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What is fundamental analysis in Forex (focusing on economic growth, capital flows, and trade)?

In forex, fundamental analysis covers the state of global economies. It includes research into economic growth, trade, capital flows, manufacturing, employment, interest rates and other economic variables. Traders use this research to determine the current value of national currencies.

The reason traders want to determine the value of currencies is that they believe the price of a currency is not necessarily equal to its value. In fact we could say that is always true, and that’s why currency prices are always changing. In short, markets always price currencies too high or too low, and fundamental analysis tries to uncover the true value of currencies to give traders an edge in the markets.

This also shows how technical analysis differs from fundamental analysis. Where fundamental analysis looks at everything except price, technical analysis is focused on nothing but price. This means fundamental analysis is often best for medium and long-term trading plans, while technical analysis is better for the short-term day-to-day and even minute-to-minute moves in the forex markets.

News and Forex Fundamentals

As a forex trader you’ll quickly notice that the largest movements in forex markets are caused by news reports. This is all tied in with fundamental analysis and how it attempts to place the correct value on currencies.

Forex traders and others involved with financial markets watch a number of indicators that provide clues to a country’s economic growth, trade balance and the flow of capital. These indicators are released in reports that come out on a weekly, monthly or quarterly basis. You can find out when various reports are due and what their results are by using an online forex calendar.

Here’s how fundamental and technical analysis differ dramatically:

With technical analysis traders receive new information every second as price quotes are updated in real-time. Fundamental updates come once a week at most, and in some cases only once every three months.

Thus fundamental analysis actually mimics real-world changes. Capital flows gradually, and changes where it accumulates slowly. Economic strength also ebbs and flows gradually. As an economy strengthens it becomes more attractive to foreign investors. That attracts new capital, which serves to further strengthen the economy, and often improves trade balance.

All of these things require investors to have the national currency of the country. This increases demand for that currency and also tends to increase the value of the currency.

Of course, if economics was that simple, we’d all be rich. Currencies react to many factors besides economic growth and capital flows,and in some cases the value of currencies is manipulated by governments and central banks. In fact, one of the direct results of monetary policy is a change in the value of a country’s currency.

In any case, the release of any economic reports is accompanied by traders examining those reports for signs of strength or weakness in the economy. Prior to the release of the report, economists and other financial professionals will forecast the data. Any significant difference from the forecasts is likely to cause forex market volatility.

That potential volatility is why new forex traders are cautioned to avoid placing trades around major news releases.

Major economic indicators for Fundamental Analysis

While there are dozens of fundamental economic reports that can influence forex markets, some are of major importance. Three are interest rates, inflation, and gross domestic product (GDP).

Interest Rates

Every forex trader monitors interest rates, and more specifically any changes in interest rates are a major fundamental indicator to the true value of currencies. While you’re probably familiar with different types of interest rates, when forex traders talk about interest rates, they mean the nominal interest rates set by central banks.

The nominal interest rate is the rate that the central bank charges commercial banks for borrowing money from them.

Interest rates are arguably the strongest fundamental factor in currency prices. That’s because interest rates can influence so many other factors of the economy. Interest rates influence trade, borrowing, investment, inflation, capital flows and even employment.

If fundamental analysis of the forex markets is your goal the best place to begin is with a study of global interest rates.

Inflation

Inflation reports focus on changes in the price of goods and services over time. Each country’s central bank has an inflation target it is trying to hit, so inflation reports can often foreshadow changes in monetary policy. If inflation becomes too strong the central bank may cut interest rates or lower money supply. The reverse of inflation is deflation, which is when goods and services become cheaper because the value of money is increasing. This can be good for a short time, but it soon leads to a slowdown in economic growth. When conducting fundamental analysis with respect to inflation forex traders always assume central bankers will adjust monetary policy to keep inflation within a target band.

Gross Domestic Product (GDP)

Gross domestic product measures the value of all the goods and services produced by a country over a given period, usually quarterly or yearly.

While an increase in GDP can be a good thing, since it indicates strong production, it needs to be matched by strong trade data and demand for the products and services being produced. If all these elements are in place a rising GDP usually indicates increased value for the country’s currency.

In Conclusion

The three fundamental factors of interest rates, inflation and GDP are the major indicators that every fundamental analysis of forex markets should include.They generate more impact to forex markets than all other factors combined in nearly every case. Beginning with these three fundamental factors and understanding how they impact forex markets will create a strong foundation for any fundamental analysis.