Fundamental analysis is based on present and historical data. It focuses on economic indicators and statistical reports. Traders pay close attention to factors like interest rates, employment reports, production and inflation. Unlike technicians, fundamental analysts concentrate on the overall state of the economy and the factors that impact price movements.
The exact date and time of the data releases is very important for the execution of trading strategies. That’s why traders should read and follow an economic calendar, where they can see a list of events that can affect a nation’s currency. Another reason for keeping an eye on an economic calendar is because during significant releases, the prices of currency pairs can move substantially, and you should try to minimize any risks associated with such price movements.
To understand better the power of fundamental analysis, we will try to explain some of the most important economic indicators and the influence they have on currency price formation.
Gross Domestic Product (GDP) is formed as the sum of all services and goods that are produced in one country for a particular time period and shows the standard of living of its citizens. It is an indicator showing the economy’s growth and is closely related to inflation levels. Inflation, on the other hand, indicates the increase of prices and can weaken the consumer buying power when rising too quickly.
Consumer Price Index or CPI is used to measure the value of a consumer basket which contains particular services and goods. The index starts from 100 and shows the changes of these prices which have an immediate impact on the consumers’ buying power. When new data is released, fundamental analysts compare it with the results for the previous period. This provides a clear view of the effects caused by inflation and the future demand for the country’s currency.
The Trade Balance of a country shows its total exports and imports for a specific reporting period. This economic indicator also affects the supply and demand for a currency, because when the balance is positive (which means that the country has exported more goods than it has imported), foreign buyers typically exchange more of their own currency to buy the currency of the exporting country. If the country has bought more goods and service than it has exported, this is trading deficit and it has the power to devaluate the currency.
Interest Rates announced by the Central Bank are an important part of its monetary policy. The implementation of this monetary policy includes different actions taken by the Government or the Central Bank and aims to achieve certain results in the spheres of spending, borrowing and taxation. Central Banks offer loans with interest to Commercial Banks, thus ensuring that there is enough operational capital and liquidity for the business and consumers.
Interest rates are used to regulate inflation and consumer spending. If there is a need to boost the economy, the Central Bank may decide to lower their rates, enabling consumers to get less expensive credits. When inflation is too high, interest rates may be increased in an effort to restrict overspending. Interest rates have a central role in fundamental analysis. One of the reasons is that some Forex traders employ the so called “carry trade,” which allows them to benefit from the differences between rates, by selling a currency with a low interest rate and buying another with higher interest rate. Returns from such trades can be high, especially when leverage is used.
Fundamental analysis also takes into consideration the fluctuations of the Commodity Price Index. This is an indicator that represents the average value of commodities like crude oil, natural gas, gold, copper, live cattle, sugar and wheat. The commodities included in the CPI may be divided into the following major groups: Energy, Metals and Agriculture. CPI is particularly important for the currency price of countries like Australia and Canada, known as major commodities exporters.
Employment reports are linked to current and future spending habits of the consumers, and an increase in unemployment rates can have a negative impact on the currency price of the respective country. Likewise, a decrease in unemployment means that a greater number of people will receive a regular income and this would boost consumer spending. The most important employment reports in the world economy include the U.S. Non-Farm Payroll report, Canada’s Labor Force Survey, UK’s Claimant Count Change and others.
As presented above, fundamental analysis is complex and is based on various economic and political factors. The official statistics and reports examined by fundamental analysts are significant, but the market does not always react rationally to the releases of financial data. Therefore it is important that traders incorporate different approaches in their investment strategies.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.