Fundamental Analysis – Key to Investing

The main goal of fundamental analysis is making financial forecasts such as will currency A rise or fall in value against currency B.

What is Fundamental Analysis

Fundamental analysis is the evaluation of the macroeconomic factors influencing the strength of economies and the resulting affect on forex & stock markets.

The main goal of fundamental analysis is making financial forecasts such as will currency A rise or fall in value against currency B. How you answer this question depends on how well you can decipher the macroeconomics that shapes the outlook.

Fundamental analysis looks at the underlying forces that are moving the markets in question and is generally used by long term investors, but can also be used by traders to gain an understanding of the markets they wish to trade.

Combining fundamental analysis alongside technical analysis, which is the study of price, can be a powerful combination which will empower you as a trader and provide you with a complete picture of the markets.

When using fundamental analysis, it is important to define the goals. Given the vastness and the complexity of the field, it is easy to lose focus or get sidelined by different factors.

Therefore, the first and most basic step in fundamental analysis is to start off with a currency pair that you are interested in trading. This will ensure that you stay focused on the most relevant details in order to help lay the groundwork for building a trading plan.

So should you simply pick out a currency pair by rolling a dice or is there some logic to follow? While there is no rule and it is entirely up to the trader to start with a currency pair of their choice, it does make sense to stay relevant to the current markets.

Example, what is the most talked about topic at the moment? Which currency or central bank’s policies are being constantly referred to in the markets? By picking the most trending instrument or asset, traders would be able to find more information and perhaps gain more knowledge by combining the technical and fundamental aspects involved.

Fundamental Analysis: Which Macroeconomic Fundamentals Influence the Markets?

The main fundamentals driving the currency markets belong to the world of macroeconomics. Macroeconomics is defined as a branch in economics dealing with the study of large scale economic factors.

Examples include interest rates, unemployment, inflation and GDP to name a few. In the currency markets, fundamental analysis is all about determining how good economy A is doing in relation to economy B, where economy A and B are represented by the currency pair in question.

So, fundamental analysis for AUD/NZD would simply mean studying and comparing the macroeconomics between Australia and New Zealand.

Fundamental Analysis – The Most Important Indicators

The following is a list of main fundamental reports to follow depending on the type of markets being monitored.

  • GDP: Gross Domestic Product is an important indicator for the currency markets. It is released on a monthly or quarterly basis and shows the rate of growth during the specified period.

    GDP is a measure of the value of all goods and services produced in the country. A GDP report is a primary indicator of strength of the economy and a rise in GDP signals higher economic activity and thus can influence central bank monetary policies.

    GDP reports are important on a quarterly and yearly basis and growth is compared on a year over year basis. Within the quarterly reporting periods seasonal trends often influence the rate of growth.For example, in the US, the first quarter GDP is usually the weakest, while growth picks up from the second quarter onwards with the third quarter GDP usually being the strongest.

    GDP reports can be used to get an idea on how well the economic engine is running, the potential jobs that could be created as a result and thus the more wages workers get which in turn can affect consumer spending and thus inflation.

  • Inflation: Also known as Consumer Price Index. It is released on a monthly or quarterly basis.

    The inflation rate tracks the rise or fall in the value of a basket of goods and services that are most commonly used, including food, clothing, transport, fuel etc.Higher inflation is a sign of a healthy economy but at the same time can influence central banks to increase interest rates in order to contain inflation.

    There are various factors that influence inflation, including the currency’s appreciation/depreciation as well as oil prices which affect the goods being imported.
    Most central banks follow a mandate of steering an economy based on the inflation target. A 2.0% inflation target is widely used and rates are changed accordingly in an effort to reach the price stability mandate.

    Therefore, higher inflation is often seen as a precursor to rate hikes, while lower inflation generally triggers rate cuts.

  • Labor/Employment reports: The labor market report is released once a month and is based on a survey of households and/or businesses.It sheds light on the general state of the labor market in terms of the number of people being employed in the economy, the unemployment rate and wage increases.

    A labor market’s wage growth is an important indicator which eventually influences the inflation rate. A higher rate of wage growth means more consumers spending which in turn pushes inflation higher, while a decline in wage growth could lead to deflation.

  • Interest Rates: All central banks have a mandate of achieving an inflation target and in some cases, helping the economy to reach full employment. Based on these targets, the central banks look at the main economic indicators and assess whether to increase, cut or hold interest rates steady.

    Central banks meet almost every month and monitor the economic progress of the country, releasing its views known as the policy statement where the central bank outlines its view on the economy and what future course it could take in regards to interest rates.

The economic indicators are not just limited to the above but include many others. Some of the other economic indicators that could be of interest are:

  • PMI Surveys: A monthly survey of businesses is conducted, known as the Purchase Managers Index, and is broadly categorized into construction, services and manufacturing.

    The PMI is an index where a number above 50 marks an expansion and below 50 marks a contraction. PMI surveys are early indicators into the general outlook of business optimism.
    Some of the important PMI reports include the Institute of Supply Management (ISM) in the US, Markit PMI’s in the UK and the Eurozone.

  • Retail Sales: Retail sales data is used to measure of the aggregated sale of retail goods measured over a period of time. Retail sales mark a big component that adds to the GDP and also signals the general consumer spending behavior.

    In an expanding economy, consumers tend to spend more and thus show a greater demand for goods (thus increasing the GDP, which in turn influences labor markets and inflation).

  • Industrial production: This report measures the output of the industrial sector and takes into account manufacturing as well.

    Growth or declines in industrial production will affect the economy’s GDP and will affect the jobs and inflation outlook.

Central Bank Action – Key to Fundamental Analysis

Aside from all the above listed fundamentals, central banks form a special category. In the past, central banks were limited to announcing policy changes; over recent decades central banks have taken a more proactive approach in order to influence their economies.

This has led to increased central bank influence and attention paid to statements made by central bank officials. These days, economic calendars are filled with speeches given by central bankers and the markets have reacted strongly to these comments.

The following example below showcases the importance of central banker speeches and their influence on the markets, especially when the speeches are made shortly before a central bank decision.

November 4th 2015: ECB officials lined up to speak at an event in Frankfurt. They included the ECB President Mario Draghi and the bank’s governing council members Daniele Nouy and Vitor Constancio among others. The focus was the ECB’s policy actions to be decided upon when they were to meet in December. The markets were closely watching these central bankers for any hints they might drop at what would happen at the December meeting.

All the officials said was that there was a need to reassess the ECB’s policies and said that inflation was weak and that the central bank was committed to reaching its 2.0% inflation target.

The markets took these comments as an assertion that the ECB would ease monetary policy further. EURUSD sold off and continued its downtrend as the markets started building expectations that the ECB would announce strongly dovish policy measures at its December meeting.

1-EURUSD-Reaction
EURUSD Reaction to ECB President Draghi’s speech at an event

Putting all the Analysis Together

When analyzing the fundamentals, as a trader or an investor, you need to analyze the strengths and weaknesses of economies. Your goal is to understand the underlying trend in an economy and compare it to another economy.

For example, a continued uptrend in GDP growth along with a pickup in wages and the labor market together with a growing inflationary trend can often point to an impending interest rate hike cycle in order to cool down an economy.

Likewise, continued declines in GDP growth, rising unemployment and falling inflation usually triggers the central banks to stimulate the economy by lowering interest rates and using additional measures to loosen the monetary conditions. Comparing this data to another economy then gives you a bigger picture of the fundamentals that drive the currency pair in question.

This information can then be combined with technical analysis and the currency pair can be traded accordingly. Taking it a step further, while technical analysis can merely tell you at which price to buy or sell a currency pair, fundamental analysis can give you the additional information of why it is better to buy or sell a currency pair.