Fundamental analysis consists of studying the core underlying elements of an economy or business to understand how those elements affect the price of an asset in the marketplace. Just like technical analysis, it tries to predict future prices and price trends based on economic data, geopolitical factors, and government policies. As far as currency traders are concerned, it is these fundamental underpinnings that determine the value of a countries currency.
Fundamentals encompass such a broad spectrum of events and data that it is easy for surprises to take the markets unaware and create rapid price changes as the markets digest the new factors. This can be anything from an interest rate change by a central bank, to a natural disaster to a simple statement by one of the influential officials in a given country. The range of factors that are considered fundamental creates a dynamic and ever changing market force.
Interest rates – Generally, as a country raises interest rates their currency strengthens and the reverse is also true. The reasoning behind this is that a higher interest rate will encourage investors to shift their asset to the country to take advantage of the higher yields.
The employment situation – Strong employment is a good gauge of a strong economy, while weak employment shows an economy that is struggling. When an economy is struggling it is likely that it will lower interest rates, thus undermining the value of its currency.
Trade balance – A large negative trade balance can also cause a weak currency as commercial interests are forced to continually sell large amounts of the country’s currency.
Gross Domestic Product (GDP) – This a reflection of the overall economic activity of a country and is followed very closely. Higher GDP shows a stronger economy, which in tun leads to higher interest rates and generally a stronger currency.
Fundamental analysis is very useful in determining overall trends, if not exact prices. As an example, unemployment figures can give a good idea of the health of a countries economy, especially over a period of time as increases and decreases are noted. However, a single unemployment report is insufficient to determine an entry and exit strategy for a particular asset. Instead, several fundamental data points are often combined to come up with a general trend and technical tools are then used to determine exact entry and exit points.