Fundamental Analysis in Forex Trading

Fundamental Analysis in Forex Trading

14.1. What is Fundamental Analysis?

Fundamental analysis is the method of forecasting future currency value through the analysis of all of the economic, political and social factors relevant to it. Unlike the technical analysis which works with the result of all these forces manifested in various technical price formations, the fundamental analysis is chiefly concerned with establishing the causes of the current and future price moves. The fundamental analysis is best used to determine the likely direction of the currency pair in the long-term. The technical analysis is better used to find entry points with favourable reward/risk characteristics (i.e. to time your entries and exits) which will allow you to align yourself with the future currency direction as suggested by the fundamental analysis. As a matter of fact, the strongest entry or exit signals are given when important fundamental (e.g. change in interest rate policy of a central bank) and technical (e.g. break of the 200-day moving average) signals coincide.

Continuing with the ocean metaphor of the trends - in which they are compared to the tides, waves and ripples depending on their degree - the fundamental analysis can be compared to the study of the tides. While the technical analysis tracks all types of "taps on the water surface" (be it one-time news or a major change in economic policy), the fundamental analysis focuses primarily on the "effect of the moon on the tides" (cycles in interest rate differentials). In other words, the fundamental analysis doesn’t concern itself with short-term price fluctuations and instead tries to measure the likely duration and the direction of the major currency trends (the tides). Due to the immense number of factors which can potentially affect the formation of the long-term currency trends, forex traders are advised not to make their own fundamental analysis (unless they have received specialized education on this subject) and instead rely on the analysis made by professional fundamental analysists most of which are usually distributed free of charge through the forex newswires and investment bank reports.

14.2. Creating Prediction Model based on Fundamental Analysis

The task of the fundamental analyst is to construct the prediction model by using those economic variables which have the highest predictive value for the currency pair in question. This means that the analyst should take into account only those factors which have proven to be strongly correlated with the movement of a currency pair during the recent years.

One of the factors most reliably connected with the long-term movements of the currency pairs is the interest rate differential. The interest rate differential is the difference between the interest rates set by the central banks of the countries whose currencies form a currency pair. When the differential is sufficiently wide the investors will be inclined to sell their domestic currency in order to buy the higher yielding foreign currency - which will cause the currency pair of the [foreign currency/domestic currency] to rise (e.g. when the interest rates in the European Union exceed those in USA, the EUR/USD pair is likely to appreciate). Because the interest rate differentials usually move in cycles, the slow but persistent increase in the differential will over time lead to a sustained appreciation of the higher yielding currency - to the creation of a major trend. So close is the connection between the major currency trends and interest differential cycles that on average over %50 of all the cyclic movements of the major currency pairs can be attributed directly to the changes in the interest rate differentials . 50% is the coefficient of determination which tells how much of one variable' variance (major currency trends) can be directly explained by the variance of the other variable (interest differential cycles). Coefficient of determination is calculated by squaring the correlation coefficient between major trends and interest differential cycles, which on average is equal to +70%. For detailed description of how this number was arrived at please visit the interest rate differential and long-term currency trends page

Because the currency movements and the interest rate differentials are so tightly connected, the professional forex trading community is always looking for the hints on the future direction of the interest rates from the centrals banker's speeches and in the economic news releases. The comments of the bank officials are usually called either "hawkish" which suggests the increased possibility of a "rate hike" (interest rate increase) or "dovish" which suggests the increased possibility of a "rate cut" (interest rate decrease). Changes in the hawkishnes or the dovishness tone of the central bankers' speeches will often lead to sharp moves of the currency pairs to which they relate.

There are many fundamental factors that can be used by market participants to determine the attractiveness of any currency pair. Some of these factors - like the direction of the interest rate differential - persist to be at the forefront of the market's attention; while the others slowly fade away out of it (due to decreased correlation to the currency movement). It is, therefore, important to keep track of those ecenomic develoments that are now watched by the majority of the professional traders - because they are most likely to affect the market sentiment as a whole. The best way to find out which fundamental factors are given the most weight by the forex trading community at this moment is to consult the forex bank reports and/or the forex newswires.

Note: It should be noted that some neural network packages allow to combine the technical and fundamental data in one model. Two fundamental factors that you might consider adding to your model are the interest rate differential and the IMM open interest. The IMM open interest (available through sources like http://www.scotiafx.com/Chart_Feed/IMM.pdf) can serve as an objective measure to identify important sentiment extremes in the market. For complete details on how to use this indicator please read John Percival's book "The Way of the Dollar"

14.3. Mastering Fundamental Analysis

To master fundamental analysis it is important to be constantly aware of the factors that the professional forex trading community is paying attention to. As a next step, all of these factors should be assigned proper weighs (i.e. they should be prioritized) for your fundamental prediction model to work correctly. The fastest and the most reliable way to learn how to evaluate the importance of various fundamental factors is through books on currency trading that cover fundamental analysis.

As with the technical analysis, excellent trading results can be achieved by fading (going contrary to) unsustainable emotional extremes in the market. One of the best examples of the contrary fundamental analysis based on the analysis of the market sentiment - that can benefit all types of currency traders - is available to subscribers of John Percival's webiste.

One of the best sources of the high quality and free articles on the fundamentals of the currency market is the IDEAS.