Fundamental Analysis

Fundamental analysis in foreign exchange involves studying numerous economic, financial or political events, as well as economic fundamental data such as interest rates, inflation rates, trade balances, gross domestic product, foreign investment, and a host of other data.

Fundamental analysis can be complex because the market may rely on a different set of economic variables for different currencies, or may shift its reliance on particular economic fundamentals as time passes and economic conditions in and between countries change. For example, at the end of 2004, the level of oil prices became an
important factor in major oil importers’ (and exporters’) currency values. At other times, a worsening government deficit, or a change in expected inflation, will be given more weight in determining currency value. Also, long-run fundamentals—economic factors that change slowly over many quarters, or years, like a country’s productivity, or consumers’ saving behavior—can move currencies in the short-run as the market
changes its expectations in reaction to new information on these variables. For instance, the possibility that the long-run growth in US productivity had risen to a new equilibrium level supported the dollar at the end of the 1990s despite a growing trade deficit.

Market Efficiency?

Because of the constant struggle that occurs as market prices change to reflect fundamental developments, a theory emerged that markets are "efficient" — each price that hits the ticker is considered an accurate reflection of all known factors that affect that market at that point in time. This theory, called the "efficient market
hypothesis," assumes that traders are well-versed in the fundamentals of a market and can immediately gauge the relative importance of any changes. It further assumes that traders tend to act rationally (buy on bullish news and sell on bearish news). Thus, every piece of information is quickly and accurately traded into the
"efficient" market and the market quickly moves to the proper price level to reflect each change in fundamentals.

If this hypothesis were correct, however, there would be little need to analyze the markets at all, because if markets were truly efficient, price movement would be random over a long period of time. From a trading standpoint, there would be no way to predict whether the next piece of news would make prices go up or down. You might as well toss a coin to make a trading decision as spend your time with fundamental or technical analysis. However, most people familiar with markets and trading would probably conclude just the opposite: markets often are not very efficient. In fact, in many cases a more appropriate theory might be the "inefficient" market hypothesis. Why? Because traders frequently aren't sure what news means, or how far prices should move. Basically, they overreact, under-react, or ignore news altogether. The result is that markets frequently don't reflect the fundamentals immediately or accurately. Sometimes reinforcing developments have to occur before an impact is made (the proverbial two-by-four upside the head) and prices make a big move to catch up. Even more commonly, traders overreact to a piece of news, causing an excessive and unwarranted price move. And at times, prices often go nowhere because the bullish and bearish news occurs randomly, or traders are uncertain about the fundamental situation. Ultimately, the market does get the job done of discounting the fundamental developments, but arriving at the "proper" price level can
be an adventure, to say the least.

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