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Fundamental Analysis - Forex

Fundamental analysis is built from the basic idea that the value of a currency is determined by comparing the strength and weakness of a country's economy to that of its trading partners. The stronger the country's economy (which is measured by higher interest rates, lower inflation, greater productivity, stronger political stability, higher GDP growth and much more), the stronger its currency. In time, these fundamental factors create the long term price trends that are typical of the currency markets.

In performing fundamental analysis, several economic factors are monitored and assessed. These factors are judged on the effect that they have on the country's economic growth and development. These trends are generally quite complicated and are often large. They can be enacted over a long period of time. The political system is another factor which can affect the economic status of a country. The balance between the individual competition and the social welfare, or how open an economy is to foreign trade and capital, can have a great impact on the economy. The natural resources, such as mineral deposits or oil play a part, as well as the cultural and social makeup of a country, such as entrepreneurship, labor mobility and productivity.

Fundamental analysis uses economic statistics to view the economy and its currency. Rather that looking at the economy as a whole, these statistics often reflect a particular sector of the economy. This means that different statistics may actually point in opposite directions. For example, one portion of the economy may be growing steadily while another portion is faltering, or one industry is rising in importance while another is declining. Most statistics are also retrograde, showing you what has already happened but not necessarily what is going to happen in the future.

Local and world events (political, military, human and even natural events) can create large, fast and long-lasting repercussions in our volatile and interconnected world. When painting the overall picture of an economy (strengths, weaknesses, vulnerabilities, future potential and future course of its currency), a fundamental analyst must take all of this information into consideration. The fundamental analyst also uses personal experience and judgment to complete the currency analysis.

Market Drivers
Transactions in the Forex market are different from those in a retail environment. When you make a purchase from a retailer, the price you pay for the product is predetermined by the seller. As a purchaser, you measure your need for the item against the asking price. Using this information, you decide whether to buy or not. In a Forex market transaction, the buyer and seller are both adjusting their price expectations continually, based on the information streaming out from the market to the participants and into the market from outside sources. A seller who is expecting the price to be higher in the near future may choose to withdraw an offer in hopes of getting a higher rate. If enough sellers withdraw their offers at a specific level, the deal price will rise to the next available offer. Likewise, if traders believe the price may fall, they may lower their own offers until they find a buyer, in turn driving the market price down.

As the market participants react to the changing information, the combined reaction causes movement in price. An observer sees the "market" as having traded lower because the thousands of individual decisions that make up the movement are viewed as one large mass decision. We often say "the market took profit today" or "the market reacted badly to the news". The "market" is a picture of the thoughts of its participants, in other words, a snapshot of our minds.

Market movement is produced by the difference between what the participants assume will happen and what actually happens in the market. When an economic statement is released and it is the same or similar to the general opinion of what would happen, the trading reaction is often muted. The statistic is said to be "priced into the market", meaning that several prior trading decisions assumed the state of the economy displayed by the statistic, which was reflected in the trading rate. On the other hand, if the statement is different than what the participants assumed, then most of those trading decisions will be immediately unwound, resulting in price movements that reflect those changes. It is the tension between the opinion of the majority of the participants as reflected in the trading rate and the economic, statistical or rate reality that dominates currency trading.

Economic Indicators 101
An economic indicator is information amassed and published by a government or private entity recording the activity in a particular economic sector, either in a specific industry or in an entire economy. Most indicators are statistical, but they can be anecdotal or subjective as well. Indicators are recorded and published on a regular basis by many organizations and are used by traders to assess the strengths or weaknesses of an economy, to predict future activity, to judge central bank policy, and to provide insight into the many economic variables that make up a modern industrial economy.

Information accumulated and broadcast by a government or private entity recording the activity in a particular economic sector (either in the entire economy or in a specify industry) is an economic indicator. Most indicators are statistical, but that can also be subjective or anecdotal as well. Several different organizations register and broadcast economic indicators on a regular basis. They are used by traders to determine the strengths and weaknesses of an economy, to judge central bank policy, to predict future activity and to provide insight to the many economic variables that establish a modern industrial economy.

Most indicators are classified as either leading or lagging. If the indicators track economic factors that often change before the general economy, they are leading indicators. These indicators are generally used to predict future economic conditions. On the other hand, lagging indicators record activity that has already occurred and may or may not prove useful in prediction.

Economy-wide indicators are the broadest measures of productive activity and record the result for an entire economy. Usually collected by governments, they are among the most authoritative statistics.

The broadest measure of productive activity are economy-wide indicators. These indicators record the result for an entire economy, rather than that of a specific sector or industry. Economy-wide indicators are usually collected by governments and are among the most authoritative statistics.

Examples or economy-wide indicators are:

  • Gross Domestic Product (GDP)
  • Consumer Price Index (CPI)
  • Producer Price Index (PPI)
  • Unemployment Rate
Industry and sector based statistics normally pertain to a particular industry, such as housing or a particular economic activity, such as retail sales. Collected by both government agencies and private sector groups, the activity they track is more limited, and can have a close correlation to the broader indices, generating considerable trading interest.

Statistics that generally pertain to a particular sector, activity or industry, such as retail sales or housing, are industry and sector based statistics. These statistics are collected by both private sector groups and government agencies. The activity that is tracked by these statistics is more limited and can have a close relationship to the broader indices, which generates a considerable trading interest.

Examples or industry and sector based statistics are:
  • Durable Goods Orders
  • Housing Starts
  • Building Permits
  • New Home Sales
  • Retail Saless
  • Purchasing Managers Index
  • Institute for Supply Management (ISM) Survey
Finally, the indicators that gauge business and consumer opinions on current economic conditions and their expectations and intentions for the future are called sentiment indicators.

Not all statistics on a single topic are of equal importance. Some government and central banks prefer one measure to another and the markets will assign that much more trading weight to the favored statistic. Other statistics gain or lose interest over time depending on their volatility, changes in the economy or newer and better measurement techniques.

Statistics on single topics vary in importance. Some central banks and governments prefer one measure to another. Based on that preference, the markets will assign the greater trading weight to the favored statistic. Depending on their volatility, changes in the economy or newer and better measurement techniques, other statistics will gain or lose interest over time.

Depending on what is believed to be more relevant to the current market and economic conditions, traders will also focus on other statistics. For example, economy-wide statistics will be prevalent when the market focus is on GDP growth. In contrast, industry-wide statistics will be the focus of interest when developments in that industry are of concern.