Fundamental analysis involves the study of currencies and currency markets on the basis of major economic reports which are commonly known as economic indicators. A classic example of fundamental analysis is the use of employment data from different regions or countries as a basis for trading in the market. An economic indicator is financial data which can be related to the movement of the prices of currencies. It is generally related to countries and some other examples include interest rate movements, the consumer price index and the balance of trade. Another example would be a country that is experiencing high growth accompanied by high inflation. Under these circumstances, traders will be looking closely at the consumer price index to assess the impact on growth. Though the data needs to be studied over a period of time, you will often find that the data i
s important in some market conditions and not as important in others.
Investment management using fundamental analysis is not exactly simple because you can sometimes see that better than expected numbers can lead to a decline in prices. This can be attributed to market sentiment because every trader does not react in the same fashion to the same piece of news. Traders will often take positions in anticipation of the announcement of important economic indicators based on what they believed the information is going to be. This also means that regardless of whether the news is good or bad, prices can move in the opposite direction to what you anticipate because traders will be covering their open positions.
Fundamental analysis works best when used in combination with technical analysis. In the long term, currency prices will tend to move in the direction of the fundamentals but during the short term, they can fluctuate considerably both up and down. Technical analysis comes in handy in the short term and is also useful in determining entry and exit points. Both schools of analysis have their followers but, as you can see, the use of one to check the findings of the other is the best possible compromise.
Why fundamental analysis can be difficult to use
The price action is generally acknowledged to be dictated by supply and demand but supply and demand themselves out influenced by fundamentals. The proliferation of the Internet means that there is plenty of information that is available in a timely fashion unlike the past when information was the exclusive preserve of a few chosen investors. This means that traders can easily gain a broader view of what is likely to happen instead of restricting themselves to the narrow view point of technical indicators and tools. The role of interest rate policy and underlying economic growth are becoming more important because foreign investment in a country is often dictated by these factors along with inflation.
However, volatility in the markets have increased considerably leaving traders more exposed to losses especially when economic indicators themselves fluctuate quite considerably. Moreover, entry and exit into the market cannot be dictated by fundamental analysis alone though the long-term trends are important. If you combine fundamental analysis with technical analysis, you will be better able to identify overbought or oversold conditions and react accordingly. You should also be aware that fundamental analysis can often help you to place trades against the trend though you need to be careful in using this. If you rely heavily on fundamental analysis, you are better off not trading on economic news such as jobs data that have a short term impact on the market and sticking to longer-term developments.
Leading economic indicators
Some of the most important indicators relate to the United States but are closely followed by Forex traders all over the world. This is because of the importance of the U.S. economy and the very considerable impact of the U.S. dollar on global currency markets. In addition to the indicators themselves, you will need to consider their effect on the sentiment of the market and therefore the probable direction of prices. An important indicator is the consumer price index which has an impact on the market because it enables investors to understand the impact of inflation on prices and demand. A sharp increase in the index is often an indication of a high rate of inflation and possible weakness in the currency. The consumer confidence index is based on the sampling of households in the United States and is considered to be accurate and reliable. When there is strong economic growth, increases in employment and wages translate into increased consumer spending and increased confidence. Interest rate policy and inflation also need to be closely watched because a high rate of inflation could lead to a weakness in the currency. It also manifests itself as reduced investment in the economy because of the possibility of who losses through currency depreciation. The underlying help of any economy can be understood with the use of numbers for GDP growth.