A Comprehensive Guide to Conducting Fundamental Analysis in Forex Trading
Table of Contents
Video Tutorial: How To Conduct Fundamental Analysis in Forex
Introduction
Fundamental analysis plays a crucial role in trading markets, whether it be currencies, equities, commodities, or fixed income.
As traders, our goal is not to become economists but to use economic information to make informed trading decisions.
This guide will walk you through: The process of conducting fundamental analysis in forex trading, emphasizing the importance of understanding market value to profit from undervalued or overvalued prices.
Why Fundamental Analysis Matters
Fundamental analysis is essential because it helps traders determine whether an asset is relatively cheap or expensive. By identifying undervalued or overvalued prices, traders can make profitable decisions.
Critical Reminder: We engage in fundamental analysis not to gain theoretical knowledge of economics but to leverage that information to buy low and sell high.
Versatility: Fundamental analysis can be applied to any asset class. Markets are interconnected, creating correlations that can serve as effective trading tools across different asset classes.
Key Fundamental Factors in Forex Trading
When conducting fundamental analysis for currencies, focus on the following key drivers:
- Economic Performance
- Fiscal Policy
- Geopolitics
- Intermarket Analysis
- Monetary Policy
Primary Driver: Central bank actions and monetary policy are always the primary drivers of currency value, with the first four factors evaluated in relation to their impact on monetary policy.
Economic Performance
Assessing the overall state of the economy is the starting point for fundamental analysis. Key indicators include:
Growth (GDP)
Determines if the economy is expanding or contracting.
Growing GDP
Indicates economic health and often leads to stronger currency values
Shrinking GDP
Can signal economic troubles and a weaker currency
Inflation (CPI)
Indicates if prices are stable, rising, or falling.
Moderate Inflation
Typically a sign of a healthy economy
High Inflation/Deflation
May lead to central bank interest rate changes
Labor Market (Employment)
Reflects the health of the job market.
- High Employment: Generally leads to stronger consumer spending and economic growth, positively influencing currency value
- High Unemployment: Can signal economic problems and a potential decline in currency value
Central Bank Sweet Spot: While growth is important, inflation often takes center stage. A healthy economy typically sees moderate inflation and low unemployment.
- Too rapid growth can lead to high inflation, risking a recession
- Low growth can lead to deflation, also risking a recession
Fiscal Policy
Fiscal policy, influenced by economic health, involves government spending and taxation. Understanding fiscal policy is crucial as it impacts monetary policy.
Weaker Economy
- Increased government spending
- Tax cuts
Booming Economy
- Higher taxes
- Reduced spending
Elections
Election outcomes can drastically impact economic policies. A pro-business candidate might implement policies leading to tighter monetary policy, while a candidate favoring increased social spending might result in looser monetary policy.
Global Events
Events like pandemics, wars, and trade disputes can disrupt economic stability, affecting currency values. For example, a trade war can reduce export revenues, weakening a currency.
Intermarket Analysis
Intermarket analysis involves examining the relationships between different markets. For commodity-dependent countries, the prices of key commodities significantly impact their currencies.
Commodity Prices
The value of commodities like oil, gold, and agricultural products can affect currency values. Understanding these relationships helps predict central bank actions.
Example: Rising oil prices can strengthen the Canadian dollar due to Canada's significant oil exports. Similarly, iron ore prices impact the Australian dollar.
Bond Markets
Interest rate differentials between countries can influence currency flows. Higher yields in one country compared to another can attract investment, strengthening the currency.
Monetary Policy
Monetary policy remains the most critical factor in fundamental analysis. Central banks adjust interest rates and conduct quantitative easing or tightening based on economic indicators.
Trader Focus: Whether a central bank is likely to tighten or loosen monetary policy, the timing of these adjustments, and the expected aggressiveness of the changes.
Interest Rates
Changes in interest rates directly impact currency values:
- Higher Rates: Attract foreign investment, boosting the currency
- Lower Rates: Can weaken the currency
Quantitative Easing/Tightening
Central banks may buy or sell government bonds to influence money supply and economic activity:
- QE (Easing): Typically weakens the currency by increasing money supply
- QT (Tightening): Can strengthen the currency by reducing money supply
The Simplest Fundamental Trading Strategy
If a central bank hikes or cuts rates – that directly affects the fundamental value of the currency – weakening it or strengthening it. Central banks often base whether they will hike or cut on very specific pieces of economic data like employment and inflation. This is why there is an entire group of people who trade only risk events.
Trading Strategy for Nonfarm Payroll (NFP)
Step 1: Analyze Federal Reserve Priorities
Understanding the Federal Reserve's current economic data focus is crucial. If the Fed is emphasizing employment data, those releases will likely cause significant market volatility.
Key Point: If the Central bank is focused on the data point – it's because they are using that data point to make a decision on rates. This is the reason data points are focused on cause volatility.
Sometimes the central bank is focused on a data point inside a data point. Like the Federal Reserve has often called out average hourly earnings as the key thing they are looking for inside the Non-farm payroll report.
Step 2: Use High-Low Expectation Forecasts
Professional traders rely on high-low forecasts to gauge market expectations accurately:
- Institutional Forecasts: Professional calendars include high and low estimates from top institutions, offering a comprehensive picture of potential outcomes
- Market Shocks: Reports that exceed the high estimate or fall below the low estimate can shock the markets, resulting in sharp movements
Warning: Retail calendars typically present the median of these estimates, which can be misleading. A professional calendar includes both high and low estimates, revealing the full range of expectations.
Step 3: Choosing the Instrument to Trade
Professional traders use institutional reports to judge which pair will be the most volatile:
City Economic Surprise Index: Identifies currency pairs that react strongly to economic surprises, helping you focus on the most responsive markets
Risk-Reversal Report: Reveals market positioning, showing a buildup of call or put options on certain currency pairs
CFTC Report: Details hedge funds' positions. If many big players are long EUR/USD but data favors the USD, some funds might have to unwind their positions, leading to an outsized move
Trade Execution Steps
1. Confirm Fed Focus: Ensure the Federal Reserve is emphasizing employment data. If so, the NFP report is more likely to move the market.
2. Check Forecast Ranges: Review high and low forecasts before the data release. Trade only if the actual data significantly exceeds or falls below these estimates.
3. Monitor Revisions: Check for conflicting revisions that might alter the initial market reaction. Ensure the primary release and revisions align.
4. Enter Trade Promptly: Once you confirm the deviation, act quickly. Speed is crucial as market reactions happen rapidly.
5. Set Stop and Take Profit: Place stop-loss below the low of the initial spike candle. Aim for 15-30 pips for tier 2 events like NFP.
Managing the Trade
- After the Initial Run: Look for a shallow pullback around a 23% Fibonacci retracement or near support/resistance levels
- Break Even: Move your stop-loss to break even as soon as possible to protect your gains
- Reentries: If stopped out, consider reentering at deeper retracements (38% or 50% Fibonacci levels)
Key Takeaways
- Focus on five key factors: Economic Performance, Fiscal Policy, Geopolitics, Intermarket Analysis, and Monetary Policy
- Monetary policy is always the primary driver of currency values
- Monitor central bank focus on specific economic data to predict market volatility
- Use high-low forecasts to identify genuine market surprises worthy of trading
- Select the most volatile currency pairs using institutional reports for optimal trading opportunities