Fundamental Analysis in Forex: Key Drivers and Real-World Examples
Jun Yuan Kwong, Dealer | Contract for Differences
Jun Yuan graduated from Universiti Tunku Abdul Rahman (UTAR) with a Bachelor’s Degree in Actuarial Science. He is a Dealer in the largest dealing team at Phillip Securities, specialising in CFDs.
Prior to this role, he gained valuable experience as a Unit Trust Consultant, helping clients with financial planning and investment strategies. In his free time, Jun enjoys exploring financial innovations and staying updated on market trends..
Introduction
The foreign exchange (forex) market is influenced by a complex interplay of economic, political, and financial factors. Unlike technical analysis, which focuses on historical price movements, fundamental analysis seeks to understand the underlying reasons for currency fluctuations. This approach is essential for long-term traders, investors, and policymakers who need to assess currency strength based on macroeconomic conditions.
In this article, we will explore three fundamental factors that significantly impact forex price movements: interest rate differentials, economic performance, and political stability. To illustrate these concepts, we will analyse the behaviour of the following currency pairs: USD/JPY for interest rate differentials, EUR/USD for economic performance, and USD/CAD for political issues. Additionally, we will examine how these factors have influenced major forex pairs since 2022.
Interest Rate Differentials: The Case of USD/JPY
Interest rates are one of the most significant drivers of forex prices. When a country offers higher interest rates compared to another, its currency typically appreciates because investors are drawn to higher returns on their investments. This principle, known as the interest rate differential, plays a crucial role in determining exchange rate movements. Traders often monitor central bank policies to anticipate changes in interest rates, as these shifts directly influence currency demand.
A prime example of how interest rate differentials affect forex is the USD/JPY pair. The United States and Japan have historically maintained different monetary policies. The US Federal Reserve(Fed) adjusts interest rates to control inflation and manage economic growth, while the Bank of Japan (BOJ) has kept rates near or below zero to stimulate economic activity and combat deflation.
Since 2022, the Fed has been raising interest rates to combat inflation. The federal funds rate increased from 0.25% in early 2022 to 5.50% by mid-2023 [1]. In contrast, the BOJ has maintained its negative interest rate policy at -0.10% as part of its ongoing stimulus measures [2]. This growing interest rate differential has made the US dollar more attractive to investors, driving the USD/JPY exchange rate higher from around 115 in early 2022 to approximately 158 by January 2025 [3].
Chart: USD/JPY
Source: POEMS
This widening interest rate gap is further bolstered by carry trades, where investors borrow in yen at low interest rates and invest in US assets offering higher returns. However, should the Fed signal a shift towards rate cuts, the interest rate differential may narrow, potentially leading to a reversal in the USD/JPY trend.
Economic Performance and its Impact on EUR/USD
Another critical driver of forex prices is a country’s economic performance. A strong economy typically supports a stronger currency, as it fosters confidence among investors. Key economic indicators—such as GDP growth, inflation rates, employment figures, and trade balances—play significant roles in forex market movements. When a country’s economy is performing well, its central bank may tighten monetary policy by raising interest rates, further strengthening its currency.
The EUR/USD pair offers a prime example of how economic performance affects exchange rates. The eurozone, composed of multiple European nations, faces diverse economic conditions, making the euro vulnerable to fluctuations based on the region’s economic health. In contrast, the US has a more unified economy, allowing the Fed to make policy decisions with greater consistency.
Since 2022, the eurozone has encountered numerous challenges, including high energy costs, slowing GDP growth, and rising unemployment. Conversely, the US economy has remained resilient, driven by strong job creation, consumer spending, and economic growth. As a result, the European Central Bank (ECB) lowered interest rates to 2.65% in March 2025 to stimulate growth, while the Federal Reserve maintained its higher rate environment [4].
Chart: EUR/USD
Source: POEMS
Consequently, the EUR/USD exchange rate has fallen from 1.15 in 2022 to around 1.03 in January 2025, reflecting the stronger US economy compared to the eurozone [5]. As investors continue to favour the US dollar for its stability and higher returns, the euro remains under pressure. However, should economic conditions in Europe improve or if the Fed signals potential rate cuts, this trend could reverse.
Political Stability and Trade Relations: USD/CAD in Focus
U.S. President Donald Trump hosts his first cabinet meeting with Elon Musk in attendance, Washington, D.C., U.S., 26 February 2025.
Source: Brian Snyder | Reuters
Political events and trade policies also significantly influence forex markets. A country’s political stability, government policies, and international trade relations can lead to substantial fluctuations in currency values. Traders closely monitor elections, trade agreements, sanctions, and diplomatic relations to anticipate potential movements in currency pairs.
One of the most politically affected currency pairs in recent years is USD/CAD. The economic relationship between the United States and Canada is strong, making the Canadian dollar (CAD) particularly sensitive to political changes and trade relations. Following the re-election of Donald Trump in late 2024, tensions between the two countries increased due to new trade policies and tariffs.
In January 2025, speculation around potential new U.S. trade policies, including tariffs on Canadian goods, increased uncertainty for the CAD [6]. Investors are closely watching for official announcements, as any new restrictions could weaken the Canadian dollar further. Analysts have expressed concerns that tighter trade policies could slow Canadian economic growth, potentially impacting GDP and leading to further depreciation of the CAD [7].
Chart: USD/CAD
Source: POEMS
Historically, political uncertainty tends to weaken the Canadian dollar, as investors seek safer assets in times of instability. If trade tensions between the US. and Canada escalate further, the CAD could continue to weaken. However, if diplomatic negotiations lead to a resolution and the US eases its tariffs, the Canadian dollar may recover, potentially reversing the upward trend in USD/CAD.
Conclusion
Fundamental analysis remains an indispensable tool for understanding the intricate dynamics of forex markets, offering traders and investors a macro-level perspective on the forces shaping currency valuations. Since 2022, the trajectories of major currency pairs have vividly illustrated these principles: USD/JPY has soared from 115 to 158, propelled by stark interest rate differentials; EUR/USD has weakened from 1.15 to 1.03, mirroring the eurozone’s economic struggles against US resilience; and USD/CAD has climbed from 1.25 to 1.44, rattled by political and trade uncertainties following the 2024 US election. These shifts underscore how central bank policies, economic vitality, and geopolitical developments converge to dictate currency valuations.
Looking ahead, the forex landscape promises continued volatility as global conditions evolve. Traders who adeptly interpret interest rate signals, economic data releases, and political headlines will be best positioned to anticipate trends and refine their strategies. Whether it is the Fed pivoting to rate cuts, Europe staging an economic recovery, or US.-Canada trade tensions easing, adaptability grounded in fundamental insights will separate the successful from the sidelined. In an ever-shifting financial world, mastering these drivers is not just an advantage —it is a necessity for thriving in the currency markets.
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References:
- Federal Reserve Interest Rates – https://en.wikipedia.org/wiki/Federal_funds_rate
- Bank of Japan Monetary Policy – https://www.boj.or.jp/en/mopo/mpmdeci/index.htm
- Japanese Yen Historical Rates – https://www.xe.com/currencytables/?from=JPY&date=2025-03-12
- European Central Bank Interest Rates –https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html
- EUR/USD Market Data – https://www.investing.com/currencies/eur-usd-historical-data
- U.S. Trade Policy News – https://www.cnbc.com/2025/02/27/what-trumps-tariffs-on-canada-and-mexico-mean-for-your-money.html?&qsearchterm=us%20tarrif%20to%20canada
- Canadian Dollar Forecast – https://www.reuters.com/markets/currencies/canadian-dollar-dips-volatile-trading-tariff-implementation-uncertainty-2025-01-31/
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