Fundamental analysis and its role in a forex trading strategy
Fundamental analysis is performed by forex traders in order to calculate the actual value of a currency pair or other financial instrument. As these financial instruments undergo overbought and oversold cycles quite often, a fundamental traders end-goal is to identify where the market is going to revert to its correct value and position themselves in a favorable trade to take advantage of the movement.
This is also where the key difference between technical and fundamental analysis lies. Whereas technical analysis focuses on the current and previous price data to gauge future price movements, fundamental analysis is aimed at providing a birds-eye view of the economic landscape by identifying the sociopolitical and geopolitical factors that may have an impact on the supply and demand of an asset and consequently its price on the global stage. For fundamental traders, short-term fluctuations are merely noise that should be ignored.
How to use fundamental analysis in forex trading
Depending on the asset you want to trade, you will want to look at the underlying economic data that are thankfully released and are easily accessible by the general public. For example, currency traders usually need to watch out for interest rate cuts or hikes by a country’s central bank, its GDP and inflation metrics in order to determine the economy’s future performance.
Strong and developed economies tend to attract foreign investments, which lead to more demand for the local currency. Consequently, the economy expands over time and so does its national currency. Looking at the big picture can help traders gauge the economy’s potential and identify the assets that provide better opportunities and greater profits.
Monetary policy and interest rates
One of the reasons that a central bank’s interest rate decisions are marked as a key event on the economic calendar is because of their impact on the supply and demand of a currency.
Interest rates are a vital tool that central banks use to boost the economy or control inflation from reaching dangerous levels.
When the economy is in a slump, a country’s central bank will opt to decrease interest rates in order to stimulate expansion, loans and outside investments. However, this isn’t a viable long-term strategy as it will eventually lead to inflation where the prices of goods and services becomes prohibitive due to too much money supply. Therefore, central banks also can increase interest rate at their disclosure in order to reign in the economy from growing too rapidly.
In general, when central banks adopt a dovish stance i.e. cutting interest rates, then this is a good indicator that there is slow economic growth and foreign investments will turn away to a stronger currency with higher interest rates and therefore greater returns.
On the other hand, a hawkish stance refers to when a central bank raises interest rates in which case the currency will appreciate in value due to the surge of investors looking to take advantage of the higher yielding rates.
Currency traders can predict a central bank’s interest rate decision by analyzing recent economic data such as payroll figures and unemployment rates which are published monthly on the first Friday of each month.
Inflation is not necessarily a bad thing for an economy, but it’s vital that it’s kept under check at all times and each central bank has its own ideal sweet-spot where inflation is at healthy levels.
Central banks need to raise and cut interest rates to strike a balance between a growing economy and the money supply. Ideally both elements should be showing growth at a stable rate where neither is outpacing the other by a large margin.
Gross domestic product or GDP is the benchmark of a country’s economic health as it measures the value of all the goods and services produced by a country during the economic quarter. If you want to know how a country’s economy is faring, the GDP can provide an accurate metric of the economy’s growth rate and this figure can act as a guide for monetary policy updates by central banks as well.
Looking at these fundamental indicators, forex traders can predict the general direction of a currency and identify developments that can highly affect currency exchange rates and generate increased market volatility.
This is why improving your skills in fundamental analysis is key in succeeding in trading forex, since it provides a better understanding of the underlying reasons markets tend to appreciate or depreciate over time.
If you want to learn more about market analysis using fundamental indicators, you can open a sign up for a free trading account and get in touch with CM Trading’s trading specialists who will create a custom education package tailored to your current experience and skill level.
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