Why is Fundamental Analysis important in Forex?
Well, in first place let us introduce what Fundamental Analysis is.
This type of analysis is quite different from Technical Analysis, which is focused in the past price and tries to discover patterns that can be applied to the future.
Fundamental Analysis on the other hand is based in the study of the variables of an economy, data of some companies or as in the case of Forex, the economic date related to each currency.
Therefore in Forex we will study all those variables related to a currency and the economy where it applies.
As you can imagine this type of analysis is quite complicated and subjected to many interpretations.
No matter how much we study the data of an economy; there will always things that will escape us.
Anyway, as much as we study the macro data of an economy we can never be sure we will take the right decisions.
Evidently, this type of analysis is not very good for the short term since analyzing the data of a country is not of much value to determine what direction the currency is going to take a single day.
Therefore this type of analysis works better for the long-term
How do we do Fundamental Analysis in Forex?
In this case we will have to analyze all economic data that affects two very important variables for an economy: capital flow and commercial flow.
With these two things we have the balance of payments.
Once we have the balance of payments and all entry and outgoing data we can have an idea of how things may turn out in the future.
It is supposed that the currency of a country is stronger when the balance of payments is positive, in other words, when there is more capital entering the country than going out.
Therefore one country is supposedly weak when it has a negative balance of payments.
This measures how much capital enters or leaves certain economy.
Here we include all investments and disinvestments private or public.
For example, we have a company that buys foreign currency and sells its own to be able to buy products in the foreign country.
In this case there is a capital outflow.
However in the long-term this company will have a positive effect in the economy if it bought production capabilities in the foreign country.
Another example is when someone buys foreign stocks.
Therefore a Brazilian citizen who buys Facebook stocks means an outflow of capital at first but as an investment means that it will have income in the future which, in theory, will be good for the citizen and Brazil.
This makes reference to the exports and imports of a country and the business sector is very important in such.
Exports and imports make up the current account.
We have a positive current account when our exports are bigger than our imports.
We have a negative current account in the opposite case.
For example, a country with more exports will have more foreign people buying its currency than own citizens buying foreign currencies.
Examples of this are Germany and Japan, countries famous by its very strong currencies.
Countries with negative current accounts like the United States or the United Kingdom maintain a good position because they hold a strong hold in the credit markets.
Fundamental Analysis theories
Purchasing Power Parity (PPP)
This theory tells us that the currency rates are determined by the baskets of goods of each country.
For example, if a burger costs 1 euro in Spain and 1.25 in the United States it means that the currency rate should be 1.25 for the EURUSD.
This theory gives a general view of how things work in this type of analysis, although there are many more factors to take into account.
Interest rates theory
This theory is based on arbitrage and the tendency of people to try to take advantage of any possibility that the former presents.
For example, if the interest rate in the GBP is 7% and the FED rate is 3%, the dollar should, supposedly, appreciate to eliminate such possibility.
In other words in such a situation the American investors would be buying English bonds.
As capital would go out the United States the Pound should increase in value.
However, there are also some ownership rights created that mean a future income for the United States citizens which will increase the value of the dollar in the future.
As you can see this type of analysis is not what it seems at first glance.
There are more variables involved.
Fundamental Analysis and News in Forex
This is the equivalent of the company’s news and dividends but in the Forex version, which comes in form of national and international macroeconomic announcements.
These announcements are released by the major central banks.
Every day we have different announcements related to inflation, unemployment, housing, etcetera.
This type of news produce big short-term moves in the currencies and consequently the traders try to take advantage of it.
However, trying to trade the news in Forex is something quite complicated.
In those moments there are big increments in spread and the conditions worsen a lot which makes it very difficult to win in the long-term.
Many traders try to master this type of trading with Technical Analysis but end up failing miserably.
Another aspect to take into account is the fact that insiders in the public houses have an edge since they know in advance the data.
You can guess that the majority of traders are not insiders.
Forex Fundamental Analysis is fascinating and has many variables.
However, knowing that the exports of a country are x does not give us an edge against other.
The real interesting part is to know what is going on internally in each country to try to determine what economic performance that country is going to have in the future.
To do that we should also some sort of sociological study of a country to determine if it will adopt bad policies to business for example.
What the politicians do to an economy of a country is very important.