Fundamental analysis is one of the essential aspects of forex trading. A lot of traders think that technical analysis can be helpful when it comes to predicting price movements. However, combining technical and fundamental analysis offers better results.
Fundamental analysis involves analyzing social, political, and economic forces that affect currency prizes. It also involves analyzing news headlines and economic data reports. Fundamental analysis gives traders a clear picture of what they need to do to make money from the forex market.
Key Economic, Political and Social Factors that Affect Exchange Rates
Economic events have a lot of influence on political and monetary policies. Therefore, it is essential to understand how certain economic conditions and factors will affect the volatility of currency prices. Understanding these events and their effects will enable a trader to take advantage of currency price movements.
The economic health of a country significantly affects the currency exchange rate exchange. A good economy leads to a higher currency value, while a bad economy leads to a lower currency value. A strong economy attracts foreign capital, which drives up the currency exchange rates. Robust economies have low unemployment rates; thus, people have money to spend.
Inflation is the purchasing power of one currency compared to another. Inflation is the reason why different currencies have different purchasing powers. Inflation can also be responsible for fluctuations in currency exchange rates.
Countries with high inflation rates have weaker currencies, while those with low inflation rates have stronger currencies. Forex traders should understand the changes in inflation rates and their effect on exchange rates. Understanding this will enable them identify opportunities and know what currencies to trade.
Interest rates significantly influence exchange rates and inflation. Central banks use interest rates to control inflation. High interest rates attract foreign capital, which strengthens local currency exchange rate. However, if the rates are high for too long, inflation goes up.
A politically stable country will attract foreign capital, which will improve the exchange rate of its currency. Political stability also affects financial policies and economic drivers, which have long-term effects on the exchange rate.
Political instability drives investors away. The economic environment is adversely affected, and the local currency weakens.
Many countries borrow to finance economic growth. However, too much public debt can lead to inflation and deter foreign investment. This will have a direct effect on currency strength and the exchange rate.
Balance of Trade
The difference between a country’s exports and imports is referred to as balance of trade. If a country’s exports exceed its imports, then it has a positive balance of trade. A positive balance of trade means that foreign currency inflow is higher than outflow, which strengthens the local currency’s exchange rate.
On the other hand, a country that imports more than it exports has a negative balance of trade. This means that the inflow of foreign currency is lower than the outflow, hence a weaker exchange rate.
Confidence and Speculation
The confidence level of traders can affect the exchange rate of a currency. Currency fluctuations from speculation are mostly sudden, irrational, and short-lived.
For example, economic news may make forex traders either bearish or bullish on a currency, which will affect the exchange rate. However, the economic information itself did not affect the currency fundamentals.
Governments use several techniques and tools to manipulate their local currency exchange rates. Some of the methods that central banks use include adjusting local lending rates, buying foreign currency, printing money, and adjusting interest rates.
The main objective of manipulating these factors is to have favorable conditions for cheap credit, economic growth, more jobs, and eventually a stable currency exchange rate.
Current Account Deficit
The current account deficit and balance of trade are closely related. A country’s current account deficit is compared to that of its trading partners. If a country has a higher current account deficit than its trading partner, then the country’s currency with a higher deficit is weaker.
Countries with low current account deficits have stronger currencies, while those with high current account deficits have weaker currencies.
With the help of fundamental analysis, forex traders can gain a deeper understanding of the factors that influence currency exchange rates. Analyzing these factors provides traders with accurate and timely information that will help them trade currencies successfully.