In terms of Forex trading, Fundamental analysis aims at analyzing group of countries’ economic data and performance in order to compare them. The use and study of this data helps traders forecast future price movements of currencies. Fundamental analysis tends to focus on how macroeconomic elements affect the exchange rate.
When one country or group of countries (in case they share a common currency) has much more solid economic data and performance compared to another, then an increase in value of the stronger one is expected; When one country or economic block has weaker economic data and performance compared to another, then an increase in value of the stronger one is expected.
Such expectations are based on the behavior of central banks that could change interest rates depending on the performance of the economy. Central banks will increase the interest rates if the economy is improving as to avoid higher levels of inflation. At the same time, it will increase the interest rates if the economy is in recession or stagnating as to spur economic growth. Subscribe JustForex free analytics to stay informed.
There is another one, higher interest rates traditionally increase demand for a currency. The reason is simple: buyers are better rewarded for owning a currency if the interest rate is higher. A trader or investor is always buying one currency and selling a second. A change of an interest rate alters this relationship and the price will reflect this change. Most often the currency which increases its rates will see an increase in its price.
Investors and traders monitor news releases, economic data, press conferences, policy statements and speeches to assess the overall economic situation of each country. As mentioned earlier, the central banks are actually responsible for making the decision how the interest rate will be changed. What economic measuring points should be considered:
- Gross Domestic Product (GDP);
- Trade balance;
- Consumer Price Index (CPI);
- Retails sales;
- Interest rates;
- Monetary policy;
- Purchasing Managers’ Index (PMI).
All this data could be used as clues and signals for potential decisions of the central banks.
Understand the direction of the interest rates
In essence, the balance between GDP and the monetary base could be seen as key. Basically, this equation shows “available” money in an economic zone versus the current economic activity.
- If the monetary base increases more than the GDP, each unit of currency is worthless and this will have a negative impact on the exchange rate of that currency;
- If the monetary base decreases more than the GDP, each unit of currency is worth more and this will have a positive impact on the exchange rate of that currency;
- If the GDP increases more than the monetary base, each unit of currency is worth more and this will have a positive impact on the exchange rate of that currency;
- If the GDP decreases more than the monetary base, each unit of currency is worthless and this will have a negative impact on the exchange rate of that currency.
Forex traders can use fundamental analysis to make decisions on a long-term basis, because the fundamentals do not change that rapidly from day to day. Many of them combine fundamental with technical analysis in order to execute trades with precise time i.e. to know entry, take profit & determine stop loss level. High impact data releases, news events, press conferences and speeches have the potential of moving price for duration of time with a lot of volatility.
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