fundamental analysis
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fundamental analysis

Fundamental analysis is the attempt to find an instrument’s fair value reasonably accurately. The core question fundamental traders ask is how the news affects or might affect financial markets. They believe that the price of an instrument depends on its real value and look to exploit significant differences between price and value.

Fundamental traders look primarily at economic data. However, they also focus on political events and consider nearly any item of news or data that might have an effect on markets. Although fundamental analysis in general is a very broad topic, for CFDs in particular it’s more manageable.

This article’s focus is on forex because it’s the most popular CFD instrument. The general principles here can work for other types of CFD as well, but there are some specific differences.

Economies

 

One of the basic ideas in fundamental analysis is that if a country’s economy is strong, its currency and index will also be strong. The opposite is also generally true. In this respect, almost every trader does some fundamental analysis. Very few traders would have wanted to buy the pound in the immediate aftermath of 2016’s Brexit referendum, for example.

fundamental analysis

Some sort of economic data comes out for basically every country in the world every week. One of the challenges for a fundamental trader is cutting through ‘noise’ and spotting patterns in these data. Most traders who use the economic calendar actively though tend to focus on five major categories of release, in rough order of importance:

  1. Change in the number of people in employment (most importantly the USA’s non-farm payrolls, ‘the NFP’)
  2. Rate of unemployment
  3. Inflation
  4. Growth in gross domestic product (‘GDP growth’)
  5. Purchasing managers’ index (‘PMI’, manufacturing and services)

These five categories are the ones which usually have the most effect on currencies. For more information about each, keep reading Exness Education’s regular series of fundamental articles.

Fundamental analysis of employment data

A big release like the NFP usually has a range of predictions. When you open the economic calendar’s subsection for the NFP, you’ll see the previous release and the consensus estimate for the next one. After the upcoming release, the box with the actual figure will fill in. Traders focussing on the news attempt to exploit major differences between the actual values and the consensus.

If the NFP is unexpectedly strong one month, the dollar usually strengthens against other currencies. If the figure is lower than expected, though, the dollar typically weakens for a period at least.

A longer term approach is to consider the balance of economic data. For example, let’s say there are several strong NFPs in succession combined with high employment, inflation on target and good growth in GDP. In this scenario, traders might keep buying positions open for the dollar and perhaps add to them. This sequence would be especially important if the dollar doesn’t react much to a series of good announcements. In that case, a trader might buy in and make a decent profit if the currency did finally react by making gains.

It looks simple on paper, but, in reality, using the economic calendar is almost never as easy as this. Psychology, technical conditions, sentiment and many other factors also play key roles. The economic calendar and the overall conditions of a country’s economy are just some of the considerations before making a trade.

Central banks

 

Almost every currency is controlled to some degree by a central bank. This is an independent national institution usually responsible for monetary policy. In other words, a country’s central bank determines interest rates, creates targets and projections for inflation and generally aims to keep economic conditions stable.

fundamental analysis

The base rates influenced mainly by central banks have a wide range of names, but for traders’ purposes they’re all the rate at which a central bank lends money. Higher rates usually cause more demand for a currency because investors want to buy it for its higher yield. Lower rates typically make a currency less attractive.

As above, it’s much more complicated than this in practice; nonetheless, there’s really no need for traders to study central banks’ activities in great detail. Instead, there are a few key events that speculators tend to monitor.

Fundamental analysis: meetings and minutes of central banks

Meetings of central banks at which the banks usually announce rates are crucially important for most currencies. As well as actual changes to rates causing major fluctuations in markets most of the time, what central bankers say about future rates is also a key factor. Heads of central banks also usually give their opinion – however reluctantly and guardedly – on their country’s economy. Traders extrapolate on this to consider the likelihood of changes to rates in the future. The most famous practical application of this is CME’s FedWatch.

Minutes from the meetings of central banks are also important. These documents usually come out about a week after meetings. They describe in summary what different members of the relevant committee said about the various factors affecting the latest decision on rates. For example, if there are many references to weaker employment data, traders usually focus more on such releases in the aftermath of the minutes.

Many traders also like to listen to or read the comments by individual members of central banks’ committees. Members of committees of monetary policy often give statements and evidence to parliaments and can appear at public events. What they say about economic prospects and data – especially inflation and jobs – can be drivers for currencies’ movements.

Politics

 

Governments are of course one of the main factors in the strength of a country’s economy. A weak, incompetent government usually means that a currency loses strength, while a strong, stable and effective one is usually a positive for the currency.

Elections and referenda are probably the most important political developments watched by traders. Most elections come down to two candidates or parties at some point, and markets generally have a ‘favourite’ of them. Victory for this party often leads to a currency moving up against others, while success for the other party can lead to losses.

Significant ongoing political events have a major impact on most financial markets. However, they’re usually impossible to predict. This category includes the Sino-American trade war in 2018 and 2019 plus the exit of the UK from the European Union. Snippets of news about these can help to inform traders, but relying on them alone is very risky and not usually a good idea.

Sentiment

 

Sentimental analysis can be as a field in itself, separate from either fundamental or technical analysis. In derivative markets, though, most traders consider it to be a category of fundamental analysis.

Studying sentiment basically involves watching how markets react to economic releases and important items of news. It’s not uncommon for a particular market to react minimally to or even discount negative or positive items of news depending on the overriding beliefs of its main participants.

For example, American indices made significant upward movements on the whole in early 2019 despite the first signs that the USA’s economy was cooling off. This also happens with currencies. A major decline in employment in the UK might lead to only a modest loss for the pound. In such a situation, many traders might conjecture that sentiment on the pound is good and consider buying.

Fundamental analysis beyond forex

 

Data, central banks and sentiment also affect other instruments apart from forex. However, they do so somewhat differently. Gold, for example, is one of the most important ‘havens’. This means that traders and investors are usually most likely to buy it during periods of higher political and economic uncertainty.

In addition to this, gold has a degree of correlation with the dollar. As the dollar weakens against most currencies, gold usually makes gains. This is an inverse correlation. Direct correlations also exist. Oil and the Canadian dollar is probably the most important of these. As oil gains, the Canadian dollar usually strengthens as well.

The reasons for correlations are diverse. They often include a country producing or exporting a large amount of a commodity with a correlation. Demand in major economies can also be important. For example, if the yuan renminbi weakens over an extended period, many traders would expect the price of oil to go down. This would be because of lower buying power and demand. Indices are often somewhat correlated with the currencies in which they’re priced. Usually this is a relatively weak direct correlation, but JP225 and the yen have an inverse correlation.

fundamental analysis

Specific data in fundamental analysis

Apart from correlations, commodities and indices to a lesser extent typically react to different data from currencies. Most regular economic data don’t have much of an impact on the price of oil. Instead, oil-specific releases such as weekly stocks and Baker Hughes’ rig count tend to drive the price of crude. 

Indices also move on more specific factors than currencies, generally speaking. Since indices consist of a certain number of companies’ shares, it can be worthwhile for traders to monitor the outlook for and performance of a particular sector. This might involve considering tech for US500 or oil and gas for UK100.

Integrating fundamental analysis into your strategy

 

Rather like technical analysis, fundamental analysis is a very broad and potentially complicated topic. The difference is that the latter is significantly less important than the former in derivative markets. It’s not necessary for most strategies to have a detailed knowledge of fundamentals or to conduct fundamental analysis much beyond the basics. 

The practical application of fundamental analysis is essentially to compare it with what technicals say. A good outlook for a country’s economy – from data, the central bank and sentiment – combined with a strong, healthy upward trend might mean that you can buy the relevant currency with relative confidence. On the other hand, when there’s a disconnect between fundamentals and technicals, you need to be more wary.

Even traders who ignore fundamentals most of the time need to monitor the economic calendar to some extent. Entering a large trade with only charts and indicators on the morning of the NFP is very unwise. You should always have some awareness of the bigger picture in addition to the smaller details.

You’ve almost finished Exness Education’s cornerstone content. The last key article is on strategic trading. Check it out and start building your strategy!

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