equivalent financial assets can be complicated, this theory is used to price forex forwards, futures, options and swaps.

Balance of Payments

This economic theory postulates that if a country is running a large current account deficit or surplus, then the country’s currency is either over or undervalued and so must be adjusted accordingly.

The theory does not consider some of the factors that are behind the U.S. Dollar having run up the highest deficits of any country and yet continues to be strong.

On the other hand, China — which has the world’s largest current account surplus — has maintained its currency artificially low in the past by pegging it to the U.S. Dollar.

Using Fundamental Analysis

Gauging market sentiment in the forex market can be a valuable trading tool if done accurately and used with caution. Nevertheless, market sentiment remains somewhat difficult to pin down because of the ever changing perceptions in the market.

Furthermore, prices will usually have already discounted the effects of market sentiment before a trader can take advantage of any change as it occurs.

Nevertheless, once sentiment has been determined, the trader can then establish suitable positions with appropriate stop levels and then attempt to gauge when market sentiment has changed again.

Fundamental Factors Indicating Market Sentiment

News and economic releases make up the traditional avenues of analysis which traders use to gauge market sentiment.

If indicators in a particular country show that the economy is strengthening more than other nations, by an expanding GDP for example, this will tilt market sentiment in favor of that currency relative to other currencies.

Rising consumer and business confidence survey indexes in a national economy also tend to result in improving market sentiment for that country’s currency.

If subsequent economic numbers for the country then continue to support the previous survey numbers, market sentiment will also tend to continue to favor the currency.

Nevertheless, market sentiment may change if an economic number is released which puts in doubt the strength of the economy in that nation or if consumer confidence reverses significantly and heads towards lower levels.

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