Fundamental Analysis in Forex Markets
The definition of fundamental analysis says that it is “an analysis method that tries to predict price movements by evaluating the underlying economic trends that affect a financial asset”. In the case of forex the first thing that must be understood is that you are not dealing with one financial asset, rather two currencies that form the forex pair. This makes fundamental analysis that much more difficult when dealing with currencies.
Fundamental analysis of currencies
As you have two mostly independent assets in a currency cross, you have to perform a comparative analysis of the two currencies in order to predict the likely movement of the pair. And of course, there is the fact that a whole country, a central bank, and the countries international relations all have a substantial effect on the currency. It’s not enough to get all these factors right, you also have to gauge how that currency will fare against the other components of the cross.
So, it’s a bit more complicated to pinpoint the most relevant trends that influence a currency pair. But don’t worry, not everything is bleak. The fact that there are whole economies behind the currencies leads to overall stable and robust trends. Why is that? Well, in the case of stocks, for example, the demand for the product of the company behind the stock can change overnight. As for currencies, population trends and economic megatrends are the main long-term drivers, and those don’t change from one day to another.
That said, from time to time there are wild moves in currencies mostly because there is one rather unpredictable and volatile factor behind the moves—politics. Central banks and other policy-makers have the power to radically change the course of a currency (at least on the short-term). From blatant manipulation to more subtle operations, the governments are often there to intervene in currency markets.
So as you can see, there are many things to consider when performing fundamental analysis. Let’s look at the main drivers behind the trends in detail!
What drives the performance of economies?
On a basic level, the value of a currency is driven simply by supply and demand. But compared to other assets both supply and demand are special when analyzing currencies. Fundamental analysis is mostly dealing with the demand side of the equation, as it is more predictable in comparison to the supply of a currency, which at least in part relies on policy decisions.
So what are the main factors to watch that drive the demand for a currency? To answer that, it is useful to first determine what money is used for, as these functions are the basis of the demand for a currency. Money traditionally has three main functions:
- Medium of exchange
- Storage of value
- Unit of account
However vague these functions are, it will be much easier to understand the role of particular factors and indicators with them. Analysts cover a lot of fundamental measures to gauge the health of an economy, with the most important one being:
- Economic growth
- Inflation rate
- Wage growth
- Trade balance
- Credit growth
Let’s see how these indicators are actually connected to the demand for a currency!
This is probably the most obvious driver, as with the growth of an economy more and more money will be needed just to “keep things going”. Sure enough, on the long run, there is a strong correlation between the GDP growth of the country and the performance of the currency. That said, don’t forget to compare the growth prospects with the other country’s likely potential, as in itself even a stellar growth number for a mature country could be low if compared to an emerging economy.
Economic growth alone can be deceiving if it’s accompanied by high level of inflation. Why? Inflation is basically the decline of the perceived value of a currency. It is partly a psychological phenomenon (so it can become dangerously self-sustaining if people “get used to it”), and it is directly connected with the value of a currency—the higher the rate of inflation the lower the value of the currency. For this reason, analysts usually calculate the “real” growth rate of the GDP, which means that the nominal growth is discounted by a special type of inflation measure.
Wages are crucial for a currency because they translate to buying power and have a direct effect on the demand for money. Although not every cent that is paid out as wages is spent by consumers the rate of transition is higher and the turnaround is quicker compared to other sources of income such as interests. Without going into details, wage growth is generally correlated with strength in the currency, as long as it doesn’t lead to excessive inflation.
For some countries and currencies this factor could outweigh almost all others, particularly those nations that rely heavily on international trade. It’s easy to see that if the cross-border trade is relevant, it will have a profound effect on the demand for the currency. For some big, closed countries like the U.S., the trade balance might be less important, but it still has to be taken into account.
Credit growth and Savings
We discuss these factors together because credit growth and savings act in the opposite way to growth. Short-term, credit boosts growth and can serve as a boost for GDP growth as well, but excessive credit growth can be a drag on future growth. On the other hand, savings today decrease the immediate economic output but if invested in productive projects they can have a positive effect on growth in the long run. It is important that both credit and savings have a place in a healthy economy and these factors are only crucial if for some reason (too low-interest rates, a crisis, or some other shock) their level gets far from the optimal. These discrepancies can lead to bubbles, in the case of excessive credit growth, or a protracted recession in the case of savings.
Investments are closely related to savings, but investing savings is a crucial step that savers need to make in order to finance the necessary investments in an economy. If this mechanism fails the currency of the nation will likely lag the currencies of other, more efficient countries. That is why a banking crisis might lead to not just a recession, but a depression if the financial system fails to channel savings towards investments.
Look at the trends, not single data points!
As we already discussed, economic trends are stable processes, and it takes a lot of time for them to turn around. As a lot of traders jump to conclusions after a single economic release, currencies tend to be
very volatile around these events. Multiple studies proved that experienced traders are right about this—don’t think that one release changes a trend! Always take the big picture into account
Trading news events is a legitimate strategy; just don’t confuse it with long-term fundamental analysis, as the two approaches require different mindsets and trading rules, even though they are based on similar principles.
The supply side: monetary policies, central banking, and intervention
The supply side of the equation is supposed to be simpler, as money supply originates in today’s world from one place -the ruling authorities. Central banks (that are independent of governments, at least in theory) determine the money supply and interest rates, in order to achieve stable prices and adequate liquidity for the economy. But with all the political pressure, central banks usually do more by intervening in the economy to boost growth, through low-interest rates, and other measures.
Because of this, a large portion of forex market news and currency analysis currently deals with central banks and monetary policies. As interest rates are close to (or even below) zero now, a lot of countries resort to unconventional monetary measures such as quantitative easing to further boosts their economies. These policies try to “cure” slow growth through supplying cheap credit to encourage investments. While the long-term effects of these measures are not clear yet, the consequences regarding the related currencies are profound. To help you understand the effects of these monetary policies here is how, in theory, they influence the economy.
- Monetary easing, or even hints on it (interest rate cut, quantitative easing): the currency gets weaker, growth accelerates and that drives the currency higher again
- Monetary tightening (interest rate hike, quantitative tightening): the currency gets stronger, growth cools and that drives the currency lower again
Fundamental analysis is a complex issue when it comes to currencies, but the potential rewards are alluring. When done properly, fundamental analysis can provide you with conviction about the long-term trends for currencies and that might be the edge that you need to be profitable. For some, strategies based on technical analysis may be more suitable, but for long-term investing the fundamental approach still has its advantages.