Fundamental analysis of a currency is foreign exchange trading strategy that we have discussed here a lot recently. As it does not require advanced technical analysis of currency movements, nor does it typically require rapid trades, fundamental analysis can be an ideal strategy for traders and investors new to the currency market.
Investing, not Merely Trading
But before we can look at what fundamental analysis really is, let’s look at what it’s not. Many professionals would take issue with my characterization of fundamental analysis as a trading strategy, deeming it an investment strategy instead. The investors at etoro.com explain the difference in a bit more details:
It would be a mistake to confuse forex investment strategy with trading. They are not the same. A trader trades foreign currencies for short or middle term gain using technical analysis as a trading tool. The investor however who has a forex investment strategy uses fundamental analysis as a tool to identify which currencies to invest in for the long term.
The major difference that they are getting at here is that an investor utilizing fundamental analysis tries to get at the underlying value of the asset whereas one using technical analysis concerns himself more with where the currency might move to next, regardless of underlying value.
So what is it?
Defined simply, fundamental analysis means looking at the major macroeconomic trends happening at the national and international levels and investing in the currencies of countries which you think are poised to do comparatively well over a period of time.
Jeremy Wagner, the head forex trading instructor at DailyFX, gives us a slightly more detailed definition:
A fundamental forex trader will analyze the country’s inflation, trade balance, gross domestic product, growth in jobs and even their central bank’s benchmark interest rate. By assessing the relative trend of these data points, a trader is analyzing the relative health of the country’s economy and whether to trade the future movement of their currency.
If this all seems a bit confusing, let’s look at it in terms of an analogy. Currency trading seems somewhat opaque because the tools that we use to measure it – inflation, interest rates, trade flows, are also unfamiliar concepts. So instead of currency, let’s look at real estate investing.
This Old House
Supposed that you have a few hundred thousand dollars lying around, and you decide that you want to use it to get into real estate investing. You know your metro area pretty well, so you decide to stay around there. You start checking out a few towns around you. You’re not looking for a place to live, as you already have a house that you’re more than happy with. However, you are looking for a place that you’ll be holding onto for awhile.
Assuming that you’re a careful investor, this should be a pretty lengthy process. There are a million and one variables to consider. First, you want to buy a house somewhere where the underlying services are solid – access to electricity, water, and waste disposal. On top of that, you want access to good government services like public schools and hospitals. However, you’re willing to discount the importance of these services for the right price – after all, you’re not going to be living there yourself, and you want to make sure that there is some room for growth. The important part is that the state government has a plan to dramatically improve the area. You’ve got a good feeling about the new governor and think he’ll be good on his word here. And if the area picks up, and you make a few small repairs to the house, you could end up doubling or tripling your investment over the next couple of years.
This is precisely how you want to think about fundamental investing. You’re looking for a currency that has been pretty badly beaten up, but which you think is poised for a comeback. Or you’re looking for a currency that has just started out on a positive trajectory, which you think will continue for some time.
Putting the Strategy into Play
For example, in the wake of recent announcements from the United States treasury department, the US Dollar has been trending upwards against most currencies, particularly developing world currencies. Given the zero-sum nature of forex trading, this means that developing-world currencies have been doing poorly against the US dollar.
To get into more specific detail, let’s look at a widely traded currency pair, USD/INR, or US Dollar/Indian Rupee. Since the beginning of the year, this trade has gone from roughly 1:50 to 1:65, a massive shift for such a widely traded pair of currencies. The reasons for this are too numerous to get into in this article, but the question for you as a trader is where this relationship will head next, based on the factors at play. According to the authors of TradersChoice.com, some of the factors at play include:
There are several basic types of factors that can influence a currency; interest rates, political events, trade balance, merger and acquisition activity. Statistics of these factors are typically put out in reports regularly issued by governments. To find out when these reports will be put out you need to observe an economic calendar.
To look a bit more at the example of the United States and India, you need to identify some of the factors that have caused the Indian Rupee to drop so precipitously. They include, but are not limited to, populist policies with negative long-term macroeconomic implications, ongoing corruption, and military disasters. The United States, on the other hand, has put out solid jobs growth data and low inflation numbers all year. This disparity has been significant enough to depress the price of the rupee 30% against the dollar. Your job as a trader is to determine where this relationship will go in the long term. Is the United States at the top of a slope? Are the economic data and the currency about to fall off a cliff? Is the worst behind for India? Or is it just the beginning of a decade of weak economic news? The real skill of fundamental analysis involves looking at the data and answering these questions and more.
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