Taking a fundamental approach to investing can be applied to the Forex market in the same way it is utilized in the Stock market. Because currencies, or more specifically the countries of the currencies in question, are affected by economic events just as stocks are, the Forex trader is able to look for a relative value among various currencies.
A fundamental approach to Forex involves analyzing the relative strength and weakness of each currency along with an evaluation of where the specific currency is headed based on certain underlying factors including current and (perceived) future economic, political, and social conditions.
As outlined above, there are numerous types of factors that can influence a currency including; interest rates, political events, trade balance, merger and acquisition activity. Such statistics can be found in reports that are regularly issues by the governments of each country. IN order to determine when these reports will be released, one must observe an economic calendar.
Now let us take a look at the various economic factors that can influence a countries currency (we will take a look at the US for the purposes of this example, however, you must note that such reports are available for multiply countries and all should be observed):
Interest Rates
In order to implement various policies, Central banks often alter interest rates. Such a change in interest rates can result in a severe affect on the inherent “attractiveness” of a country’s currency. When rates are increased, the value of a currency typically increases via investors looking to take advantage of the higher rates. Inversely, when interest rates are decreased, the value of a currency will typically fall due to the lack of investment opportunity.
This being said, Central banks very rarely change interest rates without signaling their intent to do so before the actual change is initiated. Therefore, you can get a feel for the direction of interest rates by analyzing the reports released by Central banks around the world. If you are going to concentrate of fundamental analysis, getting a feel for the meaning lying within the comments made by central bankers will be key to your success.
Political Events
The current political situation in any country always has an effect on its underlying economy. For example, the state of the UK economy or the proximity of a major election can affect the Euro’s strength. Having a strong currency results in a nation’s goods being more expensive to export, but conversely makes it cheaper for the people of said nation to purchase foreign goods and vice versa.
The above is an example of how the political environment of a country can affect it internally; however, the political environment of one country also has an effect on other countries as well. For example, the US and Japan historically have taken a strong interest in the ratio of their respective currencies and have often changed their mutual behavior in order to influence said ratio. Another example of this was seen when Iran's leader caused a massive stir by suggesting that his country would consider taking payments for oil in Euros, which would drastically alter the age old practice among the world's nations of utilizing US Dollars to settle international oil transactions.
The Economic Calendar
Both the U.S. and various other governments issue regular reports on varying sectors of their economies which provide important information on the health of the economy and nearly always result in a Forex market reaction. Some of the more crucial reports are outlined below:
- Non-Farm Payroll
The Non-Farm Payroll report, released by the U.S. Bureau of Labor Statistics, is released on the first Friday of every month and serves as a commentary on employment trends in the US. The report is used to represent the total number of paid U.S. employees with a few exceptions (hence the “Non-Farm” aspect of the report) and represents roughly 80% of the citizens who accumulate the US GDP. Generally speaking, the greater the amount of employees and the higher the salary, the stronger the U.S. economy and USD. - Consumer Price Index
The Consumer Price Index or CPI is an indicator of inflation that measures the change in the price of a predetermined basket of goods and therefore a growth in price of the basket is indicative of a devaluated currency. - Industrial Production
Industrial production is a broad measure of economic activity in US heavy industries. The report is analyzed due to its tendency to hint at future GDP growth.
In addition to these key reports, there are also many others issued that can also have a strong bearing on the Forex market including: The gross domestic product (GDP), the producer price index, automotive sales, consumer sentiment, crude oil inventories, and many others.
Fundamental Forex Strategies: Reaction is the Key
The aforementioned reports are issued on a regular basis and because of this traders tend to anticipate what the report's number will be and "consensus figure” is determined. As a result, when the report is officially released, the market's reaction is generally not to the number itself but rather to how close the “consensus figure” is to the actual number. This may seem counterintuitive, so let us explore why this is the case.
This reaction to the “consensus figure” illustrates a market dynamic that is essential for every fundamental trader to understand- "discounting". The Forex market tends create a “consensus figure” and set prices accordingly – this is known as “discounting”. Since the consensus figure is almost completely built into the market before the report is issued, logic follows that the markets react strongly when the official report offers a number that is higher or lower than originally anticipated.
Conclusion
Fundamental traders take on the ideal that a country’s underlying economic and political conditions are the driving forces behind currency prices. To be a successful fundamental trader, one must monitor regular economic reports and react to surprise figures while evaluating trading nations. Possessing knowledge of these basic market dynamics is crucial for success in conjunction with any trading approach you take to the Forex market.
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