Fundamental analysis is based on using the macroeconomic data, political events and financial news reports to predict the market development. Fundamental traders believe that the demand for currency depends of how powerful is the country's economy. Political events are considered since they can impact the economic situation.
The main Forex fundamental analysis theories are PPP (or Purchasing Power Parity), IRP (or Interest Rate Parity), Asset Market model and Balance of payment model.
The PPP theory of Forex fundamental analysis claims the exchange rates to be determined by the relative prices of similar goods' baskets. Inflation rates changes tend to be offset by equal but at the same time opposite changes with the exchange rate. The example can be shown on chocolates. In the USA, the chocolate costs $2, at the same time in the United Kingdom this chocolate is traded for 1 pound. So according to this theory, the exchange rate of pound to dollar should be 2 dollars for one pound. In the comparison, if the market rate is about $1.6 per pound, then the dollar is to be overvalued when the pound is undervalued. The PPP theory means in itself that there will be an eventual movement to the 2:1 currencies exchange rate.
In general, this theory has some major weak point. First one is that, according to this theory, all the goods are assumed to be easily tradable, with no additional fees or taxes. Another one is that PPP applies to the goods and ignores services, which can cause the significant difference in value. This theory also does not take into the account the economic reports and releases, political developments and asset markets. The main evidence of PPP's theory effectiveness was last seen prior to 1990s. And after, PPP was seem to be working only during the long terms (3-5 years or more), when prices were eventually corrected towards parity.
Interest Rate Parity or IRP claims that the depreciation or appreciation of one currency towards another should be neutralized with the change in the differential of an interest rate. If Great Britain's interest rates exceed those ones of the US, then the pound will surely depreciate towards the dollar by an amount that can prevent arbitrage without risks. The future exchange rate can be reflected into the forward exchanged rate that exists today. In the example above, the pound can be claimed at discount, because it can buy less dollars in the forward rate than in the spot one. And the dollar is claimed to be at a premium.
Sadly this theory didn't show any proof of working after the 90s. Not mentioning the theory, currencies that showed higher interest rates rather appreciated than depreciated due to the reward of future inflation containment.
The model of Balance of payments holds the fact that a Forex rate has to be at the level of equilibrium (rate that produces the stable current account balance). A nation that suffers from trade deficit will surely experience the reduction in its Forex reserves, which depreciates the value of currency of this country. The cheaper currency is rendering the exports to be more affordable on the global market, when the imports become more expensive. When the intermediate period is over, imports force down and exports rise, stabilizing the currency and trade balance against equilibrium again.
As the PPP theory, this one is focused mostly on tradable services and goods, ignoring the important role of global capital flows. Money is not chasing only goods and services, but rather the financial assets like bonds and stocks. The increase in capital flows gave the rise of the Asset Market Model.
As a conclusion we can say, that fundamental analysis is based on using economic events and financial news releases to predict the further market development. Although, the financial news release, such as Nonfarm Payroll or Retail sales, can have a significant impact on the forex market, the long-term fundamental trading strategies supposed to be supported by the technical analysis.