Fundamental analysis involves analyzing certain types of fundamental data in order to get a better understanding of the factors that affect supply and demand for a particular asset class. Just like other assets, Forex prices are largely driven by the global supply and demand for a particular currency. For instance if there is little demand and numerous sellers, then prices are very likely to fall. By looking at economic, social and political data those using fundamental analysis hope to get an insight into what is going to drive supply and demand, ultimately causing prices to change.
While supply and demand are certainly the major factors behind currency price fluctuations, working out and analysing all the factors that influence supply and demand is a much more challenging task. When evaluating the relative strength of different economies fundamental analysts take in a number of different factors. For instance certain events such as slowing economic growth or increased unemployment can harm demand for a countries currency and thus negatively affect the price of a particular currency.
Broadly speaking if a countries current or future economic outlook is good then the country’s currency should strengthen against various other currencies. For instance a strong economy will attract foreign businesses and investors into the country, who will then have to purchase the country’s currency in order purchase assets and open up shop. Again strong economies tend to export lots of goods to the rest of the world; these buyers are forced to purchase the country’s currency in order to be able to take hold of the goods further increasing demand for a currency. This is why many traders pay so much attention to economic data.
If the Great British pound has been strengthening due to fast paced economic growth in the United Kingdom, fundamental traders might speculate that the Bank of England will be forced to step in and increase interest rates to stop the economy from overheating. These increased interest rates will make Pound-denominated financial assets more attractive and lead to wave of what is known as ‘hot money’ flooding into the UK economy. This hot money would likely lead to a short term increase in demand for the Pound and would likely see the Pound strengthen against other major currency pairings.
Understanding and interpreting all the economic data released can be a complicated task, but many traders have successfully incorporated at least some fundamental analysis into trading strategy. It is almost impossible to trade during news time if you don’t have some understanding of how economic data can affect the Foreign exchange markets.