A Guide to Fundamental Analysis in Forex
Investigate the behavior of central banks
Central banks have an immense role in determining forex trends. Perceptions about supply and demand naturally play a great role in determining speculator sentiment, and the supply of a currency is usually decided by the central banks of nations. Central banks "print" money, and can control, indirectly, the supply of their national currency by lowering or increasing interest rateas and influencing the borrowing environment of a nation. But not all central banks are equal. In general, forex trends are determined by the laxity or strictness of the world`s few major industrialized nations. If these nations pursue a lax monetary policy, carry trades, risky currencies appreciate, while the currencies of major nations depreciate due to their funding role in sponsoring the growth of other nations through capital outflows. By contrast, if these central banks pursue hawkish policies, the resulting contraction of inflows to growth centers results in a scarcity of funding sources, causing their appreciation, while risky assets lose value since higher cost of borrowing in advanced nations reduces demand.
Examine interest rate environment
Central banks are the main source of a nation`s currency. As such, they have the power to set the interest rates of the cheapest funds in an economy, which they print (almost always electronically), and then lend to large banks to allow them to extend credit to citizens. But while each central bank determines its domestic policies independently of others, in practice, since every nation is subject to the whims of the commodity markets, and international trade, monetary policies of certain groups of economies tend to mirror each other. For example, exporters in Asia that follow the Asian model, will tend to devalue their currencies in tandem in order to avoid losing competitive advantage. Similarly, the large, consumption-oriented economies of the west will focus on controlling inflation, with interest rate trends mirroring each other with lags. Understanding these factors enables us to narrow down our potential trades further.
Consider credit standards, and money supply growth
At the final stage of this step, after examining interest rate policies, we take a look at the details that cause the observed trends in monetary policy. In particular, analyzing trends in credit markets help us a lot in determing the longer-term direction of stock and forex markets. Since growth in most advanced nations is sponsored by lending, credit trends correlate well with the economic cycle, helping us identify potential trades with greater clarity. If, for example, we observe that for a certain economy credit trends show strong expansion, we can expect the growth of this nation to be sustained at a high level, which then would justify our purchase of its currency. (Of course, if there is more than one nation, as it is likely, experiencing such a trend, we will narrow down our choices in light of the other criteria in this article.)
Decide which currency to buy
After determining which type of currency we wish to buy (advanced economy, exporter nation, commodity currency, etc.) we must reduce the chosen group to its individual members to enter a position. This is done on the basis of a risk/reward analysis of the balance of payments and interest rate differentials of the nations concerned. The same procedure is also to be utilized in determining which currency we should sell to fund our long.
Examine interest rate differentials
The easiest way of determining, the volatility, and therefore risk profile of a currency pair is examining its interest rate differential. The higher this gap is, the more profitable this trade will be, but at the same time, the currencies are likely to move in opposing directions with rapidity and momentum, and the swings will require a greater buffer zone in order to ensure the survival of the trade. Keep in mind, however, that the swings can be so large, that even the entirety of funds in an account may not be enough to save it from being liquidated. In this case, adopting lower leverage would help ensure the longevity of our position.
Study the balance of payments details
In the second stage, we compare the balance of payments details of the currencies we purchase and hold to gain an accurate opinion on the risk that we assume. An economy with a current account deficit is being run on debt or asset sales, and is vulnerable turmoil in the international finance world. Although the details can be complicated, one can have a general idea by comparing the deficit, if it exists, to the GDP of the nation. The higher this ratio is, the higher the risk of the currency, the greater the chance that it will experience violent swings to either side.
Conclusion
The best way of gaining a practical understanding of the method we describe here is practicing it. Utilizing very low leverage, committing a small amount of funds, and trading with a long-term view in mind will force you to familiarize yourself with the fundamental approach, since fundamental factors begin to dominate as the time-frame of a trade expands. In all cases, however, make sure that you never commit more than you can afford to lose, so that if there are disappointments, you can brush them aside as the cost of your learning experience.
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Being a contrarian in the short term, while following the market in the longer-perspective is the core of a trend-following strategy
Article written by http://www.forextraders.com
Study the secular characteristics of economic events
The first step of our analysis must begin at the highest level in order to help us put the various pieces of information into their proper context. To do this, we need to understand the background to short and medium term economic events that are often part of multi-decade trends that define the behavior of consumers, corporations, and the finance sector. We would like to determine the type of growth the world economy is experiencing, so that we can isolate the appropriate long-term strategies to exploit it. If we assume that the trading decision is like building a pyramid, by analyzing the secular factors, we build the base of the structure.
This stage of analysis is not confined to economic factors, but must incorporate social and political factors into the frameowrk defining the spirit of the times, so to speak. the repeal of the Glass-Steagal Act, leading to the subprime crisis, or the collapse of the Soviet Union, leading to global liberalization of economics and finance, are excellent examples. In general, an event does not need to be economic in nature to have a long term significance for markets. Since markets are driven by sentiment, the main determinant of sentiment, regardless of its nature, must be regarded as the trigger point for markets action. Based on the consequence of this stage of analysis, we`ll determine whether we should be optimistic or pessimistic about growth in comparison to the prevailing market opinion. And on this basis, we can construct our longs and shorts on particular classes of currencies.
Examine the phase of the cycle
Apart from the details that relate to politics and social life, we must determine the phase that the global economy is going through in order to determine what kind of bias we`ll have while taking longer-term positions. Economies around the world are strongly integrated with each other, so it is possible to speak of a global boom-bust cycle. During the boom phase of the cycle we`ll have a preference for higher-yielding, risky assets, while during the bust phase we`ll anticipate that the safest asset classes will appreciate as fewer numbers of investors exist.
Explore the background to market developments
When we speak about the background, we must think about factors such as technological progress, emerging market fundamentals, political conditions and similar variables. One example of a time when politics possessed a powerful role in determining market direction would be the decade of the 70s. Because of various complicated political events, markets at that time failed to take off in a meaningful manner. Another example, of course, is the decade of 1990s. At that time, information technology driven productivity gains led to a great improvement in profitability, and also enabled widespread access to the stock market. This process culminated in the bust of 2000, in this case, but in the period leading up to that year, there were ample opportunities for exploitation.
After determining the nature of the secular trend, we must look at the trends in the finance world that are often decided by central bank biases.