What Is Fundamental Analysis?

Fundamental Analysis is a broad term that describes the act of trading based purely on global aspects that influence supply and demand of currencies, commodities, and equities. Many traders will use both fundamental and technical methods to determine when and where to place trades, but they also tend to favor one over the other. However, if you would like to use only fundamental analysis, there are a variety of sources to base your opinion.

Central Banks

Central banks are likely one of the most volatile sources for fundamental trading. The list of actions they can take is vast; they can raise interest rates, lower them (even into negative territory), keep them the same, suggest their stance will change soon, introduce non-traditional policies, intervene for themselves or others, or even revalue their currency. Fundamental analysis of central banks is often a process of poring through statements and speeches by central bankers along with attempting to think like them to predict their next move.

Economic Releases

Trading economic releases can be a very tenuous and unpredictable challenge. Many of the greatest minds at the major investment banks around the world have a difficult time predicting exactly what an economic release will ultimately end up being. They have models that take many different aspects into account, but can still be embarrassingly wrong in their predictions; hence the reason that markets move so violently after important economic releases. Many investors tend to go with the (consensus) of those experts, and typically markets will move in the direction of the consensus prediction before the release. If the consensus fails to predict the final result, the market then usually moves in the direction of the actual result – meaning that if it was better than consensus, a positive reaction unfolds and vice versa for a less-than-consensus result. The trick to trading the fundamental aspect of economic releases is to determine when you want to make your commitment. Do you trade before or after the figure is released? Both have their merits and their detractions. If you trade well before the release, you can try to take advantage of the flow toward the consensus expectation, but other fundamental events around the world can impact the market more than the consensus read. Trading moments before the economic release means that you have an opinion on whether the actual release will be better or worse than the consensus, but you could be dreadfully wrong and risk large losses on essentially a coin flip. Trading moments after the economic release means that you will be trying to establish a position in a low-volume market which presents the challenge of getting your desired price.

Geopolitical Tensions

Like it or not, some countries around the world don not get along very nicely with each other or the global community and conflicts or wars are sometimes imminent. These tensions or conflicts can have an adverse impact on tradable goods by changing the supply or even the demand for certain products. For instance, increased conflict in the Middle East can put a strain on the supply of oil which then makes the price increase. Conversely, a relative calm in that part of the world can decrease the price of oil as supply is not threatened. Being able to properly predict how these events will conclude may be a way to get ahead of the market with your fundamental perspective.

Weather

There are a variety of weather-related events that can cause prices to fluctuate. The easiest example is the propensity for winter to create massive snow storms that can drive up the cost of natural gas, which is used to heat homes. However, there are a variety of other weather situations that can change the value of tradable goods such as hurricanes, droughts, floods, and even tornados. While some of these events are very unpredictable, sometimes it can help to break out the old Farmers Almanac or pay close attention to the Weather Channel to see how weather patterns might unfold.

Seasonality

The seasonality as related to weather is something that makes sense as the natural gas example pointed out above, but there are other seasonal factors that are not related to weather as well. For instance, at the end of the calendar year many investors will sell equities that have declined throughout the year in order to claim capital losses on their taxes. Sometimes it may be beneficial to exit positions before the year-end selloff begins. On the other side of that equation, investors typically come back to equities in droves in January, a phenomenon called (The January Effect). The end of a month can be rather active as well as businesses that sell products in multiple nations look to offset their currency hedges, a practice termed (Month-End Rebalancing).

Some fundamental factors are more long-lasting while others are more immediate, but trading them can be both difficult and rewarding for those who have the intestinal fortitude to trade them. Also, the fundamental factors listed above are just the start to a list that is much longer in length as new fundamental methods of trading are created every day. So keep your eyes open for new situations that arise and maybe you could be fundamentally ahead of the curve.

Central Banks

In its simplest context, Central Banks are responsible for overseeing the monetary system for a nation (or group of nations); however, central banks have a range of responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation and full employment.

Central banks also generally issue currency, function as the bank of the government, regulate the credit system, oversee commercial banks, manage exchange reserves and act as a lender of last resort.

There are eight major central banks today:

US Federal Reserve Bank (US)

European Central Bank (EUR)

Bank of England (GBP)

Bank of Japan (JPY)

Swiss National Bank (CHF)

Bank of Canada (CAD)

Reserve Bank of Australia (AUD)

Reserve Bank of New Zealand (NZD)

Central Banks and Interest Rates

The balancing act of stable employment and prices is a tricky one, and the main mechanism a central bank has to regulate these levels is interest rates. Interest rates are a primary influencer of investment flows.

The reason for either raising or lowering the interest rate and why it has an influence is easy to see when you really think about it. Consider for a moment an economic environment where banks are concerned about the economy and are hesitant to loan money out of fear of not being paid back.

If interest rates are high, the safer option would be to keep the money and only loan to those whom they feel would pay back the loan at a high interest rate. An environment of this kind would make it difficult for small businesses that do not have credit history to borrow money. Plus a higher cost to borrow may dissuade businesses from borrowing. The same would be true for individuals looking to buy houses.

If the same economic scenario were presented but interest rates were low, banks may feel that taking the risk in loaning to less-than-impeccable businesses is worth it, particularly since they could also borrow money from the central bank at extremely low rates. This would also lower the interest rates for buying a home.

Businesses borrowing money to grow their bottom line and individuals buying homes are two vital keys to a growing economy, and central banks typically try to encourage it. However, there are times when it gets a little out of control and too much risk is being taken, which can lead to painful economic downturns.

Central banks attempt to balance the needs of businesses and individuals by managing interest rates.



How interest rates influence traders

Traders are influenced by the rates at central banks as well. When buying one currency against another in a forex transaction, you are essentially taking ownership of that currency using the counter currency as the funds of your transaction. For instance, of you are buying the NZD/JPY (New Zealand Dollar/Japanese Yen), you are borrowing JPY to buy NZD. If you borrow, you pay the borrowing cost (interest rate) to get those funds, but on the flipside, you are earning interest on that which you bought. If the JPY has an interest rate of 0.10% and the NZD has interest rate of 2.50%, you are earning more interest than you are paying for the transaction.

Some investors take a long-term approach of borrowing low interest rate currencies and buying those with high interest rates, a strategy called the (carry trade). While the carry trade can be profitable, when only considering the interest earned it is typically negligible. The values of the currencies against one another plays a much bigger role in the day-to-day profitability of the position, and can far outweigh any interest earned.

Hawkish

This is a term referring to a central bank that is either talking about or actually raising interest rates.

Dovish

This is a term referring to a central bank that is either talking about or actually cutting interest rates.

Quantitative Easing

This is a method of cutting interest rates where a central bank will cash in some of its holdings and buy bonds; most of the time these bonds are long term. By entering into the long-term bond market, they are increasing demand for those bonds therefore driving down the interest earned on them. The goal of such a measure is to keep interest rates low to encourage more borrowing.

CPI & PPI Price Indices

The Consumer Price Index (CPI) and Producer Price Index (PPI) are inflationary measures used to determine whether prices for goods and services are rising (inflation), falling (deflation when below zero or disinflation when falling but still above zero), or staying the same (since there is no particular term for this, let us just call it (zinflation, for zero inflation). Just as the names describe, the CPI is a price measure of the consumer side of the equation, and PPI measures prices for producers.

These figures are widely used by central banks to determine the course of monetary policy (though admittedly not the only ones), and can have an overarching effect on virtually all tradable markets. So let us take a look at the (flation) aspect of these reports to see how they are interpreted.

Inflation

When prices are rising or staying consistently above the 0% level, it is called inflation. In laymans terms, prices are being inflated higher each year just like blowing up a balloon. Current economic belief is that a low and stable inflation rate can help reduce the severity of potential economic downturns by enabling businesses to adjust quickly. Central banks try to keep inflation in this range by lowering interest rates when it falls below 2% working on the belief that if capital is cheap to borrow, businesses and consumers will use that ability to buy things and keep the economic engine running. Conversely, if inflation runs over 3%, raising interest rates encourages those entities to save as they get more (bang for their buck) by keeping it in the bank.

Disinflation

If inflation is too low (but still above zero), you could potentially see a situation arise like what happened in Japan during the 1990s and early 2000s, a time dubbed as (The Lost Decades). During that period, inflation remained at frustratingly low levels and the nation fell into economic complacency, failing to see an increase in GDP over long stretches. In an attempt to combat that, the Bank of Japan lowered interest rates down to 0% to encourage spending over saving, but instead many businesses and individuals chose instead to borrow at the lower rates to pay off previous debts; very little of the increased available money went into consumerism or increased business activity. In later years, Japan accelerated their easy monetary policy even further by introducing Quantitative Easing (QE), which is the process of lowering interest rates further by outright purchases of government bonds or asset-backed securities by the central bank which essentially introduces more money to the current money supply. Opponents of QE argue that flooding the market with extra capital could eventually lead to…

Hyperinflation

There are times when inflation can get a little out of control, and this is defined as hyperinflation. There are many historical examples of this situation where prices rise at extraordinarily expedient rates including France during the French Revolution, the German Weimar Republic just before WWII, Russia after the fall of the Soviet Union, Zimbabwe in the mid 2000s, and even the United States during the Revolutionary War. As you can likely tell, most of these hyperinflationary episodes ended in war or were a direct result of conflict or lack of confidence in the states ability to govern. Needless to say, central banks try to do anything they can to prevent this from happening, including revaluating their currency and/or raising interest rates to levels where it becomes more advantageous to save rather than borrow.

Deflation

If prices are declining the term deflation is used. If you were to ask the average person on the street if they think it is a good thing that prices are falling, you would probably get a majority of affirmative responses. Who wouldn not want the prices of the things you buy every day to be cheaper? Well, manufacturers, for one, would not like it very much. It means that the margin they make on the products they produce would go down, which means they need to find ways to make it cheaper; and that usually leads to layoffs. If more people don not have jobs, then less stuff is being consumed which leads to even smaller margins for producers. You can see the nasty spiral that is self-preserving here, and it only gets worse over time. To combat deflation central banks will typically try to make the act of borrowing money more accessible by lowering interest rates and making it sensible to do so. The increase in money available has the effect of decreasing the value of the currency, therefore creating inflation by way of supply.

Zinflation

Zinflation is the term we are using for when interest rates stay the same over a period of time. Back in the 1990s the idea of zinflation was something that was debated as being the ultimate goal of central banks and even Federal Reserve Chairman Alan Greenspan expressed a desire to achieve it. Since then, the experience of Japan in the Lost Decades has served to make zinflation less desirable, as it would be likely synonymous with lack of growth for an economy as well. Therefore, the model of low inflation near the 2%-3% level has become the preferred model to begin the 21st century.

Key Economic Announcements

Economic announcements, or new events, are a widely followed aspect of trading due to their influence on monetary as well as political policy. Therefore, it is important to know which announcements are going to create the most impact and volatility so as to take advantage of their movements. Here are some of the most widely revered events and their meaning.

Employment

Whether we are talking about Non-Farm Payrolls (NFP) in the US or Employment Change in Australia, economic announcements about jobs are an incredibly important measure of the growth or contraction of a particular region. Many of the central banks around the world have (healthy employment) or some derivative of that as one of their mandates. So if employment is not performing up to the level they would prefer, they could adjust their monetary policy to boost it, therefore influencing a variety of other factors as well.

Consumer Price Inflation (CPI)

Almost always lumped in with employment on the mandates of central banks around the world is (price stability). While there are plenty of measures for inflation including Producer Price Index (PPI), Import/Export Prices, Food Price Index (FPI), Retail Price Index (RPI), Wholesale Price Index (WPI), among others, the CPI is usually the most respected due to its proximity to the consumer. Most developed economies prefer their CPI to be around 1%-3%.

Central Bank Meetings

One of the reasons we watch other economic announcements so diligently is to try and predict what the central banks will be doing with their future monetary policy. Therefore it only makes sense that we play close attention to what they actually do when they make their decisions as well. Interest rate hikes or cuts, forward guidance on future policy, or even introduction of unconventional measures are things we have come to expect from these meetings and their effects are both immediate and long lasting.

Consumer and Business Sentiment

The multitude of consumer and business sentiment reports that are released across the globe on a monthly basis is staggering; however, they all play their part in shaping the markets expectation for the future. Anecdotally, businesses are usually ahead of consumers in feeling apprehensive or optimistic for the future, and if both sentiment indicators are heading in the same direction, that is typically a stronger signal.

Retail Sales

One of the main drivers of developed economies is their propensity to consume. Retail Sales measures that consumption proclivity better than most other indicators and is widely followed because of it.

Leading Economic Indicators

Economic indicators, or economic releases, are vital components to consider when making trading decisions. While some releases like Employment data or Retail Sales gives us a snapshot of an economy strength or weakness, some are a bit more subtle in their ways and can actually serve as a leading supposition of what is to come for the main releases. In the spirit of trying to predict how the more important indicators will fare, here are some leading economic indicators that could give you a clue of how they will turn out.

Consumer and Business Surveys

When looking at economic releases, we have to realize that everything is ultimately related to the habits and actions of consumers: Retail Sales is a direct measure of how much consumers purchase; Gross Domestic Product is a direct measure of the capital spent by businesses and consumers; Employment is directly driven by demand to make product that is purchased by consumers; the list goes on. Taking that knowledge in effect means that it is incredibly helpful to have a measure of the optimism or pessimism of consumers, and surveys deliver that to us. It is imperative to be cautious when trying to assess the impact of the surveys because they have a different time reference than the more vital reports.

Survey results are usually reported about a week or two after the surveys are conducted whereas a report like Retail Sales can be reported anywhere from two to six weeks after the month end. Therefore matching the timeframes for the various reports is an absolute necessity.

Purchasing Manager Indices

There are a variety of PMI reports that get released by a few institutions (ISM and Markit chief among them), and all have varying degrees of importance; however, among them all, the flash, or (preliminary), releases are the most telling. The reasoning behind that importance is directly related to their timing. The flash reports are typically released mid-month or slightly after to measure how the month has been going so far according to purchasing and supply executives. The higher above 50 those readings are, the better the month is shaping up for them as they are showing growth. Conversely, (if the figure is below 50), then that represents a majority of negative responses and could signal a pullback in that nations economy.

Vehicle Sales

Government is slow to release their official figures due to their desire to be accurate and probably a few bureaucratic reasons, but businesses tend to be a little more expedient. For that reason, Vehicle Sales for the previous month are reported almost as soon as the month ends while the government figures are released much later. The theory is that if vehicle sales are strong then, most likely, other forms of consumerism will also be strong.

These are just a couple of the leading economic indicators you can use to help yourself get a leg up on the competition, and the more you watch them, the more comfortable you can become in utilizing their knowledge.

Using Fundamental Analysis

Fundamental Analysis is a broad term that describes the act of trading based purely on global aspects that influence supply and demand of currencies, commodities, and equities. If you happen upon someone whom is touting chart patterns or overbought/oversold levels, you have crossed over into the technical analysis realm. Many traders will use both fundamental and technical methods to determine when and where to place trades, but they also tend to favor one over the other. However, if you would like to use only fundamental analysis, there are a variety of sources to base your opinion.

Central Banks

Central banks are likely one of the most volatile sources for fundamental trading. The list of actions they can take is vast; they can raise interest rates, lower them (even into negative territory), keep them the same, suggest their stance will change soon, introduce non-traditional policies, intervene for themselves or others, or even revalue their currency. Fundamental analysis of central banks is often a process of poring through statements and speeches by central bankers along with attempting to think like them to predict their next move.

Economic Releases

Trading economic releases can be a very tenuous and unpredictable challenge. Many of the greatest minds at the major investment banks around the world have a difficult time predicting exactly what an economic release will ultimately end up being. They have models that take many different aspects into account, but can still be embarrassingly wrong in their predictions; hence the reason that markets move so violently after important economic releases. Many investors tend to go with the (consensus) of those experts, and typically markets will move in the direction of the consensus prediction before the release. If the consensus fails to predict the final result, the market then usually moves in the direction of the actual result – meaning that if it was better than consensus, a positive reaction unfolds and vice versa for a less-than-consensus result.

The trick to trading the fundamental aspect of economic releases is to determine when you want to make your commitment. Do you trade before or after the figure is released? Both have their merits and their detractions. If you trade well before the release, you can try to take advantage of the flow toward the consensus expectation, but other fundamental events around the world can impact the market more than the consensus read. Trading moments before the economic release means that you have an opinion on whether the actual release will be better or worse than the consensus, but you could be dreadfully wrong and risk large losses on essentially a coin flip. Trading moments after the economic release means that you will be trying to establish a position in a low-volume market which presents the challenge of getting your desired price.

Geopolitical Tensions

Like it or not, some countries around the world don not get along very nicely with each other or the global community and conflicts or wars are sometimes imminent. These tensions or conflicts can have an adverse impact on tradable goods by changing the supply or even the demand for certain products. For instance, increased conflict in the Middle East can put a strain on the supply of oil which then makes the price increase. Conversely, a relative calm in that part of the world can decrease the price of oil as supply is not threatened. Being able to properly predict how these events will conclude may be a way to get ahead of the market with your fundamental perspective.

Seasonality

The seasonality as related to weather is something that makes sense as the natural gas example pointed out above, but there are other seasonal factors that are not related to weather as well. For instance, at the end of the calendar year many investors will sell equities that have declined throughout the year in order to claim capital losses on their taxes. Sometimes it may be beneficial to exit positions before the year-end selloff begins. On the other side of that equation, investors typically come back to equities in droves in January, a phenomenon called (The January Effect). The end of a month can be rather active as well as businesses that sell products in multiple nations look to offset their currency hedges, a practice termed (Month-End Rebalancing).

Some fundamental factors are more long-lasting while others are more immediate, but trading them can be both difficult and rewarding for those who have the intestinal fortitude to trade them. Also, the fundamental factors listed above are just the start to a list that is much longer in length as new fundamental methods of trading are created every day. So keep your eyes open for new situations that arise and maybe you could be fundamentally ahead of the curve!