Fundamental analysis is the examination of factors that affect the strength (or weakness) of a particular currency. These include but are not limited to GDP growth, political stability, trade balances, inflation rates, interest rates, and the employment situation in the specific country.
Given the wide array of data available to traders making use of fundamental analysis, most traders simply choose to rely on economic releases from different countries as well as geopolitical events that might affect the strength of a particular currency. This is often referred to as “trading the news”.
Some of the factors that influence a currency’s performance include:
- Political Stability And Geopolitical Events
The political situation in a country has a direct impact on the strength of its currency. This is because political stability usually spurs economic growth by creating a positive environment for both local and foreign investment.
On the other hand, disruptive geopolitical events typically have an adverse effect on a country’s economy, which directly affects the strength of its currency. A good example is the recent trade war fears between the US and China. This led to the weakening of the US dollar, reflecting investor fears regarding the impact of an all-out trade war on the US economy.
- GDP Growth Rates
The GDP growth rate of a country is a measure of the economic output generated within the country, which has a direct impact on the strength of its currency. A country with a declining GDP is likely to witness the weakening of its currency against that of its trading peers. The reverse is typically true for a country with an expanding GDP.
- Inflation Statistics And Interest Rates
The inflation and interest rates within a country are generally interpreted as measures of the strength of a country’s economy. A country’s Central Bank usually sets its inflation target and interest rates. Countries with inflation rates that are slightly higher than the respective Central Bank’s target are regarded as having strong economic growth, and vice versa. Countries with high interest rates attract more investors due to their high yields, which tends to boost the value of their respective currencies.
- Trade Balance Data
A country with a positive trade balance means that it is exporting more goods and services as compared to its imports. A positive trade balance usually results in higher demand for a country’s currency in the international markets as traders buy the currency in order to pay for its exports. The opposite is also true for countries with large trade deficits, which lowers the demand for their currencies, resulting in weaker currencies.
- Employment Statistics
The employment situation in a country reveals the state of its economy as high unemployment rates typically indicates a struggling economy, while low unemployment rates usually indicate a strong economy.
Given that the employment situation changes frequently, positive employment statistics will temporarily strengthen a currency, while negative employment statistics usually weaken a currency. Examples of employment statistics include the US non-farm payrolls and weekly unemployment claims data.
There are two approaches to fundamental analysis:
The Top-Down Approach: this starts with broad macroeconomic analysis and narrows down to specific currency pairs with high profit potential.
The Bottom-Up Approach: this starts with particular currency pairs and works up to how they are affected by broader macroeconomic trends.
It is evident that traders using fundamental analysis have a wide range of data to analyze in order to arrive at conclusions regarding the intrinsic value of a currency. However, such analysis might be quite time consuming, leading many fundamental traders to simply keep track of news events, and daily economic releases. This is referred to as “trading the news”, and is the most practical use of fundamental analysis by retail forex traders.