With broad risk sentiment taking a backseat to economic data, more and more traders are paying attention to the fundamental drivers of each currency.
Remember that fundamental analysis is simply a way of looking at an economy to gauge the supply and demand of a country’s currency. The problem starts when investors look at too few or too many economic factors, which tends to limit or overwhelm their economic research. Here are three major factors that you can start with:
1. Economic Outlook
Economic development attracts both local and foreign investors. As they buy more assets to support their investments, the demand for the country’s currency inevitably rises. The gross domestic product (GDP) is one of the most closely watched reports as it paints a picture of a country’s economic activity.
The U.S. nonfarm payrolls, unemployment rate, and retail sales also get attention as they give clues on present and future consumer activity. Last but not the least, the local stock markets, as well as investor, consumer, and business sentiment reports hint at the overall optimism for the economy.
Not all reports cause volatility though. For example, new motor vehicle sales are big in Australia but they don’t usually get much attention when the U.S. numbers are released. The key is in knowing which reports matter most for each country. If you need help identifying which reports are likely to cause volatility, you can always head over to our Forex Calendar for guidance.
2. Political Stability
Remember when the dollar fell across the board on Obama’s re-election? How about the yen’s dramatic plunge at the election of Shinzo Abe in Japan? And why the heck did the euro weaken when Silvio Berlusconi announced his intention to return as Italy’s Prime Minister?
A currency’s value usually rises when investors believe that a government leader and his or her policies could promote economic growth. On the other hand, political instability (which could lead to leadership and policy changes) or the election of leaders who aren’t favored by the markets usually weaken currencies.
3. Monetary policy expectations
While economic activity and political stability hint at the demand for a currency, central banks control the supply of money circulating in their respective economies. They use monetary policy tools such as asset purchases, interest rates, reserve requirement ratio (RRR), and even central bank interventions.
The forex markets revolve around these policies because they tend to have the biggest direct affect on a currency’s value. Basically, more money in the markets usually results in a weak currency while a limited supply tends to increases its value.
Remember that not all banks use the same tools. China often adjusts its RRR; the Reserve Bank of Australia (RBA) mainly uses its interest rates, and the Fed and the Bank of Japan (BOJ), whose interest rates are already at rock bottom, now use asset purchases.
To get an idea on which direction the central banks want their currencies to go, pay attention to monetary policy statements, meeting minutes, and even speeches from central bankers.
Fundamental analysis is no walk in the park for many traders. After all, economic events could easily be interpreted in a thousand different ways. But if you know which factors currently matter most and how one scenario could impact a currency, then you know you’re off to a good start and maybe even increase your edge in the markets.