Fundamental Analysis

To illustrate fundamental analysis, a couple of years ago while I was busy trying to look for a trend in the EUR/USD technical charts, Warren Buffet hinted that he was selling the dollar. Two years later, I think I would have done better just believing the “Oracle of Omaha”.

Fundamental analysis focuses on the economic, social and political forces that drive the demand and supply of a currency. It is the fundamental forex analyst or trader who is interested in the economic growth rates, interest rates, inflation, unemployment and other macro economic factors that affect a currency.

Some of the events that move the market include the forces of demand and supply of the country, economic data, political developments and unrest, unemeployment levels, interest rate cuts and much more. They are all socio-economic based factors.

There is a common misconception that the fundamental trader sticks next to his computer trying to gain quick profits through trading economic news. Pure fundamental traders are usually long term traders who are not interested in the daily prices of a currency. Fundamental forex traders are some of the best educated traders out there.

In fundamental analysis there are two main factors that impact exchange rate fluctuations:

1. Capital Flows and
2. Trade Flows



1. Capital Flows

Suppose that the British economy is booming and the stock market is also doing very well. At the same time, in the USA, the economy is sluggish and there is a shortage of investment opportunities. With the current mortgage crisis in the USA this is not really hypothetical is it?

So, since most fundamental traders are after profits they would invest either in assets or property in the UK for the reason that the market is likely to produce higher returns.

If you are from the USA, you need to trade using the British Pound in order to buy a property in the UK. You will then sell your USA dollars in exchange for British pounds. This will lead to an increase in demand for the GBP and a decline in demand for the USA Dollar. In other words, the GBP/USD will increase in value.

Refer to the screenshot below for a simple explanation of the above scenario:

The more you sell to other countries, the higher the demand for your currency will be in order for people to buy your products. It is that simple.

Countries that export more than they import are more likely to see their currency values rise. International clients interested to buy their products must first buy their currency, thus increasing the demand for the currency of the exporter.

The reason why the Yen continues to be so strong internationally even with 0% interest rates is because you will find a Toyota or a Nissan in every country in the world. Japan is a net exporter and thus you need their currency to drive that Toyota.

Fundamental analysis also focuses on the balance of payments of countries. If a country is moving from a net exporter to a net importer, it probably means that their currency would be reducing in value over time.

Besides keeping track of capital and trade flows, the fundamental trader must also keep track of perceptions associated with a particular currency. No matter how much the numbers indicate that a currency is going strong, if the people using that currency perceive it to be weak, the currency value might continue falling.

Even if President Robert Mugabe tells the whole world that his country’s economy is strong, the Zimbabwe dollar will continue falling as long as his people do not think so!

As you can see, the life of a pure fundamental trader is not boring at all. Fundamental analysis requires one to constantly stay up-to-date with capital and trade flows, the interest policies of central banks and other many more economic news.

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