Most retail traders today, especially in Forex, use technical analysis without always considering the market ‘fundamentals’ to analyze potential trading opportunities.
This is ironic because fundamentals give most markets their underlying value and, ultimately, are critical in driving their moves. Understanding how to pay attention to fundamentals can provide traders with a stronger foundation when looking at the markets and understanding why they behave in a certain way.
This article concerns Forex's fundamental indicators and how they should impact trade decision-making.
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What is Fundamental Analysis?
Market analysis is broadly divided into two key categories: fundamental versus technical analysis. These are two quite different ways of looking at the markets, and each analytical method offers its perspective on predicting future market direction.
Fundamental analysis examines an asset's worth based on its underlying value. That may be different from its current market price.
Fundamental analysis is independent of price moves. A Forex pair may increase or decrease in price, but the price move does not alter the basic analysis of where the price “should” be based on its fundamental factors.
Important Factors in Fundamental Analysis
Gross Domestic Product (GDP)
What is the GDP? The value of all goods and services produced within a given period (usually a quarter or a year) is an often-used measure of a country's overall economic performance, and how it changes over time can indicate growth or decline. If a country's financial health can be distilled into a single metric, it would be its GDP readings that most would consider the key statistic.
Most countries release their GDP data at regular intervals throughout the year. For example, the U.S. Bureau of Economic Analysis (BEA) estimates the nation's GDP quarterly and annually and releases new GDP statistics monthly.
Higher GDP and growth in the quarterly reporting mean a stronger economy, which should translate into a stronger currency.
Employment data
Employment data is highly correlated with gross domestic product—the relationship between unemployment and GDP is known as Okun's law, named after the economist Arthur Okun. This high correlation makes employment data a key fundamental Forex indicator.
Higher employment rates mean a stronger economy, which should translate to a stronger currency.
U.S. Non-Farm Payrolls (NFP). This is the U.S.’s key employment statistic and covers 80% of the U.S. workforce (it excludes farm workers, private household employees, actively serving military personnel and non-profit organization employees). The Bureau of Labor Statistics collects data from about 130,000 businesses and government agencies monthly. NFP is one of Forex's most impactful economic data points, and I will talk more about it in this article.
Inflation Rates
All developed nations aim to keep inflation at strict target levels. High inflation erodes “real income” because the cost of everyday goods and services people buy increases, and their disposable income decreases. Inflation is commonly measured by the consumer price index (CPI).
Interest Rates
Central banks use interest rates as the main tool to control inflation. When traders look at inflation numbers, they also consider how the central bank will position interest rates in the future to control it.
Higher interest rates attract more currency holders, indicating a stronger currency.
Other Fundamental Measures
Many other fundamental measures impact currency prices. These include:
- Trade Balances: A country's trade balance (exports minus imports) can strengthen or weaken a currency.
- Purchasers Managers’ Index (PMI): a monthly indicator of U.S. economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. Economists consider it a key indicator of the state of the U.S. economy and confidence about spending.
- Average Hourly Earnings: An important indicator of labour cost inflation and the tightness or capacity within labour markets. The U.S. Federal Reserve pays close attention to this statistic when setting interest rates.
- Retail Sales: For example, in the U.S., consumer spending, or retail sales, account for 70% of GDP. Growing retail sales normally suggest a buoyant economy.
When & How to Use Fundamental Analysis in Forex Trading
Become familiar with the economic calendar.
Most key fundamental measures have scheduled release dates and times. Plan with your trading and know which economic announcements are expected for the currencies you wish to trade. For example, if I am trading EUR/USD, I will look for FOMC announcements, retail sales, GDP, and especially non-farm payroll numbers.
Bloomberg and Forex Factory offer two of the most popular economic calendars. One thing I like most about these calendars is they show which announcements have historically impacted the markets. Not all announcements will have the same effect on Forex prices.
Journal how the price moves as announcements are released.
I want to underline the benefits of journaling or record keeping, not just keeping a mental note. For example, when I journal, I can return to my notes and see if the price has moved consistently across similar economic announcements. Some announcements move currency prices quickly, and some can create more sustained trends. Experiencing and recording this in a live environment is an especially useful learning tool.
Forecast vs. Actual
The market will often ‘price in’ a forecast level for economic data releases. The market often moves based on whether the actual data is above or below the expected level. A bigger deviation from the forecasted figures can mean the price action is more volatile.
Economic calendars will usually show the forecast level averaged from professional economists and analyst sources. There is no consensus methodology for deriving forecast levels, so different economic calendars can have different ones.
The Importance of Non-Farm Payrolls.
The most impactful news announcement in moving the price of Forex pairs is the non-farm payroll NFP employment data. The U.S. is often seen as a proxy for global market performance – it is the world's biggest economy, and what happens in the U.S. can have a bearing on demand for goods and services elsewhere. Most traders mark NFP numbers on their calendars even if they do not intend to trade the data because it significantly affects price action in many tradable instruments.
- NFP data is usually released on the first Friday of every month at 8:30 a.m. E.T.
- Some traders refrain from opening trades shortly before NFP because the market can behave erratically. For example, if I open a long trade, the market can become very volatile with spreads widening and stop me out of a trade prematurely, even if it subsequently rises in price in my anticipated direction.
Strategy: Trade when the price goes against the economic release.
This has been my most profitable method of incorporating fundamental analysis into my trading.
I have noticed times when the market moves in the opposite direction to that which the economic data would suggest is likely. For example, if an economic data release is more bullish than the forecasted level, but the Forex pair moves down. In this case, there is possibly an underlying bearishness that even Fundamentals cannot save.
I then go short on the Forex pair because of the unexpected bearish reaction (keeping a stop loss usually above the last known resistance level).
Pros & Cons of Fundamental Analysis in Forex Trading
Pros
- Fundamental conditions can ultimately drive large trends. Understanding these conditions helps me see the market with more context and conviction and helps me stay longer in trends.
- When the price action deviates from the expected fundamental data, it shows a deeper underlying bearishness or bullishness, a powerful signal to enter a trade.
Cons
- Subjectivity. All trading is subjective, but fundamental analysis is more subjective than technical analysis. That means it is hard to back-test or even objectively forward-test.
- Timing price moves. Fundamental factors often take time to work themselves into price action. And the markets often anticipate economic changes many months in advance. For example, the equity markets often start moving higher months before the end of a recession is official.
Bottom Line
Fundamentals can ultimately drive large price moves and long-term trends. Fundamental analysis can boil down to a few key indicators, such as GDP, CPI, interest rates, retail sales, employment data, and manufacturing data, which help determine an economy's health and how a currency's value should move over time. Seeing the price move unexpectedly relative to fundamental data is also valuable for spotting underlying bearishness or bullishness.
FAQs
What is the best fundamental indicator for Forex?
GDP and non-farm payrolls because they directly point to an economy’s health.
What is the most accurate indicator for Forex?
GDP, non-farm payrolls, inflation, and interest rate announcements impact currency prices most.
What fundamentals should I look for in Forex?
GDP, retail sales, and employment data change over time because they point to expected growth or decline in a country's economic size.
What are Forex fundamentals?
Forex fundamentals are macroeconomic data that indicate a currency’s relative value.