How to use fundamental analysis correctly?

22.07.2021

When we look at the chart of a financial instrument, the first question we all ask ourselves is what are the reasons for price movements. The answer is most often rooted in fundamental analysis. This is the analysis that examines the main reasons behind the movements of the financial markets and its understanding is essential for the success of each market participant.

Even if we base our buying or selling decisions primarily on technical analysis, our understanding of fundamental analysis and the effect it has on markets will certainly improve our overall understanding of markets.

In this article, we will look at the most important things that market participants need to monitor in order to make optimally informed trading decisions through fundamental analysis.

1. Market sentiment

Before looking at the various economic indicators separately, we must first talk about the market sentiment. Simply put, this is the event or events that currently have a strong impact on markets and in particular on investor buying or selling decisions. It is important to note here that such events are in no way necessarily purely financial or economic.

The past few years have been volatile for the financial markets. In the United States, Trump was elected president in 2016, and one of the hallmarks of his term was the trade war with China. We have all witnessed how the major indices, gold, and oil are able to erase a large part of its price solely thanks to a post on the social network by the president, related to the trade war. Markets were in no way concerned about economic indicators, the current state of the monetary policy, and labor market data. Everyone was watching with great attention what would happen to the tariffs between the countries and whether a possible deal would be reached.

In parallel, another important event had a strong impact on the British stock and foreign exchange markets - Brexit. Absolutely everything related to Britain's leaving the European Union created panic volatility in the pound, making it one of the most volatile currencies. For several years, economic indicators such as inflation, the labor market, and GDP haven't big influenced the movement of the currency. Investors just didn't look that way. Interest was focused on the outcome of Brexit itself.

Last year, we saw what happened to all classes of instruments because of the global pandemic. Within a few months, the markets lost all connection with reality.

Therefore, before focusing on the real economic foundation, it is important to first understand what is actually affecting the market at the moment and what is currently influencing the investment decisions. At a time when the global political and economic situation is relatively calm, markets are beginning to naturally pay attention to key economic indicators.

2. Fundamental analysis

Several more important and key elements of the fundamental analysis stand out, which central banks follow closely when making decisions related to their monetary policy.

Interest rates

The most important factor influencing the movement of currencies, in the long run, is interest rates. We could say that in practice the interest rates show the true investment value of the currency, ie. what is the benefit of the investor to keep his money in dollars, euros, or other currency.

The high-interest rate is a consequence of a growing economy and rising inflation, and it follows that strong economies will have expensive currencies against others, not so well developed. Here it is important to note that for traders it is not the interest rate itself and its possible adjustments that is important, but the trading of the potential opportunity for such. Long before the official decision of a central bank, the market has already consumed the possible change in monetary policy. The purpose of a trader is not to trade the raising or lowering of the interest rate, but the possibility of such during the period when the price consumes it.

An important element related not only to interest rates but also to monetary policy, in general, are central bank statements. To understand what the bank is more likely to do in the medium term, we need to follow the statements of the central governors, as this way we can understand what are the current priorities for the bank, as well as what economic indicators will be monitored. In the chart below we can see the effect of such a statement by the Fed on the EURUSD pair.

Inflation

Inflation is one of the most important economic indicators to monitor. As we said above, one of the main factors against which the interest rate is determined is the level of inflation. The inflation target of the major central banks around the world is 2% on an annual basis. When inflation starts to rise (especially at a faster rate), the central bank must regulate this growth, and this is done by raising interest rates. Conversely, when inflation is below 2%, the bank lowers interest rates to stimulate the economy and growth. The aim is to introduce additional liquidity to help economic growth.

Important economic indicators that measure the level of inflation are CPI (Consumer Price Index) and PPI (Producer Price Index). The chart below shows the US inflation effect on the price of the EURUSD pair.

Labor market

In the United States, every first Friday of the month, investors closely monitor the publication of the NFP report - measures the change in the number of people employed during the previous month, excluding the farming industry. This is the most important indicator related to the labor market in the largest economy in the world and usually, when there are significant discrepancies from the expected values, it is possible to observe increased market volatility.

Other important indicators related to the labor market are the Initial Jobless Claims and the Unemployment Rate.

Economic Growth

The most important economic news that shows an economy's growth are GDP (Gross Domestic Product) and retail sales. Usually, around their publication, there is increased volatility and as traders, we need to know the day and time of their publication.

3. How to make full use of fundamental analysis?

The first question we need to answer when working with fundamental analysis is what is currently affecting the markets. It is quite possible that investors are currently excited about events that are very far from the real economic situation and that the indicators related to an economy are completely insignificant at the moment.

However, in cases where the interest of investors is riveted to potential changes in monetary policy, economic indicators are those that show us what is more likely to see in the movement of the currency in the medium term.

Currency trading

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