Fundamental analysis is an approach to analyzing the markets by taking into account factors such as the social, economic and political issues. These factors tend to influence the supply and demand of the security in the question.
Fundamental analysis is one of two ways to analyze the forex markets. The other approach is the more widely popular technical analysis.
Both fundamental and technical analyses are important when you want to study the markets. However, traders mostly ignore the fundamentals when trading currencies and focus only on the technical analysis.
The general argument is that day traders who only trade within a small time frame need not concern themselves with fundamentals. This is because fundamentals are what tend to impact longer-term trends.
However, regardless of whether you are day trading or swing trading, it is important to pay attention to the fundamental developments in the markets as well. You can actually expect to see losses on your trades if you trade blindly and based solely on technical analysis.
In this article, we cover what fundamental analysis is and why traders should pay attention to it.
What is fundamental analysis?
Fundamental analysis is the approach that looks at the intrinsic value of the investment. While this is the definition that is broadly used in the stock markets, it applies to the forex markets.
Fundamental analysis is the study of looking at the economic developments that can affect the value of a currency.
By understanding fundamental analysis, you can understand whether the currency is over or undervalued.
The markets are always forward-looking. Therefore, the price you see on the chart already discounts the available news at that time. However, as and when economic releases come out, the markets adjust to the updated information.
So understanding the fundamentals is an important aspect if you want to avoid any unpleasant market moves.
Fundamental analysis in the forex markets requires analyzing various economic indicators.
The Role of Interest Rates
The markets move based on the expectations of interest rates which are set by central banks. The banks set the rates by assessing economic indicators.
When the central bank tightens monetary policy, which essentially means raising interest rates, it indicates that the economy is moving at a steady pace. Inflation is rising and the GDP is expanding. The central bank raises interest rates which in turn reduces the money supply.
As a result of higher interest rates, the borrowing costs are higher and thus there is less money to go around. This creates demand for the currency in question. The central bank tightens monetary policy in order to avoid the economy from overheating.
On the other hand, a central bank can pursue a loose monetary policy. This is when the central bank signals that interest rates will fall.
A central bank pursues a loose monetary policy in order to stimulate growth in the economy. This can happen when inflation is weak, and the economy is not performing so well. By pursuing a loose monetary policy, a central bank basically makes borrowing cheap.
This, in turn, creates more supply of the money which then helps push inflation higher.
How does a central bank set interest rates?
As mentioned, interest rates form the core of currency trading. And they are based on the central bank’s board assessment of economic indicators. Many central banks around the world and especially those in the developed economies follow a dual mandate of maintaining price stability and job growth.
Thus, a central bank looks to two key indicators in assessing interest rates. These are:
- Unemployment rate
Besides the above two, other key economic indicators include the gross domestic product (GDP), retail sales and some forward-looking indicators that can signal how the economy is likely to perform in the months ahead.