When it comes to analyzing the forex market, traders have a few types of analysis at disposal. The most common ways to analyze the market include fundamental analysis, technical analysis and sentiment analysis, and each of them have their specific advantages and drawbacks which every forex trader needs to be aware of. As a brief reminder, technical analysis is based on three major premises: prices like to trend, history repeats itself and the market discounts everything. This means that all you need to make sound trading decisions are price charts, as they already include all available market information in them.
Sentiment analysis, on the other hand, measures the overall market perception of a single currency by gauging if market participants are bullish, bearish or neutral. This gives a valuable insight into how the market perceives the future price movement of a currency.
Finally, we have fundamental analysis which is often neglected by retail forex traders to the benefit of technical analysis. There are many reasons for this: first and foremost, there are not many sources which teach you fundamental analysis the correct way, as technical analysis is often easier to understand and graphically more appealing to publish on websites. And secondly, even if a trader decides to learn about fundamental analysis, he or she might find it hard to know where to start and to grasp the usually complicated definitions of a currency’s fundamentals. Finally, one might think that fundamentals are only suited for position traders who hold their trades for months, as it can take that long (or even years) for a currency to return to its fundamental equilibrium level according to traditional currency valuation models.
This article intends to show that fundamentals are a crucial way of analyzing the forex market, as exactly fundamentals affect the underlying trends of exchange rates. Fundamental analysis involves much more than just following economic reports on GDP growth, inflation or non-farm payrolls, and once a trader digests the core concepts of fundamental analysis he might see tremendous improvement in its trading performance.
Why are Fundamentals Important?
Fundamentals of a currency reveal the intrinsic, or real value of a currency. Although technicians argue that all market information are already included in the price and that charts are the only tool you need in trading, the truth is that price trends don’t form on the basis of technicals, but on fundamentals.
Generally, fundamental analysis in the forex market can be grouped into two major groups:
- Macro-fundamental analysis – includes the analysis of macro-economic numbers of a country and its currency, such as economic growth, inflation rates, monetary policies, balance of payments and labor statistics to name a few.
- Micro-fundamental analysis – includes the analysis of soft fundamental factors such as politics, news, social policies and so on.
Macro-economic factors have a direct impact on the core forces that affect exchange rates, which are supply and demand. Basically, when the demand for a currency exceeds its suppl y, the price of the currency rises and potentially creates a new uptrend. On the contrary, if the supply of a currency exceeds its demand, the price of the currency falls and potentially creates a new downtrend. In the eye of the technical practitioner, this will take the form of higher highs and higher lows during uptrends, and lower lows and lower highs during downtrends. But the reason for the development of trends has to be searched for in the currencies’ fundamentals.
As an example, let’s take two countries and their respective currencies: the US dollar and the United States on one side, and the Japanese yen and Japan on the other side. In the beginning of the 90s, Japan recorded huge trade surpluses with the United States, backed by its strong export-oriented economy which included cars, machinery, electronics etc. This is shown by the up-sloping blue arrow on the following chart.
In order to buy and import Japanese goods, American merchandisers had to exchange their US dollars for Japanese yen, to be able to pay their Japanese partners in yen.
Based on the growing demand of Japanese products which increased Japanese exports to record highs, the growing demand for Japanese yen pushed the USD/JPY exchange rate down and led to a dramatic appreciation of the Japanese currency.
In turn, a less-competitive exchange rate increased the prices of Japanese products in overseas markets, and the Japanese balance of trade experienced a substantial fall in the following years, as shown on the chart. Finally, a lower value of exports led to a depreciation of the Japanese yen, as the demand for the currency diminished in the years after 1995.
This is just one example of how fundamental factors impact the trend of exchange rates for a long period of time. While technical traders could easily trade the downward channel of USD/JPY, fundamental traders could have anticipated the exchange rate moves based solely on the analysis of the Japanese balance of trade.
Traditional Currency Valuation Models
How can fundamental traders get to the intrinsic fundamental value of a currency? By using currency valuation models. These models are well-known economic models that try to measure the equilibrium exchange rate of a currency to which the current exchange rate shall return at some point in the future. Basically, if the valuation models return an exchange rate that is above the current exchange rate, this means that the base currency (the currency on the left side of the currency pair) is undervalued at the current exchange rate. And similarly, if the valuation model returns an exchange rate that is below the current exchange rate, this means that the base currency is overvalued.
Theoretically, all exchange rates shall return to their equilibrium level over time. Unfortunately, fundamental models don’t provide the information when this shall occur. This is a handicap of traditional currency valuation models, but other forms of fundamental analysis such as order flow analysis try to bridge that gap by providing a shorter-term framework for forex analyzing.
The following are the most important and well-documented currency valuation models:
- Purchasing Power Parity (PPP) model. This model interprets the equilibrium exchange rate as the relative price of good between two countries. For a very simplified example, let’s say that a Toyota car costs 1,000,000 yen in Japan, and $10,000 in the United States. This leads to the conclusion that the exchange rate that leads to an equilibrium in purchasing power should be USD/JPY=100. If the current market rate is USD/JPY=120, this means that the US dollar is relatively overvalued compared to the Japanese yen, and that the exchange rate shall return to its equilibrium level over time.
A popular PPP model includes the Big Mac index by The Economist newspaper. It calculates the price of McDonald’s Big Mac in various countries and derives the PPP equilibrium level based on the price differences. Surprisingly, the Big Mac Index returned some great results in anticipating future exchange rate movements so far, such as in the case of the EUR/USD rate in the beginning of 2000.
- Balance of Payments model. This model takes into account the balance of payments of two countries to derive their equilibrium exchange rate. Basically, if a country is a net exporter (such as in our previous example of Japan and USA), the demand for the country’s currency shall push its price up. On the other hand, a net importer should see its currency depreciating, as the demand for the currency diminishes in international markets.
However, one should take into account that trade flows make up only around 5% of the total daily trading volume in the forex market, while capital flows have seen a large increase especially with the globalization of the world economy. As a result, it’s estimated that capital flows account for around 45% of the trading volume (with the remaining share being speculation), and that’s why traders should also look for imbalances in a country’s capital account as well as current account.
- Interest Rate model. This model is perhaps already known to retail traders who tried to trade on an interest rate change by central banks. Generally, higher interest rates imply higher returns for investors who invest in a higher-yielding currency, pushing the demand and the price of the currency up. On the other hand, currencies with lower interest rate shall experience an exchange rate depreciation over time, as investors start to sell lower-yielding currencies for their higher-yielding counterparts.
If you’re familiar with some currency crisis in the past, such as the Russian ruble crisis in the late 90s, you’ve seen that central banks try to support their currencies’ value by hiking interest rates to a significant amount. This is basically the interest rate model at work.
How to Read a Forex Calendar for Shorter-Term Fundamental Trading
Now that we gave a brief overview of fundamental analysis and the traditional currency valuation models, it’s time to move to micro-fundamental approach which is well-known to most forex traders – trading the news.
During major news reports, the forex market tends to get very volatile which can lead to potential trading opportunities. It’s not unusual that currencies move dozens of even hundreds of pips in a matter of minutes if the published numbers deviate to a large degree from market expectations.
In order to trade the news, you need first to learn how to read a forex calendar. One of the most popular forex calendars out there is the Forex Factory calendar, which can be found at www.forexfactory.com, and looks like this:
As you can see, a forex calendar consists of the date and time of the scheduled news, the currency which is impacted, the expected level of the impact itself (yellow – low impact, orange – medium impact and red – high impact), the news headline, and the actual, forecasted and previous numbers of the release.
When trading the news, it’s important to follow the actual and forecasted numbers. In general, economists and analysts will already provide a forecast long before the actual number is released. The forecasted number is also called the “market expectation”, and is used as a benchmark once the actual number is released.
If the actual release differs from the forecasted number to a significant amount, the market reaction may be very volatile. On the other hand, if the actual release is close or equal to the forecasted number, the market reaction may be very weak or even absent.
The Straddle Strategy for Trading the News
In any case, you can trade the news with a simple yet effective strategy – the “straddle” strategy. This strategy involves placing two pending orders just before the actual number is released. One buy stop order is placed just above the current market price, and another sell stop order is placed just below the current market price. This allows you to catch the immediate market reaction as soon as the actual number is released. You don’t have to care if the actual number is above, below or equal to the market expectation, because you’re ready for a ride in any market direction by using two stop orders which get triggered once the market reaches their price level.
However, keep in mind that spreads can widen significantly during high market volatility, and you need to take this into account any time you trade the news.
Fundamental analysis is a powerful way to analyze the market which can provide you with a different view of the markets than by utilizing only technical analysis. Currency valuation models such as the PPP model, Balance of Payments model or Interest Rate model can be used to reveal the intrinsic value of a currency and its equilibrium exchange rate. However, these models don’t provide you with a timeframe when the currency shall return to its equilibrium level. For a shorter-term approach to fundamental trading, you can trade the news with the simple “straddle” strategy that allows you to catch the buying or selling momentum in any direction – up and down. Knowing the fundamental factors that impact an exchange rate can prepare you for large winning trades if you make the analysis properly.