How To Use The Key Drivers of Currency Movement For Better Trading Results
Last week we’ve discussed the importance of technical analysis and its most important indicators in Forex trading. In this article, we will look at its counterpart which is equally as crucial – fundamental analysis. Even the most precise technical indicators could fail if you skip the fundamental analysis. So, what is it and how can you use it for better trading success? Be sure to read more about Jesse Livermore’s stock trading methods to further improve your trading strategy.
What Is Fundamental Analysis?
Fundamental analysis is a tool that assists traders in assessing the intrinsic value of a market using a holistic approach. Sounds complicated but hang on, it will make a lot of more sense as you read on.
Many traders and investors know fundamental analysis only in stock trading. There, key figures like equity and debt ratio play an important role. What is the situation in forex trading? Different rules apply here. Fundamental analysts rely on several factors that are mostly macroeconomic. For example:
- Interest Rates
- Gross Domestic Product (GDP)
- Consumer Price Index (CPI)
- Producer Price Index (PPI)
- Employment Reports
- Industrial Production Index (IPI)
- Trade Flow and Trade Balance
Why Is Fundamental Analysis Important?
Successful traders use fundamental analysis to determine what moves the Forex market – and predict movement in the individual FX pairs. Many traders fail because they only devote themselves to charting techniques and try to make constant profits in Forex trading with algorithms or their indicators.
This will rarely provide positive results.
Fundamental analysis is essential because the economic condition of a country and news & (international) politics determine currency movements. If you consider the big players in the financial industry, almost all of them apply fundamental analysis. The institutional traders use professional news terminals such as MNI, Bloomberg, or Reuters to gather market-relevant information within seconds. The costs for this amount to several thousand euros. Would they spend the money if it were not worth it?
Forex Fundamental Analysis: What
Really Moves The Price?
As with all other asset classes, prices are determined by supply and demand.
But whether buyers or sellers have a better negotiating position is determined by certain fundamental components that determine whether the trend in a currency pair is long or short.
So, who or what are the key rate drivers in any currency?
The Domestic Central Bank
Central banks (or the federal reserve) are responsible for the monetary policy of the country or currency area concerned. In some cases, they have powerful tools that ensure the well-being of the national economy. The strongest instrument of a central bank is the key interest rate. Central banks set the key interest rates approximately 10 times a year to control the interest rate level and also intervene in the bond market by purchasing government bonds.
In this way, central banks manipulate interest rates, which in turn can affect the economy and inflation. Decisions by central banks can lead to sharp price swings in the Forex market. The interest rate also determines the attractiveness for (foreign) investors of investing or borrowing in the respective country.
If the interest rate in the USA is 3% and in the EU 1%, then an EU investor will invest his money in the USA. To do this, he must sell EUR and buy USD on the foreign exchange market. The EUR/USD falls.
But there are more drivers for forex rates…
If we remember election nights like the Trump victory or Brexit (GBP lost 20% in a few hours against the USD), everyone should be aware of what can happen to currencies due to political events.
In 2016 you could make very good profits with shorts on the Turkish Lira. Almost every new comment by Erdogan caused the Turkish Lira to depreciate further. The markets hate uncertainty and such events provide the ideal platform for it. That is why as a trader, you should always be up-to-date and watch the news closely.
But what about the “quiet” times? After all, not every day has a “Brexit” or interest rate decisions. Of course, new exchange rates emerge every second, because currency trading is not only done for central banks. Foreign exchange is needed around the clock for international trade. Any company importing goods from abroad must exchange domestic currency via the currency market to pay for the goods. Thus, the market is dominated by a group of participants who do not (like us) have the intention of speculation. We have no influence on these orders, but they are part of our daily business. Large orders can cause a move in the Forex market in quiet times.
So now, let us transform what we learned today into practical advice. Shall we?
Using Fundamental Analysis for Your Trading
As in equity trading, we want to use fundamentals to determine whether a currency is likely to rise or fall soon. If we take Google’s fundamentals, for example, we see very strong fundamentals based on equity, cash position, market dominance, etc., and therefore no reason to short the stock. On the other hand, if we look at the Forex market, we also have to determine the fundamentals for each currency separately but based on (monetary) policy criteria.
The following questions will help you if you want to know how to perform a Forex fundamental analysis:
what is the key interest rate level in the country of the currency concerned?
how does the key interest rate level compare to other G10 countries?
what interest rate steps is the central bank likely to take?
what are the political issues surrounding the currency?
how strong is the economy?
If you can answer these questions for each currency, you have a good picture of the fundamental situation. But always remember, that it describes the overall, big picture of the currency. It does not mean that positive fundamentals can’t lead to a multi-day crash after all. Nevertheless, the fundamental parameters will determine the trend of the currency in the long run.
Tip: To be able to determine the fundamental data daily, you can use certain services. For example, Google News, Bloomberg and Reuters.