Using fundamental analysis to trade Forex can be very dangerous when it is not done right. Ironically, traders relying upon fundamental analysis rather than some form of technical analysis tend to lose money more quickly than if they just stuck with technical analysis. This seems strange and counter-intuitive, but it is true. In this article, I will explain why using fundamental analysis exclusively can be dangerous, then I will show how the right type of fundamental analysis can be used to make your trading better, if it is something you really want to use. I will focus on what the fundamental situation will likely be at the start of 2018. You certainly don’t need to use fundamental analysis to make money over the long-term in the Forex market, but it can help.
Why Mechanical Fundamental Strategies Perform Worse than Trend-Following Strategies
Fundamental analysis sounds like a sensible, conservative method to use to decide where to put your money. After all, if you were considering investing in a stock, you would feel good about performing due diligence on the company, checking its financial position, and being convinced that the economy was likely to grow over the time horizon of your investment. So, doesn’t it make sense to feel the same way about the country whose currency you are buying, even if your time horizon is shorter than that of a typical stock investment? Well, it’s a logical approach, but there are two immediate problems in applying this principle to Forex. Firstly, which fundamental indicators are you going to use to make your call on the fundamentals? Secondly, it seems clear that fiat national currencies are far less affected by economic fundamentals than stock markets are, so even if you pick the right variables for your analysis, they are not likely to be very useful. Currencies are not the “stock” of a nation, they are debt instruments issued by its central bank.
Let’s consider some of the most popular fundamental analysis indicators which can be applied to currencies:
- Fair Value: you consider the relative costs of a basket of goods in two different currencies, selling the one which seems overvalued, and buying the one which seems undervalued, hoping the values will merge. It is very logical, but it simply has not worked in recent decades. It completely discounts the fact that there are good reasons why goods and services are relatively more or less expensive in different countries.
- Interest Rate Differential: currencies with higher interest rates tend to attract more investment, meaning speculative money should flow from currencies with lower interest rates into currencies with higher interest rates. Therefore, it should be possible to profit from buying currencies with higher rates using currencies with lower rates. An added benefit of such a fundamental strategy is that the overnight fees charged daily by your broker should be low, or even positive in your favor, as they are based upon the market’s expectation of the future rates. The good news is that this strategy has been shown to generally produce a small positive edge. The bad news: the edge is small, and the strategy keeps you out of some great trades. It also tends to stop working during times of market turbulence. There can be strong, long-term price trends going against LIBOR rates for months without end. Furthermore, for some years now we have been living in an era of low interest rates, so the available differentials between the major global currencies are very small.
- Economic Growth: buy currencies with strong and/or increasing GDP numbers, and sell currencies with weak and/or falling GDP numbers. This sounds logical, yet there is no evidence it works as a standalone strategy.
Central Banks are Key
If typical fundamental approaches are flawed, what can you do? Well, a better fundamental analysis strategy is to be aligned with the positions of the currencies’ central banks. Consider the fact that any central bank can create as much supply of their currency as they want, and reduce a lot too, as well as (usually) having the power to set the currency’s interest rate. This is a lot of power to move the price. Unfortunately, central banks don’t put up signs saying “tightening” or “relaxing”, which would make this kind of strategy an awful lot easier! Yet it is possible to follow the central bank releases yourself, which are given monthly (in most cases), and to read intelligent commentary on them, to develop an opinion. You will probably require the intelligent commentary as even if you read the full texts of the central bank releases, unless you are very clear what you are looking for, you probably will not be able to come to a correct conclusion. Another approach which works well is to look for surprises in central bank releases. For example, at the time of writing, the Bank of Canada has just made it clear that they see a rate hike in January 2018 as less likely. This surprised the consensus, and the value of the Canadian Dollar continues to fall. It is normal for most central bank releases to move their currency, but when there is follow-though the next day instead of a reversion back to the mean, that can be a good sign that you have a fundamentals-driven price move going on which is likely to last longer.
Central Banks in 2018
A good starting point for a productive program of Forex fundamental analysis is to make a list of the major central banks, in order of importance, and to summarize their attitude towards their currency. Then it makes sense to check whether there are any trends which are matching any identified divergence between central banks. It is not an exact science, and it is important to realize that there are other major fundamental factors which can come into play. An excellent example is Britain’s impending departure from the European Union, the exact terms of which are still under negotiation. As Britain’s economy is highly dependent upon the terms of its trade with the European Union, the terms of that trade are going to affect the pound, with the pound advancing on a softer Brexit and falling on a harder one.
So here is my 2018 assessment of the currency stances of the important central banks (in order of importance), ranked by order of importance to the Forex market.
Federal Reserve (U.S. dollar) – tightening monetary policy, but concerned about the lack of inflation, meaning inflation rate data becomes important. If inflation is higher than market expectations, the USD should tend to rise on anticipation of more and faster future rate hikes.
European Central Bank (euro) – minor, very cautious tightening is possible in the shape of unwinding the balance sheet, but interest rates remain negative and inflation is almost non-existent. It is still hard to imagine rate hikes.
Bank of Japan (Japanese yen) – there is some economic growth, but it looks as if the BOJ is on autopilot as no tightening or rate hikes are expected throughout the entirety of 2018 and beyond. Inflation remains very weak.
Bank of England (British pound) – there is little economic growth, but the BoE seems set on a course of further tightening of monetary policy by hikes in the rate of interest, because the rate of inflation has climbed to a relatively high 3.1% annualized rate. Without the inflation, there would probably not be any hikes happening soon.
Swiss National Bank (Swiss franc) – this is a special case. As almost all major national currencies are extremely weak, the SNB maintains an extremely loose monetary policy with a negative interest rate of -0.75% to stop the Swiss Franc from appreciating as a safe-haven investment. The policy has succeeded in stabilizing the Franc, and this currency is an extremely dangerous bet. It has a strong tendency to revert to the mean and stay stable, rather as Gold has over recent years. Growth and inflation are extremely weak, so the SNB is determined to stop the currency from appreciating.
Bank of Canada (Canadian dollar) – GDP and inflation have been relatively healthy, with the interest rate also at a reasonable level of 1.0%, but recent concerns about a slowing of growth have staved off the likelihood of monetary tightening happening soon. This is one to watch carefully, but we might be seeing the start of a fundamentally-driven long-term weakening in the Canadian Dollar.
Reserve Bank of Australia (Australian dollar) – despite historically low interest rates, inflation and growth remain stubbornly low, and they seem to be taking a turn for the worse as poorer than expected trade data comes in. While it doesn’t look like we are going to see any weakening of policy, further tightening appears to be convincingly off the agenda.
Reserve Bank of New Zealand (New Zealand dollar) – growth is relatively healthy, though the GDP is still barely 1%, and the rate of inflation is marginally higher than the relatively high interest rate. The new government seem to be determined to pursue a balancing act of avoiding any real tightening while also avoiding significant loosening. All this suggests a somewhat weak monetary policy, although the market has been impressed by the nomination of a new Governor of the RBNZ who is expected to keep managing inflation as a high priority.
Conclusion on the State of Forex Fundamentals
There is no doubt that the global picture of the advanced economies listed above is one of a generally weak monetary policy, with little divergence in terms of growth, policy, or interest rates. This points to a dull Forex market, which is what we are currently experiencing. However, it can be said that fundamentally, the U.S. dollar currently looks relatively strong, followed by the euro. Continuing weakness looks most likely in the Canadian dollar. This suggests that the most fundamentally convincing Forex trades which match the technical picture are long USD/CAD, and possibly long EUR/CAD as well.
It is crucially important to only trade fundamental conclusions you might arrive at when they are matched by the technical picture. There should be a reasonably long-term trend in the direction of the fundamentals, or at least it should be clear that the price is continually failing to move against it. This is the best way to use fundamental analysis in Forex trading. Now, this would suggest that the trades best supported by a combination of fundamental and technical factors are likely to be long USD/CAD, long EUR/CAD, and possibly long USD/JPY as well. Fundamental analysis, just like technical analysis, requires constant review of the situation, which can change from month to month, so the current picture is not guaranteed to last throughout 2018.