HomeForex CurrenciesFactors Affecting Forex Currencies

Factors Affecting Currency Trading

 

Similar to any other financial price, the price of an exchange rate is determined by the forces of demand and supply. The price of an exchange rate reflects many economic and non-economic factors. The most important factors are inflation, interest rates, growth, and macroeconomic risk.

 

Here are all the major factors affecting the fluctuations of global currencies.

1. Interest Rates

The interest rates of an economy are determined exclusively by the domestic Central Bank such as FED in the US and ECB in the Eurozone. When the interest rate of a Forex currency is increasing, that means that more investment funds are attracted and buy that currency in order to achieve a higher interest return. On the other hand, when interest rates are decreasing a Forex currency is less attractive to investment funds and thus it is expected to fall against other currencies. 

Interest Rates Correlation

1) When Interest Rates increase ↑ → the domestic Forex Currency increases too ↑

2) When Interest Rates decreases ↓ → the domestic Forex Currency decreases too ↓ 

 

2. Economic Growth (GDP)

Economic growth which is measured by GDP change (%) is a key factor determining the demand of a Forex currency. High growth means that an economy is doing well, especially if growth is accompanied by relatively low inflation. Usually, growth of more than 2.5% is followed by high inflation. Additionally, high growth means low unemployment and higher national income, in other words, high growth means higher consumer spending. Overall economic growth leads to domestic currency appreciation.

Economic Growth Correlation

1) When GDP increases ↑ → the domestic Forex Currency increases too ↑

2) When GDP decreases ↓ → the domestic Forex Currency decreases too ↓ 

 

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3. Trade Balance

The balance of trade is the difference between the value of exports and the value of imports. If this difference is positive, the economy produces a trade surplus and that it is favorable for the domestic currency. That is happening as foreign buyers are obligated to exchange more of their home currency than domestic sellers. If this difference is negative, the country has a trade deficit, and that is bad news for the demand for its currency.

Moreover, a domestic currency reflects the government's economic policy regarding the domestic balance of payments. For example, when the government policy aims to shorten the trade deficit imposes restrictions and tariffs on imports or subsidies exports. But usually, this kind of government intervention results in retaliation measures from other countries and thus the long-term effect for a currency may conclude zero or even negative.

Trade Balance Correlation

1) When Trade Balance is positive → the domestic Forex Currency appreciates ↑

2) When Trade Balance is negative → the domestic Forex Currency is losing value ↓

 

4. Inflation Rate

The inflation rate of an economy has a very strong impact on the value of Forex currency. When the level of prices increases, each unit of a currency can buy fewer goods and services, and thus the purchasing power of money is decreasing. On the other hand, higher inflation means higher growth and higher interest rates, this is why usually when inflation grows the domestic currency is increasing against foreign currencies.

Inflation Correlation

1) When Inflation gets higher ↑ → the domestic Forex Currency appreciates ↑

2) When Inflation gets lower ↓ → the domestic Forex Currency is losing value ↓

 

5. Unemployment Rate

When unemployment increases the jobless workers have less income to spend on goods and services and consequently the overall consumer spending is decreasing. Additionally, higher unemployment results in lower consumer confidence and lower expectations about future economic growth and consumer spending. But what really matters in the Foreign Exchange market is that higher unemployment pushes interest rates down.

Unemployment Correlation

1) Unemployment gets higher ↑ → the domestic Forex Currency is losing value ↓

2) When Unemployment gets lower ↓ → the domestic Forex Currency appreciates ↑

Measuring Unemployment

 

 

6. Political stability

Political stability is a very important factor regarding the future value of a Forex currency. Political uncertainty increases the risk of an economy and furthermore it reduces the consumer and investor confidence. When there is no political stability the potential of future economic growth is jeopardized. Furthermore in periods of global political uncertainty investors are after “Safe-Heavens”. That means that they will exchange weak currencies for strong currencies like the US dollar or Euro.

Political Stability Correlation

1) When there is Political Stability → the domestic Forex Currency appreciates ↑

2) When there is no Political Stability → the domestic Forex Currency is losing value ↓

 

7. Central Bank Actions / The Monetary Policy

The monetary policy and the strategy of the Central Bank of a state can determine in a high extend the current and future value of a Forex Currency. As it is already mentioned a Central Bank may interfere by maneuvering interest rates, but also in many other ways. For example, an intervention may involve the purchasing of domestic bonds (i.e. the European Central Bank during 2011-2012).

  • "Never Trade against a major Central Bank unless your name is George Soros"

 

8. Market factors

Market factors may affect also the value of a Forex Rate. For example, when the price of oil goes up, oil-exporting currencies are moving higher against oil-importing currencies. Countries like Norway, Russia, and Canada are affected highly by the market prices of energy commodities and thus their currencies are reflecting and incorporating those price changes very quickly.

 

9. Natural disasters

Serious natural disasters may disturb the growth potential of a country or even increase the amount of government debt. Furthermore, if a natural disaster has a strong impact on the growth potential of an economy it is likely that the Central Bank will decrease the level of interest rates in order to achieve a faster recovery. Natural disasters have an unfavorable impact on domestic currency valuation.

 

10. Currency Speculation

Currency speculation can affect highly the real value of a Forex currency. Large institutional speculators (i.e. hedge funds) have the power to bet against a particular currency aiming profits. For example in 1992 George Soros made over 1 billion USD by short-selling British Sterling.

 

The Role of Consumer Spending

The value of a currency is highly affected by the overall level of consumer spending. When an economy enters recession, consumer spending tends to decline and consequently, the trading sentiment for the domestic currency is declining too. As an overall outcome, the domestic exchange rate is declining against currencies of stronger economies.

 

 

• Factors Affecting Forex Currency Fluctuation
G.P.
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