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Why is fundamental analysis important in trading?

 

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Fundamental analysis is a type of analysis which looks at the fundamental or the basic building blocks behind the price movement of an asset. The fundamental basis can be a number of things. But most commonly, fundamental analysis focuses on aspects such as cashflows, valuation and future expectations.

Fundamental analysis is widely used in all types of financial markets; Whether you want to trade equities, commodities or currencies. The main purpose of fundamental analysis is to answer the question of whether the asset is rightly priced and what is behind the movement in the price of an asset.

In this article, we will focus on fundamental analysis in forex or currency markets.


Fundamental analysis for currencies

Many trades struggle to find the answer to this. Fundamental analysis in the forex markets deal with interest rates. Interest rates, which are set by the central bank gives investors and traders an idea on how to value a currency.

Typically, a currency with higher interest rates tend to be more valued than currencies with lower interest rates.

But then, there are exceptions!

Fundamental analysis is also forward looking. Therefore, investors and traders who look at the fundamental analysis also speculate on the future valuation of the currency.

EURUSD Example Fundamental Analysis

Example of EURUSD with Fed rate hikes

 

Say for example, you have a currency A that has an interest rate of 3%. Whereas, currency B has an interest rate of 1.5%. It is easy to see that investors prefer to buy the currency with higher interest rate, which is currency A.

But what if the central bank for currency A signaled a dovish outlook and that interest rates would be cut?

Certainly, as someone who is looking at future valuation, you would start to sell currency A. Now if the central bank for currency B turned hawkish, you would prefer to buy currency B as your forward valuation signals that interest rates for currency B will appreciate.

Therefore, fundamental analysis is not an exact science. And to make it a bit more complex, every investor might have a different take on the future valuation.


Interest rates - The core of fundamental analysis

In the currency markets, it is the interest rates or the speculation on where interest rates will be is what drives the markets.

The interest rates, which are set by the central bank in turn look to economic indicators in the economy. When an economy is sluggish, the central bank lowers interest rates to spur borrowing. This in turn creates demand for the currency as it is cheaper to borrow. This borrowing can in turn translate to business expansion and hiring.

On the flipside, when an economy is overheating, central banks raise interest rates to ensure that borrowing is more expensive. This leads to a normalization of sorts in the economy.

As businesses borrow less, economic activity is controlled in order to keep the demand in check.


Key economic indicators in fundamental analysis

The way a central bank fluctuates interest rates are dependent on economic indicators. Most central banks have a dual mandate. The first is to maintain price stability, the second is to ensure full employment.

In fundamental jargon these are also referred to as inflation and unemployment rate. You can see that there is a close correlation to various economic indicators. Let’s look at some of these briefly.

  • Interest rates – This determines how cheap or expensive it is to borrow. Businesses borrow money to expand or fund acquisitions. Individuals borrow money to buy a home or an automobile and so on.
  • Consumer prices or inflation – This determines the price of a basket of goods. It tells you how expensive things are, compared to a month a quarter or a year ago. Inflation can rise for a number of reasons. Most importantly, inflation rises when demand outstrips supply.
  • GDP – The Gross domestic product is the value of all goods and services bought or sold in the economy. GDP is closely tied to interest rates. When rates are low and borrowing costs are cheap, you can expect the GDP to rise as businesses and individuals find it easier to fund their purchases.
  • Unemployment – The unemployment rate determines the number of people who are out of jobs. When the economy booms, unemployment rate falls as more people are needed to do more work. When you work, you get wages which in turn affects your spending and thus, inflation.
  • Income and spending – This is the income people get and the amount they are spending. Incomes and spending are influenced by interest rates. When your income increases, and interest rates are low, you can spend more.

Besides the above, there are many other measures of the economy that give a snapshot of how various aspects of the economy are performing.


Why should you focus on fundamental analysis?

It is important to note that technical analysis looks at past price history to predict future price movement. Fundamental analysis on the other hand answers the question as to what is moving the prices. When you combine the two, you can get a clearer picture of the economy.

As a trader, it also works to your benefit because your trading decisions are well informed.

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