Foreign exchange market offers great opportunities for significant profit while you are sitting on your desk and sipping your coffee. Sounds so easy, right? Wrong! More than 90% of forex traders lose their investment and most of them do it within the first few months. Remaining 10% earns good enough and most of the traders in this category are able to make living solely on trading forex. So how do they do it? Simple. They forecast the price of the pair that they invested accurately and there are two major methods to predict the market direction; fundamental analysis and technical analysis.
Fundamental analysis is a method for predicting price movements by studying macroeconomic indicators such as unemployment rate, GDP growth, inflation and central bank interest rate policies. The logic behind fundamental analysis is that if a country’s economic outlook is positive, the currency shall appreciate. On the contrary, if a country’s economic indicators show weakening, the relevant currency shall depreciate. Fundamental traders use this information to determine the trend of the currency and attempt to profit by being on the right side of the trend.
For instance, if the US economy is gaining momentum, GDP growth is accelerating and Federal Reserve is poised to raise interest rates, the US dollar will increase in value versus other currencies. A strong economy and higher interest rates are going to draw more foreign investment. Since foreign investors need US dollars in order to invest in the US, they will need to convert their local currency to US dollars. Eventually, this will lead to increased demand for US dollars and thus US dollar to appreciate.
Major Macroeconomic Data That Affect Forex Market
Rate of prices of goods and service increase over a certain period of time. It is usually measured monthly and yearly. Central banks base their monetary policy on inflation outlook. If inflation goes above target, central banks tend to increase interest rates to control money supply.
Gross Domestic Product (GDP)
GDP is the most important indicator for an economy that shows its overall health and performance. It is released quarterly and yearly. It measures aggregate value of goods and services produced and consumed by a country. When the growth rate of GDP picks up, the currency tends to appreciate and vice versa.
Unemployment rate, participation rate, employment and wage growth are among the most important employment indicators. It has a positive impact on the currency when unemployment rate is low, employment and wage growth is strong.
Difference between imports and exports of goods and services determines trade balance of a country. If a country’s exports surpass imports, it results in trade surplus and trade deficit arises if imports are bigger than exports. A trade surplus is a positive sign for the health of an economy and supports the currency.
Central banks monitor the economic indicators mentioned above for the purpose to measure overall health of the economy and determine the interest rate policy. If central banks conclude that the overall economic health is weak, they usually gravitate towards lowering interest rates to give it a boost. Lower interest rate leads to lower return for investors and thus will discourage them to invest or withdraw their investments thus bringing a pressure on the currency.
A war or a truce fundamentally influences the value of the currencies of the countries at war and contingent upon what nations are fighting, the whole forex market could get jittery. For example, don’t expect a significant impact on global risk sentiment if two small African nations begin to fight. Their currencies would get hurt for sure but you would not see sell-off at USD, EUR or JPY. On the other hand, if two big economies such as Russia and the US get into a real war, expect a huge volatility in almost every currency pair.
An unexpected early election or unfavorable election results can significantly disturb the value of the currency. For example, if an anti EU political party gets more votes than expected, or as a worse scenario, gets enough votes to set up government, Euro tends to depreciate.
A country that experiences sudden change of power such as a coup d’etat or a hard regime shift will scare off global investors and the currency will lose value versus other currencies.
When a country becomes victim of a natural disaster such as earthquake, tsunami or floods, that country’s currency may appreciate in the short term due to the need to repatriate funds from overseas for disaster recovery. This is what we saw right after the earthquake and tsunami in Japan 2011. However, the currency could suffer in the long term if the natural disaster leaves a substantial negative shock on that country’s economy.
Some fundamental factors have long term impact and some others have short term impact on currencies. For example, interest rate policies usually create long term trends for the currency that traders can benefit for months whereas international trade figures may influence the currency for only few hours. But regardless of being short term or long term trader, having fundamental analysis in your toolkit is necessary to improve your trading abilities and decision process.