Fundamental analysis is just exactly what it says – fundamental to understand the reasons why any tradable instrument moves in value. Some – such as government bond values, are simple to understand, the reasons why stocks and shares rise or fall in value are also reasonably easy to understand too.
How many novice traders thought they analyzed the fundamentals of a certain trading setup properly and still lost when they clicked the mouse? How many of these same novice traders went back to their books and found out what went wrong on that trade? That’s why currency trading needs both technical analysis supported by proper fundamental analysis, as well as to monitor history and reviewing reports; to take account of small variants that will improve your trading in the Forex market in general.
So what makes currencies fluctuate in value against others?
1- Interest Rate Differentials
If one country offers a higher rate of interest than another on simple investment instruments and both countries are considered economically and politically stable, then common sense says that the one with the higher interest rate will attract more overseas money. By the simple law of supply and demand, purchasing that countries currency to invest will push up the exchange rate. For the investor chasing the higher interest rate returns, the higher exchange rate means that any gains are offset when converting back into the original currency.
2- Inflation Differentials
Inflation has a negative effect on the purchasing power of a country and it depreciates the value of a currency. Low inflation countries tend to have better exchange rates so, in theory, following a currency whose government wants to keep the inflation rate low may be good for gains.
3- Current Account Deficits
If a country continually buys more from other countries than it sells to them it will have to finance the difference by buying currency, effectively selling their own. Supply and demand says that introducing this volume into the market will reduce its value and so the currency falls. There is usually a baseline for how far it will fall as eventually the cost of goods and services become so cheap other countries buy more, reducing the deficit and by virtue of having to buy the currency to pay for the goods and services, the value rises again.
4- Debt Financing
If a country continually runs budget or balance of trade deficits, it will eventually have to finance that through borrowing and finance the interest accrued and repayments by buying currency, depreciating their own. Large debts also worry international investors and traders and so they could sell that country’s currency, fearing a collapse.
We’ve mentioned political stability before but it’s very important in helping investors remain assured that their money is safe. Stable politics mean the chance for economic policies to work. Political stability can affect a country’s credit rating through the impact perception of stability has on government bond values.
For the trader, the difficulty is in weighing up just how much of an impact these factors will have on a currency and how much one is countered by another. Before technical analysis, fundamental analysis was all that traders and speculators had to base their decisions on, now with the popularity of technical indicators and the increasing importance of short term trading, the art of fundamental analysis is becoming less highly valued.