Introduction to Fundamental Analysis
Fundamental analysis studies the core underlying elements that influence the economy of a particular entity, like a stock or currency. It attempts to predict price action and trends by analyzing economic indicators, government policy, societal and other factors within a business cycle framework.
If you think of the markets as a big clock, fundamentals are the gears and springs that move the hands around the face. Anyone can tell you what time it is now, but the fundamentalist knows about the inner workings that move the clock's hands towards times (or prices) in the future.
Are you a technician or fundamentalist?
There's a tendency to pigeonhole traders into two distinct schools: fundamental or technical. In fact, most smart traders favor a blended approach versus being a purist of either type.
Fundamentalists need to keep an eye on signals derived from price charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or pressing societal issues that influence price action.
Forecasting economic conditions using models
Fundamental analysis is very effective at forecasting economic conditions, but it is not necessarily an exact market prices. Studying GDP forecasts or employment reports can give you a fairly clear picture of an economy's health and the forces at work behind it. But you still need a method to translate that into specific trade entry and exit points.
The bridge between fundamental data and a specific trading strategy usually comes from a trader model. These models use current and historical empirical data to estimate future prices and translate them into specific trades.
Beware of "analysis paralysis"
Forecasting models are both art and science, they have so many different approaches that traders can get overloaded. It can be tough to decide when you know enough to pull the trigger on a trade with confidence.
Many traders switch to technical analysis at this point to test their hunches and see when price patterns suggest an entry.
Look for fundamental drivers first
The fundamentals include everything which makes a country and its currency tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events.
That said, not every development will move a country's currency. Try to start by identifying the most influential contributors to this mix versus following every fundamental out there.
Rising interest rates strength that country's currency
A typical way to think about interest rates is how much it's going to cost to borrow money, whether for our mortgages or how much we'll earn on our bond and money market investments. Interest rate policy is a key driver of currency prices and typically a strategy for new currency traders.
Fundamentally, if a country raises its interest rates, its currency prices will strengthen because the higher interest rates attract more foreign investors.
For example, higher rates in the Euro zone may prompt U.S. Switzerland
When gold goes up, the USD goes down
Historically, gold is a very "safe haven", a country-neutral investment and an alternative to the world's other reserve currency, the U.S. dollar. That means gold prices have an inverse relationship to the USD, offering several ways for currency traders to take advantage of that relationship.
For example, if gold breaks an important price level, you can expect gold to move higher. With this in mind, you might sell dollars and buy Euros, for example, as a proxy for higher gold prices.
Rising gold prices help major gold producers
Oil-dependent countries weaken as oil prices rise
Just as airlines and other oil-dependent industries are hurt by rising oil prices, so are the currencies of oil-dependent countries like the U.S. Japan
If you believe oil prices will continue to rise, you can consider buying commodity-based economies like Australia Canada
What are Economic Indicators?
Economic indicators are snippets of financial and economic data published regularly by governmental agencies and the private sector. These statistics help market observers monitor the economy's pulse - so it's no surprise that they're religiously followed by almost everyone in the financial markets.
With so many people poised to react to the same information, economic indicators have tremendous potential to generate volume and to move prices. It might seem like you need an advanced economics degree to parse all this data accurately - but in fact traders need only keep a few simple guidelines in mind to making trading decisions based on this data.
Mark your economic calendars
Know exactly when each economic indicator will be released. You can find these calendars at the New York Federal Reserve Bank's site; FOREX.com clients can simply login to MyAccount and click on Economic Calendars.
Watching the economic calendar not only helps you consider trades around these events, it helps explain otherwise unanticipated price actions during those periods. Consider this scenario: it's Monday morning and the USD has been in a tailspin for 3 weeks, with many traders short USD positions as a result. On Friday, however, U.S.
What does this data mean for the economy?
You need not understand every nuance of each data release, but you should try to grasp key, large-scale relationships between reports and what they measure in the economy. For example, you should know which indicators measure the economy's growth (gross domestic product, or GDP) versus those that measure inflation (PPI, CPI) or employment strength (non-farm payrolls).
Not all economic indicators can move markets
The market often pays more attention to certain indicators under certain conditions - and that focus can change over time. For example, if prices (inflation) are not a crucial issue for a given country, but its economic growth is problematic, traders may pay less attention to inflation data and focus on employment data or GDP reports.
Watch for the unexpected
Often the data itself may not be as important as whether or not it falls within market expectations. If a given report differs widely and unexpectedly from what economists and market pundits were anticipating, market volatility and potential trading opportunities may result.
At the same time, be careful of pulling the trigger too quickly when an indicator falls outside expectations. Each new economic indicator release contains revisions to previously released data. Here's an example:
Don't get caught up in details
While your macroeconomics professor may appreciate all the nuances of an economic report, traders need to filter data judiciously for their own purposes: making intelligent trading decisions.
For example, many new traders watch the headline of the employment report, assuming that new jobs are key to economic growth. That may be true generally, but in trading terms non-farm payrolls is the figure traders watch most closely and therefore has the biggest impact on markets.
Similarly, PPI measures changes in producer prices generally - but traders tend to watch PPI excluding food and energy as a market driver. Food and energy data tend to be much too volatilve and subject to revisions to provide an accurate reading on producer price changes.
There are two sides to every trade
Hopefully this has helped you realize the importance of watching economic indicators - and knowing which data are most likely to move markets and impact currency traders.
Just remember that no trader's knowledge can be complete all the time. You might have a great handle on economic data published in the U.S. Europe or Australia
Economic indicators: a currency's vital signs
Traders can measure the economic health of a given country (and its currency) through its economic indicators - but, just like a doctor monitoring a patient's vital signs, not all stats count equally. Here's a primer of the key economic indicators that often impact currency traders.
Economic indicators divide into leading and lagging indicators:
Leading indicators are economic factors that change BEFORE the economy starts to follow a particular trend. They're used to predict changes in the economy.
Lagging indicators are economic factors that change AFTER the economy has already begun to follow a particular trend. They're used to confirm changes in the economy.
Major economic indicators
Gross Domestic Product (GDP)
The sum of all goods and services produced either by domestic or foreign companies. GDP indicates the pace at which a country's economy is growing (or shrinking) and is considered the broadest indicator of economic output and growth.
Industrial Production
A chain-weighted measure of the change in the production of the nation's factories, mines and utilities, industrial production also measures the country's industrial capacity and how fully it's being used (capacity utilization).
The manufacturing sector accounts for one-quarter of the major currencies' economies, so it's critical to watch the health of factories and whether their capacity is being maximized.
Purchasing Managers Index (PMI)
The National Association of Purchasing Managers (NAPM), now called the Institute for Supply Management, releases a monthly composite index of national manufacturing conditions. The index includes data on new orders, production, supplier delivery times, backlogs, inventories, prices, employment, export and import orders. It is divided into manufacturing and non-manufacturing sub-indices.
Producer Price Index (PPI)
Measures average changes in selling prices received by domestic producers in the manufacturing, mining, agriculture, and electric utility industries.
The PPIs most often used for economic analysis are those for finished goods, intermediate goods, and crude goods.
Consumer Price Index (CPI)
Measures the average price level paid by urban consumers (80% of the population in major currency countries) for a fixed basket of goods and services. It reports price changes in over 200 categories.
The CPI also includes various user fees and taxes directly associated with the prices of specific goods and services.
Durable Goods
Durable Goods Orders measures new orders placed with domestic manufacturers for immediate and future delivery of factory hard goods. A durable good is a product that lasts over three years, during which its services are extended.
Companies and consumers sometimes put off purchases of durable goods during tough economic times - so this figure is a useful measure of certain kinds of customer demand.
Employment Cost Index (ECI)
Payroll employment is a measure of the number of jobs at larger companies in more than 500 industries in all 50 U.S.
Retail Sales
Measures total receipts of retail stores from samples representing all sizes and kinds of business in retail trade throughout the nation. It is the timeliest indicator of broad consumer spending patterns and is adjusted for normal seasonal variation, holidays, and trading-day differences.
Retail sales include durable and nondurable merchandise sold, and services and excise taxes incidental to the sale of merchandise. It doesn't include sales taxes collected directly from the customer.
Housing Starts
Measures the number of residential units on which construction is begun each month. A "start" refers to excavation of the foundation of a residential home.
Housing is usually one of the first sectors to react to interest rate changes. Significant reaction of start/permits to changing interest rates signals interest rates are nearing trough or peak. To analyze, focus on the percentage change in levels from the previous month. Report is released around the middle of the following month.