Fundamental Analysis Explained

book-threedimensionalapproachYou don’t need to be an economist to understand the fundamental news, but it helps ! However, it’s a fact of life that fundamental news is important, as these economic releases are used by policy makers, government bodies and financial institutions to gauge the strength of the economy of the country, and to set monetary policy accordingly.

From a forex traders perspective, economic data is the catalyst that routinely stirs up market reaction and gets the markets moving, when otherwise they would meander aimlessly in a sideways channel, but the key of course is to try to make sense of the economic data that is presented and how it is likely to affect the market.

The good news is that all these releases are both freely available, and also scheduled well in advance, so we only have to look at an economic calendar of events to see what fundamental news is due for release either during the day, or over the next week or month. In addition, these economic calendars not only tell us when the data is due for release, but also generally provide an historical chart of the previous releases, along with the market’s expectation for the forthcoming announcement. For any particular piece of economic news, we have a visual picture, along with the experts view of what the number may be this time around.

This is where the simplicity of analyzing and interpreting economic data ends and the hard part starts, and many forex traders simply fail to understand either the importance of each release, or indeed why markets react positively to bad news, and negatively to good news, which often seems contrary. The place to start here is in understanding how economic data is ranked in terms of importance and why.

Why is some news important

If you’re like most people, you probably have a basic understanding of some economic reports, which often appear in the primary news channels or in the newspapers, so the unemployment rate or the latest CPI data may at least be familiar. However, like most people, you probably don’t have a strong sense of how to put this information together in order to develop a clear picture of the overall economy of the country. Whilst the economic calendar helps in terms of ranking releases in terms of their importance, so a red flag would indicate a very important release, whilst an orange or yellow may carry less weight, there is little else to help with explaining why this is important, or indeed how the market is likely to react. So the starting point in all fundamental analysis to is understand which are important, and why, and how the markets will react based on their understanding, given that the policy makers area also watching these figures and which will ultimately be used in forming future monetary policy for the country’s economy.

Jobs data

Top of the list of economic releases comes employment, or unemployment – the jobs market data, simply because this is a crude measure of the health of the economy. If jobs are being created, then more wages are being paid, consumers are consuming more, and economic activity is likely to expand resulting in more jobs. As a general rule, the currency markets will normally view a good jobs number as positive, as it is signaling growth and demand for goods, which in turn will lead to wage driven inflation, which is then managed by the central bank in terms of interest rates. The potential for rising interest rates is seen as positive in creating the all important interest rate differential for traders, investors and speculators.

From this one would conclude that any employment data that is good will result in the currency strengthening, and if the data is poor, then the currency will weaken. All very straightforward one would think! Sadly this is not the case as all data is relative, and it’s relative for two reasons.

Firstly, all economic releases are preceded by the experts view, who give the market an expectation of what the number is likely to be on each release. If the number is worse than expected then the market may react accordingly, even if the data is positive. In other words, the data is less positive than expected, so even though the news is good, it’s not as good as the market’s expectation and so disappoints with the currency weakening.

Secondly, all data is always viewed in the light of what’s gone before, so even if the number might be positive, it could be highlighting a change in the longer term trend for the data. So for example the number may exceed the market’s expectation, but when judged against the historical releases over the last few months, may show a trend of a slowing market, which could be a worrying signal. So, when you are looking at an economic release, not only do you have to be aware of what’s expected, but also what the overall trend has been over the last few weeks months or even years. As a general rule, the more pronounced the trend then the more likely the reaction to a number which is ‘out of balance’ will be short lived. Conversely, the more ambiguous or fluid the recent data, then the more likely that the market reaction to the news will be longer lasting.

This is why it is so difficult to forecast how the market will react to any news – it is all relative. A classic example of this is where a currency reacts positively to bad news, and this occurs when the news is not as bad as expected, with the market breathing a sigh of relief as a result, and promptly rises. To the untrained eye this looks extremely odd, with bad news prompting a positive response in the currency, but once again it’s all relative.

The overall trend is the key

The recent trend also plays a part here when news is released. If a market is rising, and the data is positive, but perhaps slightly less positive than expected, then the market may fall as a result, as it is in bullish mood. Equally, if a market is falling and a bad number is released, but which is perhaps not as bad as expected, then the markets may react positively by reversing temporarily. However, it is important to realise that one release of fundamental news, whether good or bad, will ever change the longer term trend. No one number, no matter how big, will ever change the trend. It may reverse in the short term, but ultimately the longer term trend will be re- established once the news has rippled through the markets and have been absorbed.

The key number that all forex traders watch every month is the jobs report from the US Department of Labor, which is released on the first Friday of every month at 08.30 EST, and referred to as the Non Farm Payroll or NFP for short. This is the big one, which causes extreme volatility each time it is released as it reports the changes in the labor market month by month, as well as providing a wealth of information about the average hours worked, average rates of pay, and detailed statistics on all aspects of the labor market.

Typically what tends to happen on the release is that the market moves violently in one direction, only to promptly reverse and move equally quickly in the opposite direction. The reason that is always given for this is that the market has reacted to the initial headline numbers, which essentially are whether jobs have been created or lost in the month, coupled with a headline rate of unemployment, so the market is reacting to these numbers. Some minutes later the market then moves in the opposite direction and the reason always quoted here is that it has now had time to absorb the detail behind the numbers and react accordingly. This is complete rubbish.

What is actually happening is this : as the news is released, those traders who trade the news, jump on the opening move and chase the market as it moves fast leaving wide stop loss orders in place. The market makers, having initially moved in one direction, then reverse the market, taking it in the opposite direction, collecting all the stop loss orders along the way.

Finally, the other important element to keep in mind when looking at any economic data is the dreaded revision, which happens all the time across all the releases, and is simply a fact of life. Data is changed for all manor of reasons, most of them spurious, but generally to put a gloss on an otherwise bad number, so when looking at historical data, it always pays to check to make sure that the number from last month was in fact correct and not revised later, which is often the case!