Fundamental analysis is used by traders to predict the future price movement of currencies. Favoured by longer term traders, fundamental analysis attempts to understand and apply the larger, underlying economic trends that can be seen to drive currency values. It also takes account of news events, reports and international environment that exchange rates operate to create a clearer picture of market sentiment and direction.
Fundamental analysis involves the analysis of underlying market trends
Trading forex using fundamental analysis has been used by large institutional investors who take account of the real factors driving markets in taking large trading positions. This analysis, however, can also be used by smaller and forex traders very effectively. The key to this is a general understanding of which key events drive the value of currencies up or down. One of the most widely used examples of fundamental analysis is following the movement of central bank interest rates to influence a decision to go short or long. Interest rates are a key indicator of a currency’s medium-term strength and reflect the basics of supply and demand that drive currency markets.
Interest rates are very important indicators of the fundamental direction of forex markets
When interest rates are raised, for example by the European Central Bank, the demand for the Euro increases as large investors take advantage of the improved interest that they will gain if they buy and hold Euro’s. This creates a fundamental demand for the Euro and increases its relative value against other currencies that have not increased the rate of interest payable. Both short and long term traders can enjoy the trading opportunities that interest rate decisions offer, although markets tend to be significantly more volatile around the time of the news release. Such large fundamental influences such as interest rate changes, however, are not often made on monthly basis and for this reason they are used by forex traders wanting to buy and hold a currency for longer periods. The understanding for fundamental traders is that the short-term fluctuations in the technical signals will give way to the fundamental demand over time.
News and other events also determine market direction
Fundamental analysis also looks to interpret newsworthy global and domestic events in order to predict future movements in the forex markets. Whilst all major news events will affect currency values, their effect will depend on their location and impact within the global financial system. A good example of this fundamental data influencing the value of forex pairs is the tendency for the US dollar to be seen as a “safe haven” investment during periods of instability. The US dollar will tend to rise in value whenever an event occurs which could be seen as destabilising or risky for financial markets. Poor GDP data, outbreak of war or the debt issues of a Southern European country can trigger a medium-term rise in the US dollar’s value. Fundamental analysts will point to the fact that investors see an intrinsic value in US dollars which will protect them from being negatively affected by the instability created by the event.
Trading decisions based on political and economic knowledge
Trading using fundamental analysis requires both a basic understanding of economics and world affairs as well as the ability to apply the relevance of these to individual currencies. These underlying factors can be seen to dictate the general direction of currency values and are especially effective over time using key economic indicators such as GDP figures, interest rates and unemployment figures. Large fundamental events such as the release of non-farm payroll data, indicating employment levels in the US, have the ability to cause havoc on both stock and currency markets from the moment that they are released. Beyond the initial fervour of activity, their impact on the general sentiment of a currency’s value can last for several weeks or even months.
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