It is common, particularly in the world of active forex trading, to see a bit of a dislike for fundamental analysis — the study of news and economic factors that drive currency rates. Technical analysis, which is more bottom-line oriented as it helps traders identify where buyers and sellers may be positioned and precise entry and exit points for their trade, is increasingly being preferred.
While I have nothing against technical analysis — in fact, I regard it as an indispensable part of my currency trading — I think it is best utilized in the context of fundamental analysis. In this post, I will offer a step-by-step breakdown of how traders can use fundamental analysis into their technical game plan to identify the best trading opportunities.
- Use Fundamental Analysis to Identify Long-Term Trends. Fundamentals can tell you what long-term trends will be, but they are terrible at telling you short-term happenings. So, start your fundamental analysis with that in mind: it can tell you long-term trends, but you will need technical analysis to give you precise timing and entry/exit points.
- Focus on Budget and Trade Deficits. Part of the challenge with fundamental analysis, and why so many traders prefer to ignore it altogether, is that there can be an abundance of information that makes analysis confusing. The good news is that traders can ignore most of the information they come across, as it most likely will not help them in their trading. One piece of information they can focus on is observing which economies have budget and trade deficits, and how large they are. Economies that have large and growing twin deficits with no signs of reversing are on the fast track to currency devaluation. In market-based economies, prosperity goes to those who produce more than they consume — and twin deficits are a sign that consumption is greater than production. In today's global economy, the US dollar has been running twin deficits for over a decade — and so it is not surprising that a long-term look at a monthly chart of the US dollar shows a clear downtrend as well.
- Focus on Money Supply. In addition to budget and trade deficits, another key factor to observe is money supply, which central banks routinely report (the US Federal Reserve, for instance, gives money supply numbers on a weekly basis). If the numbers are trending upwards, that suggests the potential for currency devaluation resulting from inflation of the money supply. Conversely, declines in the money supply can suggest cash is becoming more scarce, and thus may appreciate in value. When observing this data, do not focus so much on weekly gyrations, but rather what the trend appears to be on an annual basis — that is the key clue we are looking for to gauge the long-term direction of currencies. After all, as Forex educator and trader Peter Bain tells us, the trend is our friend.
Armed with this data — deficits and money supply — we are in a position to make a forecast years out as to where currencies will be. If we do an exhaustive analysis of major currencies, we should be able to see who is trending towards being a producer and who is consuming more than they are producing. This lets us identify the capital flow to trade: we short those who are producing more than they consume (running twin deficits and expanding the money supply) and buy those who have surpluses. Now that we know what asset to trade and what direction to trade it in, then we can bring in technical analysis to help us take positions.