Fundamental analysis is essential if you want to become a successful trader since it enables you to determine the real market value of the instruments you invest in. Unlike technical analysis which is used mostly for evaluating short-term investments, fundamental analysis allows traders to make better-informed decisions about long-term investments. The following article introduces traders to the basics of fundamental analysis.
What Is Fundamental Analysis
This type of analysis is predominantly implemented by people who trade with stocks although it can be applied to all types of securities, including currency pairs, bonds, and derivatives. While technical analysts rely on chart data to spot market trends, those who rely on fundamental analysis monitor news headlines and economic reports.
Fundamental analysts are well-informed on all factors that could influence the real value of the markets, including important political, social, and economic events. Traders who rely on fundamental analysis usually use the so-called economic calendars. The latter contain detailed information about economic events sorted by countries.
Supply and demand have an effect on market prices as well. Therefore, traders must also carefully analyze all the phenomena that have an impact on supply and demand. For instance, supply and demand drops whenever the unemployment rates within a given country jump. In turn, this would have a direct impact on said country’s economy and the demand for its respective currency will, therefore, decrease.
Traders who rely on fundamental analysis hunt for instruments whose current trading market value is below or above their actual “fair” value. When the real price of a stock is higher than its current market price, a fundamental analyst would buy and the opposite.
Central Banks and Monetary Policy
Fundamental analysts who trade on the price movements of Forex pairs must consider how monetary policy impacts the value of currencies. Monetary policies and central banks are of utmost importance when it comes to performing accurate fundamental analysis. This is because the banks play a crucial role in determining the return rates for a given economy’s assets. In turn, this influences the demand for the respective country’s currency.
The central banks base their decisions on a variety of economy-related factors such as the local economy’s overall growth, the inflation rates, the citizens’ spending level, and their confidence level. A central bank also has a say in how much of the country’s currency is currently in circulation.
If the local economy performs strongly, the national bank may decide to decrease the currency in circulation to prevent inflation from going out of control. This is known as an accommodative monetary policy.
It makes sense this would cause a surge in the value of the currency due to the higher demand. A country’s national bank can also cause a decrease in the local currency value through the sale of large chunks of said currency. All these factors are taken into account by fundamental analysts.
Inflation Management Tools
The levels of inflation in a country have a serious impact on the local economy and should be taken into account by fundamental analysts. The term inflation refers to when the prices in a country jump while money’s purchasing value decreases significantly. This phenomenon is to be observed whenever higher spending drives the economy’s growth. The local currency would then weaken in value in comparison to other countries’ currencies.
Governments and central banks rely on different tools to manage and control the inflation rates. One way to achieve this is by controlling the local prices and wages. Another method is by enforcing a contractionary monetary policy whereby the central bank would reduce the supply of the local currency by decreasing interest rates and the prices of bonds.
Major Economic Indicators
Fundamental analysts usually rely on several important economic indicators when evaluating the real value of the markets. The first, and perhaps the most essential indicator is employment. Each government tracks the employment rates and regularly releases reports with the results, usually on a monthly basis.
The inflation rates are the second big indicator of how a given economy is doing. Since inflation is directly related to the economy’s growth and prices, fundamental analysts monitor its levels by reading the governments’ inflation reports each month. This enables them to make informed estimates about the future monetary policies of the central banks.
Citizens are a major driving force for economies so their spending patterns along with their level of confidence in the economy are also worth tracking. If people fear they might lose their employment, their level of confidence in the economy drops, and vice versa. In turn, this influences spending decisions such as buying a new vehicle, paying for a vacation, purchasing a home, and so on.
Force Majeure Events
Force majeure is a legal term that denotes a special clause included in contracts that eliminates the liability of the involved parties in the event of unusual and unforeseeable circumstances.
Such unpredictable circumstances usually include natural or politics-related catastrophes. There is a wide range of unforeseeable events, including natural disasters, pandemics, wars, and asteroids, among others. The exact definition of force majeure varies between jurisdictions.
All of these unforeseeable events impact the markets, leading to unpredictable price fluctuations. The trouble is that there is no sure-proof way for fundamental analysts, and traders in general, to accurately predict force majeure and the effect they will have on the market. Said effect manifests itself after force majeure events have already occurred.
The impact of political and social events on the market prices and the economy is much easier to predict. Protests, strikes, impeachment, and armed conflicts often lead to a drop in the values of the countries’ currencies.