Trading CFDs carries considerable risk of capital loss. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you can afford to take the high risk of losing your money.
In order to establish both the state of the market and also the most probable direction of any future currency exchange rate movement two types of analysis are undertaken and one of those is Fundamental Analysis. Fundamental analysis requires learning the macroeconomics of a country and establish the impact this has on the value of its currency. Fundamental analysis is the analysis of all the forces that influence the economy. We can break down the fundamental factors into four categories:
The fundamental analysis identifies those drivers that the broader markets use to guide capital flows. This typically involves economic growth, interest rates or market themes for larger trends; and scheduled event risk for short-term volatility. If technical analysis studies chart patterns, fundamental analysis studies the causes of market movements and why chart pattern form. The major fundamental factors that professional traders use when making a trade decision, include GDP growth figures, unemployment rate, inflation, monetary policy changes, geopolitical affairs and many others.
We have to keep in mind that everything is relative in this market. You’re trading two currencies against each other; you’re not trading just one thing. In this regard, one currency will appreciate against the other currency regardless of what direction is going. If, for example, we look at the EUR/USD, it’s either Euro appreciates against the US dollar, or the US dollar appreciates against the Euro. To get that appreciation or ups and downs in the currency exchange rate, we need to see a relative performance.
One of the things that relative performance really plays through is the GDP or economic growth. How is the US economy performing against the European economy? This is the kind of question a fundamental trader would need to ask. The GDP factor is a very easy kind of measure and an easy indicator to see how it’s working, but this is not for short-term trading as it comes out on a quarterly basis.
Strong and positive economic growth doesn't always translate into a strong currency. The markets are way too complex than this simple cause and effect theme. A fundamental trader needs to look at the economics of a country as a whole, not in isolation, and compared to the economic performance of the other country.
Interest rates are actually one of the most critical components of fundamental analysis. To understand how the Forex exchange works, it's critical to understand the role of interest rates play in the marketplace. Each country has their key interest rate and yields depending on their macroeconomic conditions and inflation expectations. Investors are generally looking for higher yields and currencies with higher rates tend to attract more capital inflows.
In theory, higher interest rates mean stronger currency, while lower interest rates mean weak currency exchange rate. Investors usually will borrow in a currency with low interest rate and park the money in assets or country with higher interest rates. At the end of each day, the investor pockets the rollover interest. In the financial world, this type of investment is called the carry trade.
This strategy of being able to sell a low-interest rate currency and simultaneously buy a higher interest rate currency only works when the exchange rate for the currency with the lower interest rate is falling. The risk to this strategy happens when the opposite occurs as the investor can lose more on exchange rate changes than he gets in rollover interest.
If the economic factors provide us with a degree of predictability, the political factors often can be unpredictable. This is the most difficult thing to grasp without a doubt. There are many themes that could be played out any one time and deciding which market theme has more weight on the currency exchange rates requires some experience. Trading currencies that are currently driven by political themes require first to establish what the market expectation for that particular risk event is so we can learn what the general consensus is. General elections, referendums on important issues, geopolitics and wars are all major risk events that have the potential to distort the market volatility and can be the catalysts for a black swan event.
Financial news has both a real and a speculative value. This is because, on the one hand, the financial news actually shares something about how the economy has performed. And on the other hand, traders also react to the news which accounts for the speculative value. The speculation because of financial news often starts before the news is out. Hence the saying “Buy the rumor, sell the news,” which happens because traders start speculating on what the news might be.
For instance, when the Fed is about to have a press conference in the coming days and there is a rumor that the interest rate will probably be lowered by the central bank because they want to stimulate the economy. You’ll see in the days leading up to the event, traders will start taking positions reflecting that probable decision. When the decision is actually made public and it turns out that the Fed indeed cut interest rates it’s quite possible that the EUR/USD exchange rate moves in the opposite direction you would expect because the decision was already priced in. If you’re a short-term trader, it’s important to keep a close eye on the financial news because unexpected news can hurt your position. On the other hand, the changes in the central bank’s monetary policy also affect the bigger trends. Being aware of the fundamentals of a currency pair can bring more light into the technical trends and potentially can be a source of new trading ideas.