Before you place a trade, you should have an idea of the future direction of the security you plan to transact. You should avoid going with your gut and consider focusing on research. There are two common types of research which include fundamental and technical analysis. Fundamental analysis is a technique that uses a combination of economic, political, interest rates and financial factors to value an asset. Fundamental analysis is broad-based. It can cover everything from economic influences to monetary policy. Your goal in performing fundamental analysis is to derive the future value of an asset so you can compare the current value of an asset. You will then be able to determine if an asset is overvalued, undervalue, or correctly valued. Fundamental analysis does not consider past price movement which is referred to as technical analysis.
What Does Fundamental Analysis Include?
- Economic Analysis
- Monetary Policy (interest rate) Analysis
- Political Analysis
Fundamental analysis is a technique where you are attempting to determine if an asset is correctly valued. Fundamental analysis includes both a macro and micro perspective to identify assets that are not correctly priced by the market.
Economic Analysis
There are several ways to evaluate the performance of an economy. You can start by looking at current economic growth and then create a view of future economic growth. You can use Rakuten Securities Australia website to read about future economic catalysts, as well as look at a reputable news organization that will provide you with information about a specific country or region’s growth prospects. There are a few key inputs that drive economic growth and inflation. This includes:
- GDP
- Employment and Jobs Data
- The Consumer Price Index
GDP, employment, and CPI are generally the most important data points that move currencies. You can find data releases on many new websites online. If a news release is stronger than analyst estimates there is a good chance the currency will appreciate, and vice versa. You can trade this news in real-time, and it will help you generate a long term view of a currency that is performing well versus underperforming currencies. If a countries interest rates are increasing and another is decreasing or staying the same there is a good chance that currency will appreciate over time. This is because money investors are always looking for higher yields and money generally flows to the higher-yielding currency.
Monetary Policy
Changes in economic performance can directly impact interest rates. Short term interest rates are generally controlled by central banks. This would include the Federal Reserve, The Bank of Japan, The European Central Bank, the Bank of England. In normal times, a central bank will alter or keep interest rates unchanged at a regularly scheduled meeting. The meetings are usually scheduled more than a year in advance, giving investors and traders time to schedule their trading around the release of new monetary policy information. Following a decision, the head of the central bank will often hold a press conference describing to economists and reporters why they either made a change or kept interest rates steady. There will also usually be a question and answer session where members of the press are allowed to ask questions. In volatile times, a central bank can make changes to interest rates at any point, by calling emergency, unscheduled meetings. This occurred in 2020, in the aftermath of the COVID-19 crisis, as the US Federal Reserve made several intra-meeting changes to monetary policy. Monetary policy can drive both short-term interest rates and long-term interest rates. While a central bank only usually changes short term borrowing rates, they can also purchase bonds, which can drive the price higher and interest rates lower. The drivers behind the movements of interest rates are actions of market participants, who take their cues from the central bank. Market speculation and hedging are generally driven by what the market believes that a central bank will do in the future. Interest rates play a large role in determining the future direction of the currency pair because they are used to help determine forward forex rates. An FX forward trader will generate a forward rate by adding or subtracting the difference between each currency’s interest rates to the spot rate.
Political Analysis
Fundamental analysis can also include issues related to the political landscape. This can include an election or even a coup. A new president or prime minister could usher in a new political landscape. This could include changes to trade, including tariffs that might alter capital flows, and change the value of a currency. This became evident in the wake of the Brexit vote in the UK. The UK decided to leave the financial framework of the EU, which had significant ramifications to both regions.
Key Takeaway
Fundamental analysis is a broad-based evaluation of an asset using several different pieces of information. This can include macroeconomic information, pollical evaluations as well as interest rate analysis. Economic data is generally the impetus that drives the value of interest rates. GDP, CPI, and employment are the key data points that usually move interest rates and currency pairs. Economic data is released daily by each of the developed countries around the globe. Changes in economic data will not only drive interest rates and currencies but they can also change the view of monetary policymakers. Central banks around the globe are constantly monitoring new information which helps them determine the future direction of short-term interest rates. Additionally, political pundits are constantly evaluating polls to determine if a new regime is likely to win the next election. Generally the information needs to create a large change in the political landscape like Brexit or a coup to significantly alter the value of a currency pair. Fundamental analysis is used to determine if the current value of a currency pair reflects your view of the potential future value based on economic analysis, monetary policy analysis, or political analysis.