Do you remember the first time that you came across the financial markets, or more specifically, forex trading?
Unless you had a keen interest in economics, it's highly likely that you were almost immediately drawn to technical analysis (T.A). Those attractively colourful indicators, pin-point accurate support/resistance lines and rumours of other technical traders trading for a living, is usually enough to lure the majority of newcomers into this category. There is, however, another technique used to analyse the markets: fundamental analysis (F.A).
Both approaches have strengths and weaknesses. Some traders choose solely to adopt one method over the other, whereas other traders elect to use both.
What is fundamental analysis?
When traders elect to follow F.A, what they're really doing is analysing the economic situation of a country, and its potential effects on its currency. Through research of macroeconomic events and geopolitical data, market speculators essentially try to foresee future exchange rates.
Just like T.A, F.A also has a wide-range of indicators on offer, with some attracting more interest from the financial community than others. A country's employment situation, interest rates, housing, balance of trade, growth data and inflation figures are just some of the top-tier indicators fundamental analysts use to gauge a country's well-being.
Economic Indicators that print better-than-expected numbers over consensus is usually deemed good for the country's currency, and imply that the country's central bank may look to take on a hawkish stance. This basically means that interest rates could increase. On the other side of the coin, disappointing numbers could force the country's currency southbound and cause the central bank to step in and take a dovish stance by lowering interest rates.
Apart from the economic indicators that grace the news calendar virtually each business day, F.A goes a lot deeper than this. For example, when the UK voted for 'Brexit' the British pound took an absolute hammering and dropped more than 20% in value against the US dollar. Now, even if there was an economic indicator that chalked in upbeat news for the GBP that day, it would have likely been ignored! The steep downward move on the GBP that day was a direct market reaction in response to the result.
More recently, we had the UK elections. As no party secured an outright majority, Britain is facing a hung parliament. This saw a 250-pip bearish move take shape on the GBP/USD pair in space of a few minutes! This, again, was a direct market reaction in response to the result.
A brief look at the US employment report
As this is one of the most eagerly awaited economic indicators, we thought it'd be an idea to peer into this market-moving report to give you a brief idea of what we look at…
First of all, let's just say that the US employment report is extremely well timed as it's released after the end of the month being reviewed. Timing is important!
It's also a leading indicator of consumer inflation. This is because when businesses pay more for labour, the higher costs can sometimes be passed on to the consumer. The economic statistic that generates the most excitement within this report, though, is the monthly change in non-farm employment. Other figures that warrant close attention are the following:
- The unemployment rate.
- Average hourly earnings.
- Participation rate (commonly known as labour-force participation rate).
US employment news can greatly affect the dollar's value in the currency markets. After a string of better-than-expected months, it can suggest that the Fed may increase interest rates which generally attracts investors. By the same token, weakening employment data may well indicate that the Fed could step in and lower interest rates, which would likely see a dollar selloff.
The US ADP non-farm employment change is another indicator worthy of mention. This data provides an early look at employment growth, and is considered to be a precursor to Friday's BLS (Bureau of Labour Statistics) non-farm employment change as it's released the day before.
Different ways of using fundamental analysis
With the majority of technical traders viewing charts differently, we believe it's also fair to say that not all traders view fundamentals the same way as well.
For market participants who favour T.A, some will occasionally use the economic indicators as a way of knowing when to step away from the market, or reduce risk. For example, say that one has a long trade that's in profit on the EUR/USD pair, and the non-farm employment report (see above) is due to be released within the hour. Does that trader hope that the number favours the current position? Of course, one could do this but it is not something we'd advise! Letting a winning trade turn into a losing trade is NEVER fun! To our way of seeing things, the trader has the following options:
- Close the trade in profit and be satisfied with what the market has already provided you.
- Take partial profits and reduce risk to breakeven.
- Depending on by how much the current position is in profit, move the stop-loss order below/above clear structure. With this you're essentially using market structure to hide your stop from any possible gyrations the non-farm payrolls report may cause.
Another way of utilising fundamentals is by incorporating a fundamental trigger alongside a technical entry. Let's imagine that the Federal Reserve has been talking about raising interest rates for a while now, and you're seeing a considerable amount of dollar buying come into the market. Of course, one could simply buy on the premise that the dollar is the favoured currency at the moment. However, we'd personally prefer to wait for a break above a noteworthy resistance or a trendline resistance followed by a retest as support, as it would, at least in our book of setups, be valid technical confluence for a long entry.
Instead of using the central bank's words as a fundamental trigger, one could, if you're looking to trade intraday, use the top-tier market events scheduled for that day to find a potential trading opportunity. Say the Aussie dollar had been trading beneath resistance over the past couple of days, and housing data recently came in much stronger than expected, forcing the unit above this line. Now that short-term sentiment has cleared this level, should a retest of this base come about and hold successfully as support, then a long from here is certainly worthy of consideration.
If you're a longer-term trader who prefers to ride trends or catch huge reversals, you can, as we briefly highlighted above, also make use of F.A in gauging how economic data can affect central banks' interest-rate decisions and monetary policy actions. Interest rates vary for different economies and central banks are able to raise or lower these in order to maintain price stability and boost economic growth.
We agree that there's a plethora of information to take on board regarding the fundamental landscape, so we're not surprised that a great deal of traders coming into the business choose to adopt a technical approach. Still, we feel that completely ignoring the fundamental events is extremely risky. Even knowing when the next few high-impacting events are scheduled for release can save one an unnecessary loss!
For those interested in furthering their understanding, we would advise beginning by learning how to interpret the economic indicators. A noteworthy book: 'The Secrets Of Economic Indicators' by Bernard Baumohl is fantastic, and will really help one understand how economic indicators function.
Apart from economic indicators, traders are also urged to keep abreast with the current economic climate of the market you're trading, such as: upcoming elections, wars, comments from political figures and also speeches from key members representing major central banks.