Fundamental Analysis is a technique to calculate or find the real intrinsic value of any security. Fundamental Analysis is done by analyzing the economic and financial factors to find the Fair Value. Fundamental Analysis is a complex method where the macroeconomic, as well as microeconomic factors, are examined. Normally the data used for the Fundamental Analysis is publicly available. Like, in the case of stocks all the data is available on the company’s website, Financial Market Website, and Yearly Financial Reports. The purpose of Fundamental Analysis is to find the estimated value of any security which is closer to the intrinsic value or real value depending on the economic and financial conditions. This value is compared with the current value of the security to check the security is undervalued or overvalued. A Forex Trader who uses Fundamental Analysis trades the security long or short depending the security is undervalued or overvalued. It is important to note currency pairs are traded in pairs and while doing the Fundamental Analysis of Currency Pairs, two different currencies are compared to each other. In Forex Trading multiple factors are considered while doing the Fundamental Analysis. Some of the main Economic Indicators used for Forex Fundamental Analysis are discussed below.
Gross Domestic Product (GDP)
Gross Domestic Product is considered to the primary and most important indicator to evaluate the economy of a country. The GDP represents the size of the economy of a country by gauging the total production of a country and its growth. The GDP consists of the total consumption of a country, total investment, how much the government spends on development, and total exports of a country. A Forex Trader does not have to calculate GDP as it is easily available on different Financial Forums, generally, the State Bank or the Central Bank releases the country GDP figures quarterly or annually. Suppose if the GDP of a country is 500 billion USD in 2019 and 525 billion USD in 2020 it means the economy of that country has grown by 5% as compared to the previous year. Normally two types of GDP are used by professionals to evaluate the health of an economy, Real GDP and Nominal GDP. In the case of Real GDP, the inflation of a country is adjusted while nominal GDP is calculated using current prices without considering the impact of inflation. Therefore, Nominal GDP is usually higher than the Real GDP. If the GDP of a country is increasing continuously on yearly basis it means that the overall production of that country is increasing. The economy is flourishing and businesses are expanding. The overall increase in GDP suggests that the standard of living of people is increasing resulting in strong buying power. This continuous increase in the GDP of a country and all factors related to the increase of GDP mentioned above depict that the currency of that country would become stronger as the GDP grows and the currency of a country would become weak if the GDP of a country is not growing. This analysis of GDP over an extended period is important for Forex Traders who are more inclined on the Fundamental Analysis but a Forex Trader should note that the GDP is a lagging indicator of the economy.
Consumer Price Index (CPI)
The Consumer Price Index (CPI) is the measure of the cost of living of any person in a country. The Consumer Price Index (CPI) tracks the cost of a consumer’s basket of goods and services. The Consumer Price Index (CPI) is used to make adjustments in the cost of living due to the effects of inflation. Consumer Price Index (CPI) is used to calculate how much money is required by a typical consumer to buy goods and services. The consumer basket is determined by the Burea of Statiestines after research and surveys of different consumers and markets in a country. The Bureau of Statistics collects statistics about the prices of the goods and services in that consumer basket. Then the total cost of consumer’s basket is calculated. The Consumer Price Index (CPI) is calculated as
CPI = 100 × cost of basket in current year
cost of basket in the base year
Typically a Consumer Price Index (CPI) consists of Housing, Transportation, Food & Beverages, Medical Care, Recreation, Education, Communication, and apparel.
Complications in Consumer Price Index (CPI)
Over time some prices of goods rise faster and consumers go for the cheaper goods and try to substitute those goods with the expensive ones. The Consumer Price Index (CPI) uses a fixed basket of goods therefore the goods that are substituted are not accommodated. Moreover, new goods or services are not added to the consumer basket to increase the variety of the consumer basket. Goods in the basket are also not replaced with the improved ones as quality is hard to measure and quality goods are missed. Thus, all these factors add up to show the increased cost of living of people than the actual in Consumer Price Index (CPI).
Consumer Price Index (CPI) and Forex Currency Pairs
Consumer Price Index (CPI) is a great tool to track inflation within a country. Consumer Price Index (CPI) numbers can be used to evaluate the purchasing power, living standard, and prices of goods and services within a country. Consumer Price Index (CPI) has a direct effect on the monetary policy and interest rate of a country due to aforesaid factors. The changes in the interest rate and monetary policy have a direct impact on the currency pairs traded on Forex Market. When inflation rises, to balance the economy the state bank or central bank increases the interest rates. As the interest rate rises the currency of that country becomes stronger. Conversely, if the interest rate is cut the currency of that country becomes weak. Consumer Price Index (CPI) is also a tool to measure the effectiveness of government policies. Normally Forex Traders are advised not to trade during the release of Consumer Price Index (CPI) data as a currency pair can drastically gap up or gap down. Consumer Price Index (CPI) is considered to be a lagging indicator because past price data is used to calculate the index.
Interest Rate
Interest is the amount of money or cost anyone has to pay to borrow any type of asset from someone. The asset can be money, car, property, vehicles, or goods. For Example, a bank charges the customer’s interest when anyone takes a loan from the bank. Contrary to that when someone deposits money in a saving account interest is the amount you receive on your savings from the bank. The Interest Rate is maintained by the State Bank, Federal Bank, or Central Bank of a country. When the interest rate is set high, the cost becomes high for the borrower to take a loan. Due to the higher interest rate fewer individuals or companies would be willing to take a loan that would eventually slow down the consumer demand resulting in a sluggish economy. People will try to save more money to receive high interest from banks instead of investing in a business or stock market. Economies have a positive impact when the interest rate is cut. Rather than saving the cash in a bank, people and companies would now prefer to invest the money where they can earn more in profit resulting in a positive growth of the economy.
When a country has a higher interest rate compared to other countries more Foreign Investors would be willing to invest in that country in hope of better returns. That would increase the demand for that currency and the price of that currency would go up. On the other hand, when the interest rate is low, Foreign Investors would take out their investments to invest in some other countries resulting in the decrease of the price of that currency in the International Forex Market.
Current Account Deficit
Countries have limited resources, industries, and skills to produce certain types of products for different kinds of markets. Some countries produce certain products in excess due to their geographic location and conditions. Countries depend on other countries for the import of certain products for the growth and development of the economy. In reverse, countries export certain products and services to other countries to earn revenue. When the value of imports of a country rises more than the value of the exports, this measurement of the difference between the value of imports and exports is called the Current Account Deficit. Dividends, interest payments on deposits, payment transfers, and aid are also included in the Current Account Deficit. The Current Account Deficit is a part of the country’s Balance of Payments. The Current Account Deficit also indicates that the country is spending money more than its income. The Current Account Deficit can not always be harmful to the country for example if the rate of the return on the value of imports which are financed by the external debt is more than the interest rate which has to be paid on the debt used to finance the import than actually, a country would earn revenue from this cycle in long term. In the case of the Current Account Deficit, the imports are high which means companies, businesses and individuals are paying more money for the imports of products or services which is causing more outflow of currency. Due to this increase in the supply of currency of one country the value of that currency can decrease in the International Forex Market. Australia had incurred a Current Account Deficit for 44 consecutive years from 1975 till 2019. The Current Account Deficit of the United Kingdom (UK) for the First Quarter of 2020 was recorded at 21.1 billion Pound Sterling whereas the United States (USA) recorded a Current Account Deficit of 195.7 billion US Dollars in the First Quarter of 2021.
Unemployment Rate
The Unemployment Rate is the estimation of the number of people who are unemployed during a certain period. Unemployment numbers are released by the department of statistics of any country monthly or quarterly. Forex Traders don’t pay attention to the unemployment rate of any country as this rate does not have a direct impact on the prices of Forex Currency Pairs. For Professional Forex Traders and Institutions, the Unemployment Rate is one of the important Fundamental Indicators in Forex Trading. A decrease in the employment rate suggests that more people got jobs doing certain periods which indicates more companies are hiring new people due to growth and expansion in the economy. On the other hand, an increase in the unemployment rate suggests that more people have lost their jobs which indicates the health of the economy is degrading. The continuous low trend of employment rates means that the economy is becoming strong with time, which would increase the demand for that currency in the International Market. When the demand for one currency increases due to a strong economy relative to the currency of a country where the employment rates are high and the economy is weak then the value of that currency increases. If the unemployment rates are too high then the government may intervene in this situation. Very high unemployment rates can trigger a chain of socio-economic problems in society and start political unrest. The government tries to stimulate the economy to generate more jobs or the government will bring unemployment compensation package for the unemployed people. These negative events can lead to a bearish trend of the currency of that country.
Type of Fundamental Analysis
Fundamental Analysis can be categorized into two major types. Quantitative Fundamental Analysis and Qualitative Fundamental Analysis.
1) Quantitative Fundamental Analysis
In Quantitative Fundamental Analysis, a Trader uses mathematical and statistical models to understand and calculate the fair value of a security or a currency pair. A quantitative analysis is an analysis that can be measured and represented in numbers and amounts. For Example, Gross Domestic Product (GDP), Interest Rate, Inflation, Sales, Earnings, Earnings per shares (EPS), etc.
2) Qualitative Fundamental Analysis
In Qualitative Fundamental Analysis, a Trader uses an independent and rational judgment to predict the future trend of any security or currency pair. Qualitative Fundamental Analysis can not be presented in numbers, ratios, or amounts. Qualitative Fundamentals Indicators are less measurable as compared to Quantitative Fundamentals indicators of a country or a currency. Qualitative Fundamentals include quality of Governments Executives, Governance Policies, Relationships of a country with other countries, regulations, business cycles, and others.
Drawbacks of Fundamental Analysis
Fundamentals Analysis can dodge you, can be wrong or it can take a hell of a time for a security or a currency to move in the direction indicated by Fundamental Analysis. It is necessary to stay vigilant while using the Fundamental Analysis approach during Forex Trading. Some of the pitfalls of Fundamental Analysis are described below
1) Broadness of Fundamental Analysis
The problem with Fundamental Analysis is that it is a very broad term. Fundamental Analysis is everything related to Financial as well as Economics of a currency, a country, or a share. There are no set rules written somewhere for Fundamental Analysis because assumptions can be different. If we talk about the Fundamental Analysis of a Currency Pair it is not obvious which Economic Indicator can trigger the price to move up or down because your assumption of the impact of Fundamental Indicator can be different from other Forex Traders or Institutions.
2) Miscalculations
A Forex Trader using Fundamental Analysis tries to predict the trend of a currency pair based on some Economic Indicators. Most of the Economic Indicators are lagging indicators and they are based on historical data whereas a change in the price of a currency pair is a future event. It can be possible the assumptions a Forex Trade makes or calculations of growth rate, future interest rates or profits can be wrong.
3) Long Impact Period
Whether you are using Fundamental Analysis for stocks, commodities, currency pairs, or any other security the impact of Fundamental Forces on the price of any security can take a long time. Prices move due to big instructions and investors which generate volume. If the volume is not there and big investors are not convinced about the Fundamental changes the impact on the price of that currency pair can be little or negligible.