Fundamental analysis, is a method of explaining and predicting where a certain market moves because of real developments which affect the economy. These effects can be anything from the release of economic data, to a speech made by an influential policy maker or economist, to a widespread geopolitical event, such as natural disasters or war.

All of these things influence how markets move, and will have important implications for foreign exchange.

Fundamental analysis works on the principle that the market movements are the result of new information being priced into a currency pair. This information is not just that which is already freely available, but more importantly, what the expectation are for certain outcomes.

For instance, if a trader suddenly expects the U.S. economy to grow faster than the euro zone, it is logical for that person to put in an order to buy U.S. dollars against the euro, anticipating that that the demand for U.S. goods and services would likely increase, and consequently the currency. If enough people buy into this theory, you experience a gradual appreciation of the American currency over the euro (EUR/USD falls).

If this expectation becomes widespread, it is said to be “priced” into the markets.

As a consequence, if ahead the U.S. GDP (the benchmark data point for economic growth) expectations are for an upbeat result, and suddenly the data comes in weaker than expected, you almost always see a steep sell off in the USD, as traders price in the fact that the economy is performing below expectations.

This concept of market expectations is crucial to the understanding of fundamental analysis, because, traders are not content to just trade on new information, but also expectations of future information. Fortunately we have some mechanisms for knowing where the market’s expectations broadly lie, the consensus forecast.

The Consensus Forecast

A consensus forecast is calculated by first interviewing a broad survey of economic agents, traders, strategists, economists etc… and taking the median estimate as the “market expectation”.

Because of its popularity, news agencies across the globe calculate their own consensus forecasts for economic indicators, but as a general rule, Reuters, Bloomberg, and Dow Jones are regarded as providing the most reliable estimates of market expectations.
If an economic data point comes out better than the consensus forecast, the demand for a currency will rise.

Economic Indicators

You also have to be careful about knowing what every economic data point means for the economy, and how much importance the markets give them. To make this easier below is a list of some key indicators and how they impact FX.

Interest rates: In simple terms, the interest rate is the cost someone is going to pay to borrow money. If I want to take a loan to start a business, the bank is going to charge me a premium to lend me money today, which I can pay back at a later date (hopefully after my business venture has become profitable). Consequently, it makes sense that if interest rates are high, so are borrowing costs, and consequently the value of the currency.

Another way or looking at this is from the savings side. Interest rates are also the premium an investor will be paid to lend out money to a borrower. So logically it makes sense that investors would seek to buy assets in countries with higher interest rates, which would consequently increase the value of the country’s currency.

GDP: GDP (also known as gross domestic product) is the benchmark data point for economic growth. If a county’s GDP rises by 0.3% year-over-year, then the total amount of goods and services produced by the economy has risen by that much. Logically, if GDP comes in better than expected, you can expect to see a currency appreciate against majors.

Inflation: Inflation is the amount that the price of goods and services increases for an economy. So if I can buy a candy bar today for one dollar, and next year the price goes up to $1.10, then we have seen a 10% increase in prices, or the inflation rate. While logically this means that my dollar has lost its purchasing power and is worth less down the road, the analysis is more complex, because as I said before, markets move on expectations, and so far we haven’t talked about a very important player in the financial markets, central banks.

Central Banking

When growth starts to rise rapidly, members of the economy become more wealthy, jobs are being created, wealth is being generated, people spend more. So what happens when everyone in an economy gets richer? Merchants start charging higher prices, causing inflation.

High inflation is bad for the economy because it damages savings, and essentially scares people away from buying a country’s assets. That’s why we have central banks to control the balance between high growth and inflation.

Central banks do this by setting interest rates in an economy, such that when growth is getting a little too hot, they hike interest rates, to cool growth, to make sure inflation doesn’t get out of control. These higher rates, coupled with strong growth data will raise the value of a currency. Likewise when growth and inflation are weak, central banks will cut rates, to stimulate them. This will weaken a currency.
So since we know that markets act on expectations, it makes sense that when growth or inflation are higher than expected, a currency will rise, and that when either are low, a currency will fall.

Example of Trading New Zealand GDP

As an example, let us examine New Zealand’s second-quarter GDP report on September 23, 2009. The consensus forecast for this key data point for New Zealand was for a 0.2% quarter-over-quarter contraction of the economy.

Instead, the kiwi economy proved to be more resilient than expected, and the economy grew 0.1% in Q2.

The immediate result was a 100 pip rally in the kiwi dollar against the greenback, trading as high as 0.7308NZD to the USD. But the reaction did not stop there. The Australian dollar, which is closely linked to the kiwi surged 50 pips to 0.8787 against the USD, as economic agents concluded that a stronger economy in New Zealand is also good for Australia.

In theory, had the economy contracted 0.1%, as predicted by the consensus, one could have expected the currency markets to ignore the release entirely.