Fundamental Analysis

Introduction to Fundamental Analysis

There are 2 different schools of thought used when predicting price movement: technical and fundamental analysis. Understanding both can be a great tool in your repertoire of trading tools.

While technical analysis uses price action and charting to anticipate market movement, fundamental analysis takes a look at the underlying reasons as to what caused the market to move (high unemployment, inflation etc). Think of a train station: fundamental analysis can hint which way the train is going, and technical analysis can help tell the passenger when to get on.

What Makes the Market Tick?

As with all other commodities freely traded on the open market - currency is considered a commodity - the price is determined by supply and demand. The choices a country's elected leader make can affect the global demand for their currency. Here are a couple of factors that influence the market:

Interest rates

Central banks, like the U.S. Federal Reserve, have the ability to set core interest rates, which use these rates to help steer economic conditions in their respective economy.

Take for example the recent USD/JPY carry trade from 2006. The Japanese central bank had an interest rate of 0.25%, while the U.S. Federal Reserve's interest rate was 5.25%. Traders would borrow Japanese Yen (and pay an interest rate of 0.25%) and invest it in US Dollars (bearing interest of 5.25%), yielding a net gain of 5% interest. This situation attracted many investors which increased the demand of USD in exchange for JPY, and the value of the USD/JPY appreciated greatly as result.

Inflation

The rate of inflation can quickly erode away one's profits: if the rate of inflation is higher than the rate of return, the investment is at a net loss.

A modern example of inflation can be seen in Zimbabwe. Inflation got so out of hand that, for example, if an investor had $10,000 worth of investments in Zimbabwe, that investment would have been worth less than $1 in 15 days. While this is an extreme example, it illustrates the point: even a slow deterioration of an investment from inflation is avoided by major investors. A country with inflation higher than return on investment will be avoided by investors, which will lessen the demand for that nation's currency.

Economic Health

It should be no surprise that overall economic health is a contributing factor. There are many important economic indicators (GDP, unemployment etc) that give insight to a nation's well-being. Visit our education center to learn more about the important economic indicators that influence each currency.

Market Sentiment

As the word sentiment describes, market sentiment is simply what investors feel about the market - regardless if their feelings are entirely justified or true. As such, market sentiment could be - and is - influenced by rumors and false reports.

For example, recently a reporter from The Independent reported that the oil states of the Middle East were in talks to stop using the US Dollar for oil trading. Even though the report was repeatedly denied as false, it still had an impression on the market.

Stay in Touch

To help our traders stay in touch with the happenings of the market, Got Money FX provides a free Dow Jones news streaming straight to the Got Money FX MetaTrader 4 platform.