The Power of Fundamental Analysis in Trading Forex Successfully

As we have seen, fundamental analysis concerns itself with why currency prices are behaving in a particular fashion and what are the underlying causes of the movement. The fundamental analyst uses economic factors and news announcements as the basis for his analysis. From ancient times, speculators have used fundamental analysis and factors like supply and demand to make a profit out of speculation.

The most important thing that fundamental analysis does for us is that it enables us to establish a fair value for an asset such as a currency. Far more importantly, it enables us to use our mental faculties to decide whether the asset is overvalued or undervalued in the current market conditions. We can also estimate when there is likely to be a correction and base our forex trading on this estimation. If we feel that an overvaluation is not sustainable, we can go short on the currency and cover when the correction occurs.

As always, the best way to learn is to use a real-life example and we will consider George Soros and the Bank of England. The story has been told often but it still remains a great story and, more than that, provides an excellent illustration of the triumph of fundamental analysis. The story begins in 1979 when, to establish a measure of currency stability, the European countries established the European exchange rate mechanism (ERM) which established a fixed-rate between the national currencies and the currency that would become the Euro. Currencies were allowed to fluctuate against each other within a band of 2.5 percent of the fixed-rate.

Britain decided to join the ERM in 1990 when inflation was quite high. For various reasons, Britain decided to tie its interests to German Bundesbank policies at a time when German interest rates were even higher than Britain’s. George Soros and his team had an impeccable track record in fundamental analysis and they had already made a lot of money out of the collapse of currency pegs and the general deregulation of the 1970s. Soros was quick to spot the increasing difference in performance between the British and German economies at that time and the fact that the relatively fragile British economy just could not be expected to keep pace with the Germans. He was convinced that Britain would sooner or later be forced out of the ERM and he began shorting the pound sterling. It is thought that his accumulated short position eventually touched 10 billion US dollars.

Britain’s position as an exporter became increasingly untenable as the US dollar continued to depreciate and the breaking point was reached when first Denmark and then France expressed reservations about the ERM. Despite spending billions of pounds defending the pound sterling and raising interest rates to 15 percent to stem the damage, Britain was forced to abandon the ERM and to fix interest rates at 12 percent. Soros is popularly credited with a profit of over one billion US dollars and will forever be known as “the man who broke the Bank of England”.

The main lesson to take away from the story is that fundamental analysis, if correctly performed, is reliable and that imbalances will always correct themselves sooner or later. Soros had both the capital and the courage of his convictions to hold his position for months. The other lesson to take away from the story is that politics is inseparable from major economic decisions and Soros had the understanding of both to be able to capitalize on this opportunity.