The basic premise of fundamental analysis is that the value of a currency is determined by the comparative strength and weakness of a country's economy in relation to those of its trading partners. The stronger a country's economy - measured in higher GDP growth, lower inflation, higher interest rates, greater productivity, more political stability, etc. - the stronger a country's currency. Over time, these fundamental factors produce the long lasting price trends typical of the currency markets.
Many factors pertaining to a national economy are monitored, assessed and judged for the effect they have on economic growth and development. These trends are often large and complicated, and can be enacted over a long period of time. Another factor which affects a country's economic status is its political system - the balance between social welfare and individual competition, or the openness of an economy to foreign trade and capital. Other areas include the social and cultural makeup of a nation, such as the productivity, labor mobility, and entrepreneurship. Natural resources also play a part, such as oil or mineral deposits.
Fundamental analysis views an economy and its currency through economic statistics. These statistics often depict a particular sector of an economy rather than the economy as a whole. Because of this, different statistics may point in opposite directions; one area of an economy may be growing while another falters, or the importance of one industry declines as another rises. Most statistics are also retrograde, telling you what has already happened, but not necessarily what is to come.
In our interconnected and volatile world, political, military, human, and even natural events can have rapid, vast, and long-lasting repercussions. A fundamental analyst must take into consideration all this information to create an overall picture of an economy - its strengths, weaknesses, vulnerabilities and, most importantly, its future potential and the likely future course of its currency. Personal judgment and experience come into play to complete the fundamental currency analysis.
Technician or Fundamentalist?
There's a tendency to pigeonhole traders into two distinct schools: fundamental or technical. In fact, most smart traders favor a blended approach versus being a purist of either type. Fundamentalists need to keep an eye on signals derived from price charts, while few technicians can afford to completely ignore impending economic data, critical political decisions or pressing societal issues that influence price action.
Forecasting economic conditions using models
Fundamental analysis is very effective at forecasting economic conditions, but not necessarily exact market prices. Studying GDP forecasts or employment reports can give you a fairly clear picture of an economy's health and the forces at work behind it. But you still need a method to translate that into specific trade entry and exit points.
The bridge between fundamental data and a specific trading strategy usually comes from a trader model. These models use current and historical empirical data to estimate future prices and translate those into specific trades.
Beware of analysis paralysis
Forecasting models are both art and science, with so many different approaches that traders can get overloaded. It can be tough to decide when you know enough to pull the trigger on a trade with confidence. Many traders switch to technical analysis at this point to test their hunches and see when price patterns suggest an entry.
Look for fundamental drivers first
The fundamentals include everything that makes a country and its currency tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events.
That said, not every development will move a country's currency. Try to start by identifying the most influential contributors to this mix versus following every fundamental out there.