Currency forms the building block of any economic activity in any nation. Any development in the economic sector of the country, therefore, has an impact on its currency value and the direction that the currency market takes. Though the amount of related data is very huge and seems unmanageable to a new entrant in the field, most of these factors are closely related. That is, it is possible to trace a path from the simple concepts such as prevailing interest rates on mortgages to complicated factors like the industrial produce of a nation and balance of payments.
Firstly, for any beginner that wants to be a successful forex trader, and want to base their trades on fundamental analysis, it is important that they follow the statistics of the central bank of the nation and the fundamental news. The beginner trader should also have a clear idea as to the times that they live in and the factor that mainly drives the economic development during those times. That is, in other words, the trader should be aware as to which part of the boom bust cycle the country’s economy is currently going through.
Economy’s Boom and Bust Cycle
This is possible if the trader keeps track of the loan statistics that are maintained by the central banks of the nation. Generally, financial institutions tighten their lending rules when the economy is approaching or when into a bust cycle. This is to prevent institutions from going bankrupt. However, when the economy approaches or is in the midst of a boom phase, the lending standards are relaxed by financial institutions. This is when they would like to generate income through interest and also increase dividends for shareholders.
When the other factors do not change, during the bust cycle of the economy, it is vital to understand that the reserve currency tends to appreciate against other currencies, while in a boom phase the reserve currency tends to depreciate. This happens because the booms happen primarily due to increased lending of the reserve currencies as is the norm of the global financial system. Proper identification of the boom-bust cycles can help the forex trader to deriver advantage from the currency markets.
The next factor to be tracked are the news releases because the large amount of data that they provide can be assembled to form the big picture of the events to come and what actually is going on in the current economy. Once a trader understands the big picture, it is possible to see who derives the most benefit and then the trader can place the trades in a way that is in line with those who drive the economy. In this way it can be very beneficial for the trader.
How to Construct the Big Picture
For a beginner trader in forex, it is important to keep track of the interest rates and how they are being channelled into the economy via financial institutions and big banks. The next option to be aware of is whether there are emerging nations, financial products, technological findings/innovations, etc. these have the capacity to propel the economy into healthy growth for a period of time on global terms. Political climate is also another important factor.
The dynamic nature of the economy and the political stability/instability impact the forex market’s volatility, capital flows across the border, etc. It also plays an important role when the trader has to decide whether to be optimistic or conservative when analysing economic data such as jobless claims and orders for durable goods and other such factors that occur at high frequencies.
Currencies – What to Buy and What to Sell
If the economic policies of a nation are both healthy and credible and the nation’s most powerful actors that drive the economy are in alignment and in favour with the market, then the trader can buy the currency of the nation. On the contrary, if the economic policies are not healthy and the markets are not in favour with these, then the trader can sell the currency. In case the policies are not sound, but the market still favours such policies, then it is not good idea to trade that currency at all. In case the economic policies are sound but the market does not favour the policies, the trader should exercise caution while selling the currency. Buying the currency in this case is a no-no.
The fact is that fundamental analysis is always right. However, when the trader disregards the market completely in favour of fundamental analysis, the trader may have to wait for a long time for the corrections to occur. Any abnormalities that are defined by fundamental analysis are always corrected either by policy change or by market developments.
Aim of Fundamental Analysis
The job of fundamental analysis is to characterize the money flows from and into a country. The analysis decides the most preferred course the economy of a country should take based on the soundness of its major financial institutions, the health of its economy and the opinions of its politicians and academics. However, when determining the actual causes of the price trends, fundamental analysis cannot present the complete picture by showing what is good or bad about the economy. This is because it is possible for price trends to be completely independent of the economic scenario and the theory.
If the trader understands the nature of the price trends, it is possible to understand whether the cycle is driven by speculation or by increased productivity and innovation. It is important to realize that even in the healthiest of economies, bubbles can be formed when there is support from the speculators. Traders can profit even from bubbles that grow from opportunities to make profit. It is advised participate in such bubbles in their early stages and turn in a profit before they burst. With the backing of fundamental analysis, the trader will avoid participating in the bubble at the height of euphoria when things can suddenly deflate.