The main goal of fundamental analysis is making financial forecasts such as 'will currency A rise or fall in value against currency B'.
How you answer the above question depends on how well you can decipher the macroeconomics that shapes the outlook. Fundamental analysis looks at the underlying forces that are moving the markets in question and is generally used by long term investors, but can also be used by traders to gain an understanding of the markets they wish to trade.
Combining fundamental analysis alongside technical analysis, which is the study of price, can be a powerful combination which will empower you as a trader and paints a complete picture of the markets.
When using fundamental analysis, it is important to define the goals. Given the vastness and the complexity of the field, it is easy to lose focus or get sidelined by different factors.
Therefore, the first and most basic step in fundamental analysis is to start off with a currency pair that you are interested in to trade. This will ensure that you stay focused on the most relevant details in order to help lay the groundwork for building a trading plan.
So should you simply pick out a currency pair by rolling a dice or is there some logic to follow? While there is no rule and it is entirely up to the trader to start with a currency pair of their choice, it does make sense to stay relevant to the current markets.
Example, what is the most talked about topic at the moment? Which currency or Central Bank’s policies are being constantly referred to in the markets? By picking the most trending instrument or asset, traders would be able to find more information and perhaps gain more knowledge by combining the technical and fundamental aspects involved.Macroeconomic fundamentals influencing the markets
The main fundamentals driving the currency markets are macroeconomics. Macroeconomics is defined as a branch in economics dealing with the study of large scale economic factors.
Examples include interest rates, unemployment, inflation or GDP to name a few. In the currency markets, fundamental analysis is all about determining how good economy A is doing in relation to economy B, where economy A and B are represented by the currency pair in question.
So, fundamental analysis for AUD/NZD would simply mean studying and comparing the macroeconomics between Australia and New Zealand.Macroeconomic Fundamentals – The most important reports to follow
The following is a list of main fundamental reports to follow depending on the type of markets being monitored.
* GDP: Gross Domestic Product is applicable for the currency markets. It is released on a monthly or quarterly basis and shows the rate of growth during the specified period.
GDP is a measure of the value of all goods and services produced in the country. The GDP report is a primary indicator of strength of the economy and usually signals higher economic activity and thus can influence central bank monetary policies.
GDP reports are important on a quarterly and yearly basis and growth is compared on a year over year basis. Within the quarterly reporting periods seasonal trends often influence the rate of growth.
For example, in the US, the first quarter GDP is usually the weakest, while growth picks up from the second quarter onwards with the third quarter GDP being the strongest.
GDP reports can be used to get an idea on how well the economic engine is running, the potential jobs that could be created as a result and thus the more wages workers get which in turn can affect consumer spending and thus inflation.
* Inflation: Also known as the Consumer Price Index. It is released on a monthly or quarterly basis. Inflation rate tracks the rise or fall in the value of a basket of goods and services that are most commonly used, including food, clothing, transport, fuel.
Higher inflation is a sign of a healthy economy but at the same time can influence central banks in increasing interest rates in order to contain inflation rate. There are various factors that influence inflation, including the currency’s appreciation/depreciation as well as Oil prices which affect the goods being imported.
Most central banks follow a mandate of steering an economy based on the inflation target. A 2.0% inflation target is widely used and rates are changed accordingly in an effort to reach the price stability mandate.
Therefore, higher inflation is often seen as a precursor to rate hikes, while lower inflation generally triggers rate cuts.
* Labor/Employment reports: The labor market report is released once a month and is based on a survey of households and/or businesses. It sheds light on the general state of the labor market in terms of the number of people being employed in the economy, the unemployment rate and wage increases.
The labor market’s wage growth is an important indicator which eventually influences the inflation rate. A higher rate of wage growth means more consumer spending which in turn pushes inflation higher, while a decline in wage growth could signal deflation.
* Interest Rates: All central banks have a mandate towards achieving an inflation target and in some cases, helping the economy to reach full employment. Based on these targets, the central banks look at the main economic indicators and assess whether to increase, cut or hold interest rates.
Central banks meet almost every month and monitor the economic progress of the country releasing its views, known as the policy statement, where the central bank outlines its view on the economy and what future course it could take in regards to interest rates.
The economic indicators are not just limited to the above but include a lot more other details. Some of the other economic reports that could be of interest are:
* PMI Surveys: A monthly survey of businesses is conducted, known as the Purchasing Managers Index, and is broadly categorized into Construction, Services and Manufacturing sectors.
The PMI is an index where above 50 marks an expansion and below 50 marks a contraction. PMI surveys are early indicators into the general outlook of business optimism.
Some of the important PMI reports include the Institute of Supply Management (ISM) in the US and the Markit PMI’s in the UK and the Eurozone.
* Retail Sales: Retail sales data is used as a measure of the aggregated sale of retail goods measured over a period of time.
Retail sales mark a big component that adds into the GDP and also signals the general consumer spending behavior. In an expanding economy, consumers tend to spend more and thus show a greater demand for goods (thus increasing the GDP, which in turn influences labor markets and inflation).
* Industrial Production: This report measures the output of the industrial sector and takes into account manufacturing as well.
Industrial production doesn’t contribute much to the economy’s GDP but they do signal at an early stage the state of the manufacturing and industrial sector especially in terms of jobs and inflation outlook.Central Banks – Why you should pay attention
Aside from all the above listed fundamentals, central banks form a special category. While earlier, central banks were limited to announcing policy changes; over the recent decades central banks have taken a more pro-active approach to the markets, in a way to improve its communication on policy changes.
This has meant increased volatility especially when a central banker is speaking. Nowadays, economic calendars are well sprinkled with a lot of central banker speeches and many times the markets have reacted strongly to these comments.
The following example below showcases the importance of central banker speeches and their influence on the markets, especially when the speeches are made closer to a central bank decision.
November 4th 2015: ECB officials lined up to speak at an event in Frankfurt. They included the ECB President Mario Draghi and governing council members Daniele Nouy and Vitor Constancio among others.
The focus was the ECB’s policy actions when it met in December. Previously, the ECB said that they would take a decision on further monetary policy at the December meeting. So the markets were closely watching these central bankers for any hints they might drop at what would happen at the next December meeting.
All the officials said that there was a need to re-asses the ECB’s policies and said that inflation was weak and that the central bank was committed to reaching its 2.0% inflation target.
The markets took these comments as an assertion that the ECB would ease monetary policy further. EURUSD was sold off and continued its downtrend as the markets started building expectations that the ECB would announce strong policy measures at its December meeting.
EURUSD Reaction to ECB President Draghi’s speech at an eventMacroeconomic Fundamentals – Putting it together
With macroeconomic fundamentals, as a trader or an investor, you are in a way behaving like a central bank. Your goal is to understand the underlying trend in an economy and compare it to another economy.
For example, a continued uptrend in GDP growth along with a pickup in wages and the labor market in general with a healthy inflation trend can often foresee an interest rate hike cycle in order to cool down an economy.
Likewise, continued declines in GDP growth, rising unemployment and falling inflation usually triggers a central bank to stimulate the economy by lowering interest rates and using additional measures to loosen the monetary conditions.
Comparing this data to another economy then gives you a bigger picture for the fundamentals that drives the currency pair in question. This information can then be combined with technical analysis and be traded accordingly.
Taking it a step further, while technical analysis can merely tell you at which price to buy or sell a currency pair, fundamental analysis can give you the additional information of why it is better to buy or sell a currency pair.