What is a fundamental trader in forex?

Fundamental analysis helps traders determine what a trade really worths. They don’t just look at previous prices or market sentiment. When trading forex this means examining a country’s economy to understand the factors affecting the value of its currency.

Fundamental analysis is used to evaluate the markets through looking at various types of information to understand an asset’s real value. In contrast to technical analysis that focuses solely on price charts, fundamental analysis examines the bigger picture, such as what could possibly make a financial instrument strong or weak.

People tend to connect fundamental analysis with deciding which stocks to trade. However, this type of analysis is used to trade various types of instruments. For instance, in forex trading, fundamental traders may watch factors that could have a strong impact on a currency pairs’ value.

Such factors include economic news, political events or natural disasters. These traders don’t just rely on random data. They aim at determining whether an asset’s current value is too high or low.

In this article, we are going to explore fundamental analysis, what it is, how it works and what fundamental factors to look at.

Understand fundamental analysis in forex

Ideally, a strong economy should reflect a strong currency and vice versa. However, reality is much more complex. Often, when an economy is weak there are other external factors involved. The way a currency moves will be determined by central bank interest rate policy and by the relative growth rate in one country vs another because currencies are traded in pairs. There are times when both countries are weakening or growing at the same time.

One way to approach forex fundamental analysis, is to imagine that you are the Central Bank Governor or the FED chairman. What matters the most to you? What are the metrics you look at regarding how your economy is doing and how does that impact your decision on raising, lowering or doing nothing with interest rates?

Doing so is essential because interest rates are the most important factor affecting currency prices. Interest rates are influenced by inflation, growth and what is happening in the world.

The latter is especially important for countries that depend on exports like Canada and Australia. These countries are sensitive to the growth of their biggest trading partners, US and China respectively.

GDP, inflation & interest rates

Inflation refers to how fast prices go up or down. If inflation is too high, central banks will try to limit the increase by raising interest rates and vice versa. Central banks’ primary objective is to achieve the highest employment level without driving up inflation. That means that prices remain stable.

Finding the balance is not an easy task though. There are times that there are no changes in interest rates. Therefore, traders are left thinking who’s going to increase first or decrease first. This is the key for forex fundamental traders. Market participants’ expectations of interest rates is more important than the actual changes in interest rates.

Gross Domestic Product (GDP) measures a country’s total value of all goods and services produced within a specific time period. This is a good way to see how an economy is doing and how healthy it is. If you look at how GDP changes over time it will bemore useful than relying on GDP alone, as it doesn’t show much. If GDP is going up, this is usually a sign that the economy is growing which can make a country’s currency stronger.

Nevertheless, a country’s economy might sometimes grow while its currency is getting weaker. This can happen when fast growth leads to high inflation, which can in fact lower a currency’s value.

Now regarding interest rates, when people talk about them, they usually mean the base rate set by the central bank of a country.  This is how much it costs private banks to borrow money from the central bank.

Why do interest rates matter?

The answer is pretty straightforward. They affect almost everything, starting with inflation, trading, spending, jobs and more. Central banks use interest rates to control the speed in which the economy grows. When interest rates are low, borrowing is cheaper.

This means that people and businesses can more easily take loans and spend more, boosting the economy. However, with too much growth, prices may rise too fast leading to potential economic issues at a later stage.

When interest rates are high, borrowing is costly. This means that spending is slowed down, and that inflation is more easily controlled. However, growth might also be reduced.

Macro, micro & monetary policy

You could also see fundamental analysis as in the 3Ms. Macro, micro and monetary policy. The first one involves big news that can drive the longer-term trend in currencies, like the Covid-19 pandemic, wars, elections etc.

Usually, there’s a lot of speculation around these events. The best way that traders use this fundamental information, is to be aware of the bigger fundamental picture to look for opportunities to join the trend using technical setups. Such events are usually not quickly resolved.

Micro analysis now refers to analysis economic data, such as the monthly non-farm payroll report (NFP), that usually has a short-lived impact on a currency.

While macro events could potentially fade, monetary policy changes slowly and there’s generally a lot of built-up before monetary policy changes.

What are the disadvantages of fundamental analysis?

Uncertainty is the first drawback of fundamental analysis. Even if you conduct a solid research, prices might not move the way you expected. Natural disasters or any other scandals, which are considered unpredictable events, can impact prices. The market might also act in an irrational way longer than you can wait.

Too much information is another disadvantage of fundamental analysis. Markets globally produce a very big amount of data making it hard to know what to focus on. To deal with it in a simple way, you can start with the broader picture and then look at the smaller details.

You may start with looking at the economy overall, then narrow down to certain markets and eventually specific assets. This way you can avoid distractions and focus on what matters the most.

Final thoughts

The three main factors fundamental traders look at are GDP, inflation and interest rates because of their big impact on a country’s economy and currency. They are also connected to each other and to what is happening in other countries. Bond prices, retail sales or trade balances are of less importance.

It is crucial to realise that the foreign exchange market is greatly affected by the large amount of economic data released. To speculate on market movements, you should become familiar with how to add fundamental analysis to your trading strategy.

In the end, everything comes down to central banks. Being the ones affecting interest rates, everyone is thinking about who will cut the most or who will cut first. In any case, the one who fits the bill will probably see its currency weaken the fastest.

If everyone else is talking about lowering interest rates, the most reluctant central banks will probably see more demand for their currency. So, if a central bank is looking to cut rates faster than the others, use your technical analysis to look for opportunities to sell that currency. To know what the market is thinking, you need to read. Knowing about fundamentals, will make you a better trader.

Disclaimer: This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication.