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Fundamental Divergence

What is Fundamental Divergence in the Forex Market?

The Forex market is the world’s biggest financial market, run through an electric system with no central exchange. Therefore, traders from all around the world see the same chart and the same price from any place and at any time. The forex market's main price driver is the fundamental releases and news where there is a smooth relationship between fundamental releases. 

However, when one fundamental release does not support another, then fundamental divergence may create a potential trading opportunity.

Why are Fundamental Releases Important?

Fundamental releases are the most significant price driver for the forex market. As we know, the forex market is driven by the central bank and prominent financial institutes; any central bank intervention directly affects the forex market.

For example, if the central bank raises the interest rate, people have to pay higher interest if they lend money from the bank to reduce the country's money supply. As a result, the investment will reduce, and finally, it will reduce inflation.

On the other hand, a decrease in interest rate will increase the money supply in the country. As a result, inflation will be higher. Moreover, the higher GDP, retail sales, and controlled CPI will allow the central bank to decide whether they should increase the interest rate.

If we match the news and its effect, we will find this:

Cause

Effect

Increase interest rate

Decrease Inflation

Decrease interest rate

Increase Inflation

Increased Unemployment

Decrease Interest rate

Decreased Unemployment

Increased Interest rate

As a trader, we have to analyze the economic releases and match the effect to find a suitable trading idea.

What is Fundamental Divergence?

What is Fundamental Divergence in the Forex Market? 1

If you read the above section, you would know how an economic release affects other economic releases. However, in some cases, one economic release might not support another, called fundamental Divergence.

For example, an economy struggling with higher unemployment and if the central bank raises the interest rate will be weaker immediately instead of getting stronger. Therefore, traders who have good knowledge about the fundamental releases of a country would interpret those releases to predict the upcoming movement.

Fundamental Divergence happens due to an unbalanced decision from the central bank that makes a sharp impulsive movement in the currency market.

Why does Fundamental Divergence Happen?

The main reason for the fundamental Divergence is the unbalanced economy. Every central bank has a long-term goal where there is a country's economic situation in the next few years. In that case, the central bank sometimes violates the economic balance to achieve the target. Moreover, the geopolitical condition and other inbound and outbound factors for the economy are also a reason for fundamental Divergence.

For example, Japan is an export-oriented country. Therefore, the Bank of Japan always tries to keep the interest rate lower and inflation higher to ensure enough money supply worldwide. However, any increase in interest rate would negatively impact the Japanese yen instead of making the Japanese Yen stronger.

Identifying the fundamental Divergence is very simple, where traders should focus on economic releases as soon as the news comes. 

How To Trade the Fundamental Divergence?

What is Fundamental Divergence in the Forex Market? 2

There are many trading strategies globally based on fundamental convergence where economic release supports another economic release. However, fundamental Divergence is also an effective way to make money from the forex market. Follow these steps to understand how to trade the fundamental Divergence:

1# Economic Condition

Focus on four major releases that have an immediate impact on the currency valuation-

  • Interest rate
  • Inflation
  • Unemployment
  • GDP

Make a list of economic releases for the last two year data and carefully monitor if the present release supports the condition or not.

2#Identify the Divergence

In this section, you have to evaluate the present data with the past data to identify the Divergence when you input the latest economic data. For example, if you find that the interest rate change is not supportive of inflation or the Unemployment rate is not supportive of the interest rate change, you can consider the report a fundamental divergence. 

3# Understand the Market Context

Identifying the fundamental Divergence does not mean jumping the trade immediately. Instead, it provides an idea about the market that may increase the probability of trading. In that case, you should consider the fundamental Divergence as an indication of future price movement and take trading decisions based on a systematic trading strategy.

If you see the interest rate is increasing by the central bank, but other economic factors are not supporting the rate hike, you can consider that the interest rate hike might not sustain longer. 

Summary

Let’s summarize the fundamental Divergence in the forex trading-

  • Fundamental Divergence happens when one economic release does not support another economic release.
  • Fundamental Divergence indicates a market reversal.
  • Traders should include fundamental Divergence in their trading strategy to increase accuracy.

Besides, having healthy trading psychology and money management is evident for every trader. Whether you follow technical or fundamental analysis, you should stick to your trading strategy firmly. 

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