How to Capture the Underlying Logic of Currency Value through Fundamental Analysis in the Forex Market?

TradingKey - Fundamental analysis plays a crucial role in forex investment decisions. In a highly interconnected global economy, economic data and policy adjustments from different countries directly impact the direction of the forex market.

By systematically analyzing fundamental factors, investors can identify the underlying driving logic of currency value and make more forward-looking investment decisions, avoiding blind adherence to market sentiment.

Economic indicators are quantitative data that reflect a country’s economic conditions and provide important insights for assessing the long-term trends of currencies.

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) serves as an important metric that assesses the total value of goods and services produced in a nation or area during a designated timeframe.

It comprehensively reflects the overall scale and growth rate of the economy.

A robust GDP suggests that the economy of the country is flourishing.

Companies are busy expanding production, consumer spending is high, and there are many job opportunities, which naturally attracts global capital for investment.

In such cases, everyone wants to hold that country’s currency, driving its appreciation. For instance, if you observe U.S. GDP growing by more than 2% for two consecutive quarters, the dollar typically strengthens as a result.

Conversely, if a country's GDP consistently declines—leading to layoffs and capital outflows—its currency may deflate like a punctured ball and struggle to recover.

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Inflation Rate

The inflation rate (commonly measured by CPI and PPI) indicates whether prices are rising or falling and directly affects the purchasing power of a currency.

If CPI rises by 4% year-on-year, it means that your money will only buy 96% of what it could last year—indicating a decrease in real purchasing power; in this case, central banks may raise interest rates to combat inflation.

For instance, when inflation in the Eurozone soared to 8% in 2022, the European Central Bank was forced to raise interest rates.

Although this temporarily boosted the euro's value, it also placed pressure on the economy. Moderate inflation (around 2%) is normal; however, excessively high or low inflation (deflation) can harm currency value.

Unemployment Rate

The unemployment rate is a direct indicator of how competitive the labor market is.

When you see a country’s unemployment rate declining, it indicates that companies are actively hiring, residents' incomes are increasing, and there is a strong enthusiasm for consumption and investment.

All of these factors contribute to economic growth and make the currency more sought after.

Interest Rate (IR)

Interest rates directly impact the direction of global capital flows.

If the Bank of England raises interest rates from 0.5% to 1.75%, you might think, "Saving in pounds will earn more interest—should I convert my euros into pounds?" This illustrates the power of interest rate differentials: currencies with higher interest rates attract capital like a magnet, driving up their exchange rates.

Conversely, when interest rates decrease, funds tend to flow toward currencies offering higher returns; for example, when the Federal Reserve lowers interest rates, the dollar often weakens.

However, raising interest rates can have side effects: increased borrowing costs for businesses may suppress economic growth; therefore, central banks are cautious with each adjustment.

Trade Balance (TB)

The trade balance represents the disparity between a nation’s exports and imports.

The surplus or deficit in a country's trade balance directly influences its financial standing in international markets.

When exports exceed imports (a surplus), as seen in China, foreign buyers need to convert large amounts of currency into renminbi to pay for goods—this increases demand for renminbi and naturally creates upward pressure on its value.

Conversely, when imports exceed exports (a deficit), as seen in the United States, it necessitates borrowing from abroad to fill the gap; over time, this can exert downward pressure on the dollar’s value.

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Political Events

Significant political events can have a substantial impact on the forex market, altering investors’ expectations regarding a country's economy.

For example, during U.S. elections, investors' predictions about the electoral outcomes can influence changes in the dollar's exchange rate.

The Brexit referendum serves as a classic case; after the results were announced in 2016, the British pound (GBP/USD) plummeted by 11% overnight.

In subsequent years, every piece of positive or negative news concerning Brexit negotiations (such as agreements reached or negotiations breaking down) caused extreme fluctuations in the pound.

Political stability acts as a currency’s “foundation”; when this foundation is shaken, exchange rates can experience abrupt volatility.

It is crucial to check your target country's political calendar before trading.

Economic Policy Releases

Adjustments to monetary and fiscal policies by central banks or governments significantly influence currencies:

Monetary Policy (Interest Rate Hikes/Cuts): When the Federal Reserve announces an interest rate hike, the dollar often surges in the short term because high interest rates attract global capital seeking returns in U.S. markets.

A typical example is when, in 2022, the Fed raised rates to 4.5%, leading to a 15% increase in the dollar index that year.

Conversely, interest rate cuts diminish a currency's attractiveness.

Fiscal Policy (Tax Cuts/Increases): Government tax cuts or increased infrastructure spending may stimulate economic growth (positive for currency), but they may also lead to high inflation or fiscal deficits (negative for currency).

Geopolitical Conflicts

Wars or tense international relations can trigger risk aversion among investors.

Following the outbreak of conflict between Russia and Ukraine, you would have seen significant declines in the euro against the dollar (EUR/USD)—due to Europe's proximity to crisis zones prompting investors to flee euro-denominated assets into safe-haven assets like dollars and gold.

Similarly, during heightened tensions in regions like the Middle East, traditional safe havens such as Swiss francs (USD/CHF)tend to strengthen while currencies closely tied to conflict economies (like those of energy-exporting countries) may experience dramatic volatility.

When geopolitical risks arise, technical analysis often becomes less effective; at this time, it’s vital to assess risk exposure: Are you overly leveraged in Ukraine-related currencies? Should you use hedging tools (like going long on dollars) to mitigate risk?

Release of Major Economic Data

Monthly data releases—such as non-farm payroll figures, GDP growth rates, and PMI indices—can cause market fluctuations if actual figures deviate from expectations.

For instance, if market forecasts predict U.S. CPI at 5%, but actual figures come out at 5.5%, exceeding expectations can heighten anticipation for rate hikes and potentially cause a sharp rise in the dollar's value short-term.

Conversely, if it comes out at 4.5%, this could lower expectations around inflation.

You should use an economic calendar beforehand to better understand market expectations and adjust your positions before data releases: for example, before releasing key data ensure you're not heavily positioned long euros/dollars before announcements; After announcements assess based on "expectation discrepancies" when deciding buy/sell actions.

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Given how vital news information is, how can we effectively keep track of significant events affecting markets?

This brings us to emphasize the importance of an economic calendar—it outlines key upcoming events over the next week, such as Federal Reserve meetings, UK election voting days, and China’s PMI release dates.

You should spend about ten minutes each day reviewing it and marking events that have the most significant impact on your trading pairs.

For example: If you primarily trade AUD/USD and see that there’s an Australian Central Bank interest rate decision scheduled for Wednesday, you should adjust your positions ahead of time on Tuesday to avoid being heavily leveraged before the decision is made.

Afterward, based on the policy statement (whether it indicates a hike/cut/neutral), you can then decide whether to go long, short or remain on the sidelines.

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