17. How to do Fundamental Analysis

17. How to do Fundamental Analysis

Fundamental analysis is the analysis of economic factors and not the technical details. Factors like unemployment rate, changes to interest rates and inflation also affect the price of currency. So as a trader you should play close attention to social and economic factors. Interest rates, country’s budget, employment rate and GDP are some of the fundamental factors. Fundamental analysts focus on news and press releases pertaining to the economic and political conditions in a country.

Central bank websites and brokers release economic calendars which lists dates and times of important releases. Economic calendars are created by economists in which they predict the economic figures based on previous month’s data. Since the fundamental factors can impact the price movements it is very important to know the release due dates so that traders can plan accordingly. It is also seen than spreads widen while nearing to an economic release. In addition to this, speeches given by economists or politicians also known as economical announcements should also be looked for. 

Interest rates

In this section we will try to understand how interest rates affect Forex traders. Value of a country’s currency is higher if it offers higher interest rates when compared to other nations offering lower interest rates.

Interest rate changes are made by these central banks:

  • Federal Reserve – US
  • Bank of England
  • Swiss National Bank
  • Reserve Bank of Australia
  • Bank of Canada
  • European Central Bank
  • Reserve Bank of New Zealand
  • Bank of Japan

When there is hike in a country’s interest rate, foreign investors are attracted towards it and hence higher will be the demand for that country’s currency. Similarly, lower the interest rate in a country, lower will be the rate of foreigners investing and hence lower will be the value of its currency.               

article17_1

Now you would be thinking who decides these rates and how is it calculated. You have the answer. Those banks which we mentioned above. Each bank is responsible for controlling the monetary policy of its country. Bank also decides the short term interest rates at which they can borrow from one another. Monetary policy refers to the actions taken by these central banks to control the money supply in their country.  Central banks can raise the interest rate in order to control inflation. Or they can lower the interest rate to strengthen the economy by encouraging lending.

Mentioned below are some of the roles played by the Central Bank:

  • Controlling and maintain the monetary policy of the country.
  • Maintain the stability of country’s financial system.
  • Publish economic reports indicating the overall status of the country’s economy.
  • Promote consistent economic growth and employment.

Interest rates alone don’t determine the value of currency. GDP and balance of trade are two other key factors which are of interest to the fundamental analysts. Another factor may be the country’s debt. Higher debt may result in higher inflation rates and hence lower the value of currency.

So, what we are trying to understand here is that there are lot of fundamental factors that can affect the value of currency. It is not simple enough to point one or two factors that directly influence the currency. It’s a combination of all these factors which we spoke about.

As we already discussed there are various fundamental factors which affect the value of a currency. We are going discuss a few of these factors next in this article.

Economic strength

The economy of a country and how people feel about it makes a huge impact on the value of currency. In a strong economy, individuals and businesses spend more money and hence a positive growth in the governments revenue. On the other hand, in a weak economy businesses don’t make money and they don’t spend money either. And thus country’s economy goes down and directly affects the value of its currency. 

Supply and Demand

Similar to any other commodity the value of a currency is also governed by supply and demand. Central banks can increase or decrease a country’s currency value by decreasing and increasing the supply of currency. Let’s try to understand how this can be achieved. If the Central Bank wishes to lower the value of its currency, it can supply currencies from its reserve and increase the supply, which in turn will reduce its value. On the other hand if Central bank wishes to increase its currency’s value, it can hold on the currency in the reserve and thus lower the supply and hence increase the demand which thereby causes its value to go high. Also, demand for a currency increases when it exports goods to foreign countries. If a country exports more than it imports automatically the demand for its currency rises high. 

Trade Flows and Trade Balance

Globalization has helped countries export and import goods from other countries. We buy good from other countries (import) and sell our goods to other countries (export). In either case, there is a flow of currency between countries. There is an exchange of money involved.

Trade balance is the difference between a country’s exports and imports. An ideal scenario is when the country imports less than what it exports. This scenario is known as being trade surplus. In case a country imports more than it exports, it is said to have a trade deficit. 

Thus,

Trade balance = Export – Import

If Export > Import, trade balance will be positive (+) and hence trade surplus. If Export < Import, trade balance will be negative (-) and hence trade deficit. 

article17_2

In case of trade deficit, the value of currency goes down. Since Import is more, country’s currency is used to buy foreign goods and hence the currency will have very less demand when compared to other nation’s currencies.  

Employment Reports

If the rate of unemployment increases, it means people are spending less and hence it has a negative impact on the currency. Also, a country with a higher unemployment rate is looked upon by the investors as a weakening economy and hence lowering the value of its currency.  Unemployment rate is considered to be a lagging indicator because it doesn’t change as long as the economic conditions of the country changes, which takes time. Employment reports indicate the unemployment rate in the country or in other words the percentage of people who are unemployed or seeking job opportunities. Thus, these reports are also of importance to the fundamental analysts.

Here we come to the end of Fundamental analysis. Hopefully by now you understand the fundamental factors effecting the economic conditions of a country. Cash flow statements and balance sheets are few other stuffs which are of interest to the fundamental analysts to help them analyse the economic situation of a country. It is essential to understand each factor contributing to the economic condition before diving into a conclusion.

previnext