Forex Currency Trading For Beginners – Fundamental Analysis
Fundamental analysis is the study of the reasons behind why a currency appreciated or depreciated and it’s an important basis for decision making for beginners in forex currency trading. Factors to be considered include, amongst other things, the employment rate, inflation and interest rate outlook, and these are all influential factors behind a currency move. The reasons used in fundamental analysis are explained below for the beginners who want to participate in forex currency trading
It is usual for Central Banks such as the Reserve Bank of Australia, Bank of England and the Federal Reserve to decide on the interest rate level for their country. Interest rate setting form part of monetary policy and are a key determinant of the value of a country’s currency. As an example, a country with a higher interest rate is likely to have a stronger currency than a country with a lower interest rate. A high interest rate environment is attractive for investors as the return on their investment is greater, i.e. an interest rate of 5% is more attractive than an interest rate of 0.5%.
Interest rate outlook is also important. A country with a positive interest rate outlook, or one whereby future expectation is for interest rates to rise, is likely to witness currency appreciation; whereas a country with a negative interest rate outlook compared to another higher yield environment is likely to see its weaken.
The level of a country’s inflation can have a positive and negative effect on a currency value. From an investment perspective, inflation erodes the real rate of return on an investment. Consider an investment that has yielded 7% per annum. In one country the level of inflation is 2%, whilst in another inflation is 6%. The real rate of return is higher in the first country, 5% in this case, as inflation or the cost of living is lower than it is in the second country.
It is important to understand how the inflation outlook can affect the value of a currency. If it is expected for inflation to rise, and in turn for the country’s Central Bank to raise interest rates in response (part of monetary policy), then the value of the currency may appreciate due to the positive interest rate outlook. Low inflation can cause the Central Bank to adopt a low interest rate environment, thereby reducing the yield potential for investors.
The current state of the country’s economy, as well as future expectation, is an influencing factor. This can be a combination of a number of key indicators, including the general level of employment, interest rate and inflation outlooks, as well as the level of manufacturing activity.
The level of output, otherwise known as Gross Domestic Product (GDP) is significant here. Developed countries such as the US, UK and Australia will generally aim for around 3% GDP growth each year, whereas developing countries tend to have a higher rate of GDP relative to previous years.
Positive and negative GDP outlooks have respective positive and negative effects on a currency.
Currencies are very sensitive to overall market sentiment. In times of market nervousness, investors react in a “flight to safety” whereby they take their money out of riskier or higher yield investment for the relative safety of US Government bonds or gold – both of which are US Dollar denominated. Hence in risk events or times of nervousness, you may see the US Dollar strengthen in reaction.
A positive market outlook tends to encourage investors to invest in higher yielding assets, such as currencies with a higher interest rate (New Zealand and Australia, and the emerging economy currencies as an example), or commodities. Some countries with a natural source of commodities, such as Australia and Canada as an example, tend to appreciate in times of positive outlooks.