Fundamental analysis is a way of looking at the market by analysing the economic, social, and political forces that can affect the supply and demand of an asset. As anyone with even a basic grasp of economics will tell you, price is almost entirely determined by the laws of supply and demand.
It is easy to determine where price could be headed using supply and demand as an indicator. The difficult part is to determine the factors that affect the supply of, and demand for an asset. When dealing with currencies, it is predominantly economic factors that determine the movements. You need to understand, for example, how events such as an increase in unemployment can affect a country’s economy and the level of demand for their currency.
Basically, if a country’s current or future economic outlook is good, their currency should strengthen. The better shape a country’s economy is in, the more foreign businesses and investors will want to invest in that country. This means that investors will need to purchase that country’s currency in order to obtain those assets.
For instance, if the US dollar has been growing in strength due to an improving US economy, the government may need to raise interest rates in order to control growth and inflation. Higher interest rates will mean that financial assets denominated in dollars become more attractive to investors. In order to purchase these assets, investors need to buy some dollars first, which will increase the demand for the dollar and therefore its value on the foreign exchange market.
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