I think fundamental analysis has a bad name in the retail trading community because it is (1) hard to do -- almost no one knows how to do it here, (2) requires a more thoughtful analysis, and (3) requires substantial learning. The professional trading world is primarily driven by fundamental research.
In reality, prices exhibit autocorrelation, mean reversion,
and violent regime shifts (gaps). If you are serious about making money, you will want to differentiate between these characteristics and identify what will cause a shift in the characteristic or a level higher/lower. A person trading on just the technicals either doesn't have the curiosity or the skill to analyze the drivers of price and, therefore, won't have an edge or build cumulative excess pnl. Don't mistake visual learning with "technicals vs. fundamentals".
Let's give an example of the USDJPY. Here's how you would approach this fundamentally:
Start with getting "facts" -- what's happening and why?
- Well, from an asset perspective, USDJPY is an exchange rate, which means I can start with the international Fisher effect and work from there. The Fisher effect states that the exchange rate is primarily driven by the difference in interest rates between two countries ("interest rate differentials"). Fundamental insight #1: one driver of dollar-yen is expectations on the rate differential between the Fed and BoJ.
- The chart above also illustrates that rate differentials has been a better strategy than MoMo or mean reversion on USDJPY since Covid/2020. this likely has to do with the big policy differences between BoJ and the US Fed (and other DM central banks).
- From a trading perspective, the BIS compiles analysis of FX trading and liquidity which is insightful. As we can see, derivatives on spot make up 2/3rds of market turnover. This means that activity in the derivatives market for FX is likely driving shorter term price action in spot. If you know about how FX swaps are traded, when you know that dealers can manage delta risk through a variety of means including forwards, options, and dynamic hedging similar to options dealers in stocks. Fundamental insight #2: daily trading is dominated (2/3rds) by derivatives and may be driving price action intraday.
- But there's no real relationship between the level of FX vol on USDJPY and change in price:
Now figure out your edge:
Do you have an edge in trading vols and knowing dealer positioning? Or do you have an edge in predicting rate policy?
Once you know what your edge is you can then build a strategy around trading it. On a trade-by-trade basis, you will look at things such as current price vs. fair value (measured on a z-score) and against the scenarios you think are embedded within price.
E.g. at USDJPY 140-150+, the currency may be pricing in higher for longer US rates with JGBs trading flat. If the Fed cuts, rate differentials will compress, and USDJPY may trade at 120-140 if a soft landing occurs or USDJPY 100-120 in a hard landing where JGB trades flat. If BoJ cuts, then dollar-yen will stay within range.
When you think the distance is sufficient (expected return vs. fair value) and less than the expected risk (a mix of both the sigma of price chg and the level you think the currency will move to if you're wrong), then you enter the trade (and vice versa).
This is typically what a general approach to using "fundamentals" looks like.
