There are many different kinds of analysis done in the forex market. The goal of the analysis is ultimately to track the direction of the market so as to make worthwhile trades. The fundamental aspect of forex analysis is all about the broader economy as a whole and not any specific market factors. The goal of this analysis is to determine how the major factors in the economy affect the value of the currency. There are many facets involved in this kind of analysis. The overriding philosophy, however, is that the price of assets always returns to the normal range in the long term.
Because of the dynamic nature of this method of analysis, it is often possible to determine the correct value of assets. This is in stark contrast to technical analysis, which relies on analyzing the price of the asset and not necessarily its value. So, what sets fundamental analysis apart from other forms of analysis?
Mode of Operation
Fundamental analysis does not merely focus on one economic factor to bring about information. Instead, it looks at various models that involve theoretical frameworks with the goal of gathering as much information as possible to compare with data. The nature of data inflow, however, is that it is dynamic and periodicals. Forex reports for instance, often come either on weekly, monthly, or even quarterly basis.
In the forex trading business, where data flows every second, technical analysis reigns as it follows the data by the second. Fundamental analysis is nevertheless also critical even though data comes on a weekly basis at the minimum. The basic laws of economics dictate that when there is a high demand for a particular currency, its price is bound to go up. But this does not mean that every time a currency appreciates, the economy becomes more vigorous.
Currencies only have a fiat value, unlike commodities with an intrinsic value. Monetary policies can, therefore, lead to the depreciation or appreciation of the currency’s value. In this case, the demand and supply forces have nothing to do with the value change. Economic reports often influence the price of a currency. Traders who generally rely on fundamental analysis should not rely on such news reports as they can be misleading and potentially damaging.
Economic Indicators and Their Role in Fundamental Analysis
Since fundamental analysis focuses on the significant economic factors in the market, long-term economic data is often a great source of information on the market’s direction. The various factors that surround the monetary and fiscal policy are thus crucial for this kind of analysis. In general, there are three key economic indicators that are of importance in fundamental analysis. These are:
- GDP
- Interest rates
- Inflation
1. GDP
GDP is the measure of the total value of commodities that have been produced in a country over the period of a year. GDP is considered to be a great indicator of the economic status of a country. While it does not take into account the demand for commodities, it is often assumed that both the forces of demand and supply work hand in hand. The fundamental analysis proposes that the rise in GDP without an actual increase in demand or product affordability indicates poor economic health.
Interest Rates
Interest rates form the basis of fundamental analysis. The base interest rates set by the central bank are the most important for fundamental analysis. This is because the interest rates that banks pay to the central bank are crucial for determining consumers’ relationship with the banks. When central banks change the monetary policy, the effect is felt in the areas of investment, trade, production, inflation, and other economic factors. Central banks often adjust the interest rates upwards or downwards depending on the economic forecasts.
Inflation
Finally, inflation is also important is also crucial for analysis. Inflation is the general increase in the price of commodities in a market. Certain levels of inflation can have devastating effects on the economy. Inflation determines consumption trends. When goods have higher prices, people tend to buy less, and this slows down economic activity. Monetary policy therefore dictates that a careful balance must always exist in order for the economy to be healthy.